What’s a 1031 Exchange?
The 1031 exchange has become a popular tax break in the real estate world. It governs a property swap that saves the investor money they would have to pay in capital gains tax. However, the 1031 exchange can be quite complicated as many conditions exist.
If you’re a mineral owner wondering if your mineral interest or royalty interest can qualify for the 1031 exchange, you can learn all about it in this article. It will answer what’s 1031 exchange, how it works, and how it can benefit you as an investor.
What’s 1031 Exchange?
1031 exchange gets its name from Section 1031 of the Internal Revenue Code (IRC). According to Section 1031, an individual who sells an investment property and buys another in its place won’t be liable for paying any capital gains tax on the property sold. The new property also has to be for the same purpose, i.e., investment property.
With a 1031 exchange, you can defer capital gains tax until you cash out on your property investment. It’s a tax break that applies to real estate, except for certain properties, like vacation properties.
The Internal Revenue Service (IRS) only allows 1031 tax breaks for ‘like-kind’ properties. While there’s no specific definition for what constitutes like-kind, the general understanding is that it should be a similar property (for example, a house swapped for a house).
How Does It Work?
To qualify for the 1031 exchange, you must follow certain conditions and a strict timeline. As such, an exchange of property would be selling your property to someone and buying theirs. However, that can be difficult to achieve.
Therefore, you can sell your property to one party and buy from another. However, the money must be held by a third party. If you take the cash for the property you sell, it won’t qualify for 1031.
The third party would keep the money in escrow and buy the new property on your behalf. This third party is called a qualified intermediary.
Another essential condition is that the new property you buy must be of the same value or more as the property you just sold. If you buy the new property for an amount lesser than what you earned selling the previous property, you will no longer qualify for a 1031 tax break.
Reverse exchange is also possible, wherein you buy the new investment property first and then sell the property. You must transfer the new property to an exchange accommodation titleholder. Again, this intermediary or middleman holds the property while you sell your existing one.
1031 Exchange Timeline
The 1031 exchange also follows a timeline that’s broken down into two durations: 45 days and 180 days.
The 45-day rule in Section 1031 specifies that after you’ve sold your property and moved the money to an intermediary, you have 45 days to designate replacement property. In other words, after selling the first property, you have to submit in writing to the qualified intermediary the property you’re interested in buying.
You can designate three or more properties based on their valuation.
The 180-day rule of the Section 1031 follows that the qualified intermediary has 180 days from the time of the sale of the first property to close the sale of the new one.
The 180 days also include the 45 days for designated properties. Therefore, if you designate on the 45th day, the intermediary would have 135 days to close the deal and buy the new investment property on your behalf.
Benefits of 1031 Exchange
1031 exchanges can be complicated and require the services of realtors, accountants, lawyers, and other experts. However, many successful real estate investors have used it to defer capital gain tax and create wealth.
The main benefit of this exchange is that you don’t have to pay capital gains tax immediately on selling the property. You can use the profits from the sale to buy an even higher value property.
Also, there’s no limit to how many 1031 exchanges you can carry out. So if you keep swapping properties and deferring capital gains tax, you can benefit from lower capital gains tax rates applicable on old investments when you finally sell the property.
You may have to pay capital gains tax eventually, but by that time, you would have increased your investment significantly and walked away with more profits.
Furthermore, IRS also allows 1031 exchange to work beyond state lines. You can swap properties in different states, which makes it all the more beneficial.
What is 1031 exchange California? Well, it’s the same thing as the federal 1031 exchange. It also applies to state taxes in the states that charge capital gains taxes on real estate investments.
Can Mineral Interest Qualify for 1031 Exchange?
As mineral rights are considered real property, mineral interest can also qualify for 1031 exchange. Again, the same rules would apply, and you can only avoid paying capital gains on the sale if the new property is of the same kind.
For mineral rights, you can swap with other mineral rights or similar real estate.
The applicability of the 1031 exchange also depends on the mineral lease. For instance, the lessee with a mineral interest can buy the mineral interest as a 1031 exchange after selling another property. However, the lessor with a royalty right may not benefit from the 1031 exchange as they still possess the mineral rights.
With mineral rights and interests, the 1031 exchange is even more complex. That’s why it’s best to consult with a professional who understands the law, especially regarding oil and gas royalties.
The 1031 exchange can allow real estate investors to defer paying capital gain taxes in federal and state taxes. Not all properties may qualify for it, and not all exchanges may uphold the conditions.
If done right, it can help create more wealth and increase investment over the lifetime. 1031 exchange is also used in the oil and gas industry for buying/selling mineral rights and mineral interest.