Using Mineral Rights for §1031 Exchange- Part 2

This is Part 2 of Min­er­al rights and the focus in using Delaware Statu­to­ry Trust (DST) that holds min­er­al rights as replace­ment prop­er­ty for 1031 tax deferred exchanges.

May 20, 2024

By Al DiNi­co­la, AIF®, CEPA™
DST 1031 Spe­cial­ist
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD, LLC Mem­ber of FINRA/SIPC

This may be con­sid­ered a strat­e­gy that may be some­what sophis­ti­cat­ed. The process for min­er­al rights DST acqui­si­tion is sim­i­lar to oth­er DST pro­grams. We cov­ered the Sec­tion 1031 tax deferred exchange require­ments in Part 1. Part 2 will focus on the DST acqui­si­tion.  Min­er­al rights in the con­text of the DST includes a vari­ety of rights includ­ing oil and nat­ur­al gas. Typ­i­cal­ly, the own­ers of the min­er­al rights lease the land to oper­a­tors of the min­ing or drilling oper­a­tions.

Delaware Statu­to­ry Trusts (DSTs)

Cre­at­ed under the laws of the state of Delaware, a Delaware Statu­to­ry Trust is a legal enti­ty pro­vid­ing an invest­ment struc­ture for hold­ing real estate. This struc­ture also pro­vides for a DST to be used in exe­cut­ing a §1031 tax deferred exchange.   DSTs are pas­sive ben­e­fi­cial own­er­ship struc­tures, and the ben­e­fits can be reviewed in many oth­er post­ings.

Min­er­al Rights Held by DSTs

Min­er­al rights are con­sid­ered one of the accept­able replace­ment assets for a §1031 exchange. DSTs typ­i­cal­ly are struc­tured with the core real estate com­mer­cial asset class­es such as mul­ti fam­i­ly, indus­tri­al, self-stor­age, etc. How­ev­er, there are DSTs struc­tured with min­er­al rights. The DSTs will invest in real estate prop­er­ties that con­tain the rights to extract min­er­als, oil, or gas. The DST owns the rights but will lease those rights to oper­a­tors.

Acquir­ing DSTs with Min­er­al Rights

The steps on acquir­ing a DST with min­er­al rights start out sim­i­lar to acquir­ing oth­er exchange replace­ment prop­er­ties.

1. Sell the Orig­i­nal Prop­er­ty: When you own rental prop­er­ties held for invest­ment or busi­ness you would offer that prop­er­ty for sale. This deci­sion should be based on a vari­ety of indi­vid­ual rea­sons.
2. A Qual­i­fied Inter­me­di­ary (QI) is Required: We have stat­ed in many arti­cles the need for a QI (IRS require­ment). There must be an engage­ment agree­ment between the QI and the sell­er of the prop­er­ty that will be relin­quished. The QI will han­dle all the exchange pro­ceeds that will be used to acquire the replace­ment prop­er­ty and, in this case, the min­er­al rights.
3. Iden­ti­fy DSTs with Min­er­al Rights: The time frame for iden­ti­fy­ing the min­er­al rights are the same as with any replace­ment prop­er­ties.  There are only 45 days from the sale (clos­ing) of the sale. There are DSTs and offer­ings that qual­i­fy as replace­ment prop­er­ties for the exchange. Albeit there are few­er selec­tions of spon­sors who focus on this spe­cial­ized DST.  AS will all replace­ment prop­er­ties the descrip­tion, loca­tion or spe­cif­ic iden­ti­fi­ca­tion of the replace­ment DST ben­e­fi­cial own­er­ship needs to be in writ­ing.
4. Acquire Inter­ests in DSTs: The same final­iza­tion of the exchange with­in a total of 180 days is required.  The val­ue of the min­er­al rights the DST inter­ests con­tain must be equal to or greater than the prop­er­ty sold or relin­quished. This is need­ed to defer all cap­i­tal gains tax­es and avoid boot.

Key Items to Con­sid­er

• Like-Kind Require­ment: DST inter­ests that hold or con­tain min­er­al rights qual­i­fy as like-kind prop­er­ty in a §1031 exchange. Min­er­al rights are rec­og­nized and con­sid­ered real prop­er­ty and thus qual­i­fy as a replace­ment prop­er­ty for a §1031 exchange.
• The Need for Due Dili­gence: All DST struc­ture, func­tion and man­age­ment need to be ful­ly reviewed. The min­er­al rights need addi­tion­al reviews as to the over­all poten­tial per­for­mance of the asset. The pri­vate place­ment mem­o­ran­dum (PPM) will con­tin­ue the risks, finan­cial state­ments and min­er­al rights agree­ments.  In most cas­es the DST that con­tains min­er­al rights may be already struc­tured as ongo­ing oper­a­tions in spe­cif­ic areas of the US where these pro­grams are a viable option. How­ev­er, the suc­cess of any DST does rely on the man­age­ment.
• The Role of the QI: The Qual­i­fied Inter­me­di­ary must accept the pro­ceeds from the sale of the relin­quished prop­er­ty and then com­plete the acqui­si­tion of the DST that con­tain the min­er­al rights.  One of the over­looked require­ments is the rela­tion­ship or lack there­of between the QI and investors. There can be no busi­ness rela­tion­ship with­in the past two years. This does not include the QI han­dling oth­er exchanges.
• Spe­cial Pro­fes­sion­al Guid­ance: Acquir­ing a reg­u­lar DST should involve finan­cial advi­sors, tax pro­fes­sion­als, and legal experts who spe­cial­ize in §1031 exchanges and DSTs. Min­er­al rights are a spe­cial­ized type of invest­ment and the com­plex­i­ties of the acqui­si­tion or trans­ac­tion need spe­cial guid­ance.

DST Ben­e­fits with Min­er­al Rights

• Tax Defer­ral: As with all DST min­er­al rights DST defers cap­i­tal gains tax­es, allow­ing more cap­i­tal for rein­vest­ment.
• Diver­si­fi­ca­tion: As with all invest­ments there is no one solu­tion for all investors. There may be a diver­si­fi­ca­tion strat­e­gy in play using invest­ment in min­er­al rights. How­ev­er, there may be an under­ly­ing expo­sure to nat­ur­al resource mar­kets.
• Pas­sive Invest­ment: There is pas­sive struc­ture of all DST acqui­si­tions that offer man­age­ment of the prop­er­ty. Many investors enjoy this pas­sive own­er­ship.  There are no man­age­ment respon­si­bil­i­ties.

Risks, Rewards, Chal­lenges

• Volatil­i­ty: The mar­ket val­ue of min­er­al rights can be volatile. This may be influ­enced by mar­ket demand for resources. There may be reg­u­la­to­ry changes, and envi­ron­men­tal fac­tors. Under­stand­ing the con­tin­ued need for min­er­als with­in the US includ­ing oil and nat­ur­al gas is piv­otal to under­stand­ing the long-term run­way or needs.
• Com­plex Trans­ac­tions: Many investors may be new to the DST invest­ment struc­ture. There may be com­plex legal and finan­cial struc­tures involved. Finan­cial advi­sors who spe­cial­ize in 1031 and DST should be con­sult­ed.
• Liq­uid­i­ty Issues: All DST inter­ests dis­close that invest­ments can be less liq­uid than direct real estate invest­ments. This by struc­ture and func­tion makes it hard­er to exit the invest­ment quick­ly if need­ed.
• Long Term Ben­e­fits: There are long term ben­e­fits for DSTs that pro­vide for future §1031 exchanges. In addi­tion, if DST and oth­er §1031 exchanges are con­tin­ued upon the pass­ing of the investors there is a step up in basis pro­vid­ing an elim­i­na­tion of tax­es.
• Debt Replace­ment: There is an IRS §1031 require­ment to replace the relin­quished prop­er­ty debt. Some DST min­er­al rights pro­grams may or may not have an assign­ment of debt includ­ed in the pro­gram.

Con­clu­sion

Investors who hold min­er­al rights typ­i­cal­ly are seek­ing tax ben­e­fits.  Investors seek­ing to ben­e­fit using a §1031 exchange may use DST hold­ing min­er­al rights. These struc­tures are accept­able replace­ment prop­er­ties in a §1031 exchange. This may be an effec­tive way to defer tax­es. This could also diver­si­fy your invest­ment port­fo­lio. How­ev­er, as will all invest­ments there needs to be thor­ough due dili­gence. Work­ing with expe­ri­enced pro­fes­sion­als is essen­tial. Com­pli­ance with the 1031 exchange time peri­ods and finan­cial require­ments is also required. Under­stand­ing the risks and rewards with all min­er­al rights is also required.

DSTs are not for all investors. The acqui­si­tion of a DST is for accred­it­ed investors only. Con­tact your invest­ment advis­er for addi­tion­al details on how a DST may be a solu­tion to your 1031 Exchange and suit­ed for your invest­ment future. For more infor­ma­tion on how to prop­er­ly set up an IRC §1031Tax Deferred Exchange or if you are an accred­it­ed investor and would like addi­tion­al infor­ma­tion on a DST con­tact Al DiNi­co­la at 239–691-8098 or email adinicola@namcoa.com.

This is not an offer to pur­chase or solic­i­ta­tion to pur­chase any secu­ri­ty, as such be made only through an offer­ing mem­o­ran­dum or prospec­tus. Invest­ing in secu­ri­ties, real estate, or any invest­ment, whether pub­lic or pri­vate, involves risk, includ­ing but not lim­it­ed to the poten­tial of los­ing some or all of your invest­ment dol­lars when you invest in secu­ri­ties. You should review any planned finan­cial trans­ac­tions that may have tax or legal impli­ca­tions with your per­son­al tax or legal advi­sor. NAMCOA, LLC is a Reg­is­tered Invest­ment Advi­sor, reg­u­lat­ed by SEC (Secu­ri­ties and Exchange Com­mis­sion).

Our cor­po­rate office is locat­ed at 999 Van­der­bilt Beach Road, Suite 200, Naples Flori­da 34108. Secu­ri­ties Offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC. 8215 SW Tualatin-Sher­wood Rd, Suite 200 Tualatin, OR 97062.  MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed.

Thank you.