 Tax Free Exchanges and the Western Slope
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Nearly everyone has heard of the tax-free exchange provisions of Internal Revenue Code Section 1031. Most people equate this to trading a business vehicle in on a new business vehicle, or selling real estate and reinvesting in another piece of real estate. |
But Section 1031 exchanges apply to a wide variety of transactions that are not commonly thought of, and which could have significant impact on the operations of Western Slope farming, ranching, logging, real estate and extractive industries.
What are the major issues Western Slopers are dealing with? Water, mineral development and land uses. Using tax-free exchanges can mitigate the tax impacts from transfers of these assets.
Code Section 1031 provides that no gain or loss is recognized if certain qualifying property is exchanged solely for "like kind" property. Property qualifying for non-recognition treatment is limited to "property held for productive use in a trade or business, or for investment.” Personal use property does not qualify for a tax-free exchange.
The like kind requirement states that the property transferred and the property received in the exchange is of ‘like kind.’ The regulations define what like kind is with respect to real estate, and refer to the nature or character of the property and not to its grade or quality. The fact that any real estate involved is ‘improved’ or ‘unimproved’ is not material, for that fact relates only to the grade or quality of the property and not to its kind or class. Furthermore, no gain or loss is recognized if a taxpayer who is not a dealer in real estate exchanges city real estate for a ranch or farm; or exchanges a leasehold of a fee with 30 years or more to run for real estate; or exchanges improved real estate for unimproved real estate.
Property that is otherwise personal in nature, when physically attached to the soil, or constructively attached by its use or intended use with the soil, ordinarily becomes a part of the realty. Thus, a building permanently fixed to the land becomes part of it. “Land” includes not only the soil, but also everything attached to it, whether attached by the course of nature, such as trees, herbage, and water; or by human hands, such as fixtures, and fences. The phrase covers all that goes to make up the earth in its natural condition, and thus generally includes gas and oil, and minerals that have not been severed from the soil.
Examples of property determined as like kind that would be pertinent to Western Slope ranchers, farmers, land and extractive mineral developers would include:
1) Easements: A perpetual easement and right-of-way granted to an unrelated party are properties of like kind to improved or unimproved real estate.
The IRS has ruled that an exchange of a perpetual conservation easement in real estate for an interest in real estate that is also subject to a conservation easement, will qualify as like kind property.
2) Rights in Natural Resources:
a) Timber rights for timber rights: The right to timber on one piece of property for the right to cut timber on another piece of property is like kind property.
b) Timberland: The quantity, quality, age and species of the timber growing on the land may influence the grade or quality of the timberland involved in the exchange, but does not influence the kind or class of the property exchanged, which is land. Thus, as long as the timber rights are transferred with the land, it will be treated as like kind property to real estate.
c) Unharvested crops: Land with unharvested crops can be exchanged for land with unharvested crops. Land with unharvested crops should be able to be exchanged for land. Unharvested crops cannot be exchanged for unharvested crops.
d) Mineral estates: A mineral estate may be exchanged for real estate, as a mineral estate by definition is a real property interest.
e) A mineral lease can be exchanged for other real estate, or another mineral lease.
f) Overriding royalty interest: An overriding royalty interest can be exchanged for other real estate.
g) Intangible drilling costs: Intangible drilling costs (IDC) that have been capitalized can be exchanged for other real estate. The capitalized IDC are deemed similar to improvements to real estate. Presumably, the IDC must be incurred prior to the date you take title to the replacement properties.
h) Production payments: Production payments and net profits interests cannot be exchanged tax-free. For exchange purposes, these are considered an assignment of income and not a real property interest.
i) Water rights: Water rights in perpetuity can be exchanged with other real estate. Water rights that are not in perpetuity, or are limited to a specific total amount of water, or to a specific amount of water for a limited amount of time, are not considered real property and cannot be exchanged tax -free.
There are many transactions relating to water, mineral rights and easements that can be structured as tax free exchanges; so Western Slope farmers, ranchers, and mineral interest holders should consider these provisions when opportunities arise.
Robert Drury is a tax partner at the Grand Junction office of Gordon, Hughes & Banks, LLP. He can be reached at (970) 245-5181, or (877) 882-9853 toll free. This article appeared in the September 15th, 2004 issue of the Colorado Real Estate Journal
