With the increase of gas drilling in the Marcellus Shale region, many Pennsylvania landowners are being approached to either sell or lease the rights to access and develop the minerals/natural gas reserves underlying the surface of their property. The sale or lease of these rights results in taxable income subject to capital gain or ordinary treatment, depending on the character of the transaction. However, with proper planning, the income from sale or exchange may be able to be deferred using the like-kind exchange rules of Internal Revenue Code (IRC) Section 1031. The like-kind exchange rules are not available to landowners who choose to enter into an oil and gas lease arrangements with an operator. A lease arrangement is the more typical arrangement for Marcellus drilling and results in ordinary income tax treatment to the landowner/lessor.
IRC Section 1031 provides an exception from the general rule requiring the current recognition of gain or loss realized upon sale or exchange of property. For federal tax purposes, no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged solely for property of a like-kind to be held either for productive use in a trade or business or for investment. Any gain realized in the exchange transaction is deferred until the “exchange property” is disposed of in a subsequent taxable transaction.
Like-Kind Property – “Like-Kind” refers to the nature or character of property, not its grade or quality. The type of interest held in the property given up and received must be similar in character or nature. Thus, the exchange of virtually any parcel of real property held for use in a trade or business or for investment in the United States for another parcel of business or investment real property in the United States should qualify as like-kind.
Property of similar character has been broadly viewed in many cases. For example, in Revenue Ruling 68-331, the Internal Revenue Service(IRS) held that an oil lease granting the lessee rights to take the oil until exhaustion of the deposit is like-kind to a fee interest in a ranch.
Under Pennsylvania law, three distinct estates in land are recognized – the surface estate, the mineral estate, and the right to subjacent (surface) support. These estates are severable from each other, and different owners may hold title to separate estates in the same parcel of land.
Revenue Ruling 68-226 declared that an interest of a lessee in oil and gas in place is an interest in real property. In addition, the courts have determined that the exchange of real property for an undivided mineral interest constituted a like-kind exchange since the mineral rights were treated as real property under state law. In Revenue Ruling 55-749, the IRS held that an exchange of an interest in a natural resource for another such interest, or for a fee title to land, qualified for nonrecognition treatment as a like-kind exchange if the interests exchanged are both realty under the relevant state law and of the same character as defined by federal law.
Accordingly, the exchange of gas rights for other real property will qualify for federal income deferral under IRC Section 1031 and is an effective method to defer tax on the exchange as well as a method to diversify current real estate holdings. However, the Commonwealth of Pennsylvania does not follow the federal rule under Section 1031 with respect to like-kind exchanges for Pennsylvania personal income tax purposes. Accordingly, the excess of the fair market value of the property received over the Pennsylvania tax basis of the property transferred would be subject to Pennsylvania personal income tax as of the exchange date.
Structuring a successful like kind exchange is a complicated procedural process. A description of these procedural requirements is beyond the scope of this article. Should consideration of the tax benefits of a like kind exchange be of interest to you, it is advised that you consult your Schneider Downs representative for further assistance and information regarding the requirements of a like-kind exchange transaction.
For further information on the contents of this article, contact Ryan Broze at email@example.com.
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This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax-related matter.