Tips from the IRS on Reporting Natural Resource Income

Tips from the IRS on Reporting Natural Resource Income


FS-2013-6, April 2013

Taxpayers who own land that contains valuable natural resources should be aware that arranging for the development of the resources by means of a lease creates tax consequences.

Landowners may make complex financial agreements to receive royalty, bonus or other income in exchange for access to the resources on their land, such as natural gas and oil from shale deposits. Here are some important facts from the Internal Revenue Service about these transactions.

Lease Agreements

Natural resource extraction agreements involve payments for extracting resources such as oil and gas. Payments can include delay rental, royalty and lease bonus payments.

Taxpayers who receive these payments are royalty owners who do not have a working interest in extraction operations. Taxpayers should normally report these payments as income on Part I of Schedule E (Form 1040), Supplemental Income and Loss. Income reported on Schedule E is usually not subject to self-employment tax.

Taxpayers who do have a working interest in the extraction operations are subject to self-employment tax, and must file Schedule C (Form 1040), Profit or Loss from Business.

Leases and Lease Bonuses

Taxpayers/lessors typically receive a lease bonus from a lessee — the party that extracts the natural resource — in consideration for granting the lease. A lease bonus may be paid in a lump-sum or multi-year payments. The lessee should provide the taxpayer with a Form 1099-MISC, Miscellaneous Income, listing the amount of bonus payments as “Rents” in Box 1. Taxpayers usually report their lease bonus income as rent on Schedule E.

Royalty Payments

Taxpayers/lessors may receive periodic payments for their share of the natural resource. These payments are commonly known as royalty payments. They must be based on natural resource production on a recurring or intermittent basis, per the terms of the lease.

The lessee should provide the taxpayer with a Form 1099-MISC reporting the payments as “Royalties” in Box 2. Most taxpayers report royalty payments received as royalty income on Schedule E.

Depletion Deduction

Depletion is the using up of natural resources by mining, drilling, quarrying stone, or cutting timber. The depletion deduction allows a taxpayer who owns an economic interest in a mineral deposit or standing timber to reduce their taxable income and account for the reduction of reserves.

There are two ways of figuring the depletion deduction: cost depletion and percentage depletion. A taxpayer who owns an interest in a mineral deposit must use the method that yields the greater deduction. The percentage depletion rate for federal tax purposes varies depending on the mineral being produced.

A taxpayer must be an independent producer or royalty owner to use percentage depletion for oil and gas. A taxpayer who owns an interest in standing timber can only use cost depletion.

Taxpayers claim depletion and other allowable deductions in the “Expenses” section in Part I of Schedule E. See IRS Publication 535, Business Expenses, for more information.

Additional Expenses

Taxpayers who own working interests may be able to deduct expenses to reduce their natural resource income. This applies to taxpayers who have working interests in extraction operations. Expenses may include overhead, dry holes, certain legal and administrative fees and county health department water testing fees. Severance tax and operation expenses should be detailed on an Authorization for Expenditures (AFE) statement provided by the exploration company.

Only taxpayers who have a working interest in the extraction operations may deduct business expenses such as depreciation, tangible or intangible costs, utilities, car and truck and travel from their natural resource extraction income.

Free Natural Gas

Taxpayers may receive natural gas from a lessee oil and gas company. The receipt of gas may be taxable income if the gas is not from the taxpayer/lessor’s retained ownership interest. In general, the ownership of raw gas extracted by a lessee is based on the lease terms and state law.

Reporting Rental and Royalty Income

Rental and royalty income or loss is calculated on Schedule E. That amount is then transferred to Line 17 on Form 1040 to be combined with income received from other sources such as wages, dividends and interest to determine total income. Net income from royalty and lease payments is not considered passive income.


Estimated Tax

Since federal income tax is not typically withheld from these payments, taxpayers may want to consider making estimated tax payments on their natural resource income. See Publication 505, Tax Withholding and Estimated Tax, for more information.

Income from leasing mineral property and royalty payments for the extraction of natural resources can be significant. Taxpayers who receive this type of income should familiarize themselves with the tax rules to avoid an unexpected bill at tax time. More information is available in Publication 525, Taxable and Nontaxable Income, and the Instructions for Form 1040, Schedule E and Form 1040, Schedule C.

Call us at 888-367-1031 or email us at 1031@1031cpas.com if we can help with any questions about an Exchange of a Mineral Interest. See our Exchange Manual at www.1031cpas.com. 1031 Corporation is the Intermediary of choice for thousands of real estate professionals, CPAs and investors.

The New 2013 Capital Gains Tax Rates for Individuals

The American Taxpayer Relief Act of 2012 has established the way long-term capital gains will be taxed in 2013 and in the future until the law is once again changed. The top rate for capital gains and dividends will remain at 15% for individual taxpayers with incomes of $400,000 or less ($450,000 for married taxpayers). The top rate for capital gains and dividends exceeding this level of income will rise to 20%.

 

In A Nutshell, here are the general rules for Federal long-term capital gains tax of individuals on the sale of investment real estate commencing with 2013 using maximum capital gains tax rates for property held 12 months or longer -

 

     20%      High income taxpayers (see above)                          
     15%      Taxpayers in a tax bracket higher than 15%              
       0%      Taxpayers in the 15% or 10% regular tax brackets     

25% Rate for “Depreciation Recapture” - Depreciation taken on the real estate which is sold is taxable at a maximum 25% tax rate (15% for taxpayers in 10% and 15% tax bracket). The remainder of the gain from the sale of depreciable real property is taxed at the maximum tax rates referred to above.

The New Medicare Tax of 3.8%. In addition, commencing in 2013, a Medicare tax of 3.8% will be imposed on capital gains from the sale of real estate for high-income taxpayers. High-income taxpayers for this tax are taxpayers with gross income of $200,000 for individuals ($250,000 for married taxpayers). This tax will only apply to the amount of gain which causes adjusted gross income to exceed this high-income threshold. Exceptions for real estate sales -  

•      Real estate owned and used in a trade or business 
•      Real estate sold by Real Estate Professionals 

A Real Estate Professional is a taxpayer who spends more than half of his time during the year (and at least 750 hours of service) in real property trades or businesses in which he materially participates.

 

A married couple filing jointly in 2013 using the standard deduction is in a 10%/15% tax bracket until adjusted gross income (including capital gains) exceeds $90,700.

Call us at 888-367-1031 or email us at 1031@1031cpas.com if we can help with any questions. See our Exchange Manual at www.1031cpas.com. 1031 Corporation is the Intermediary of choice for thousands of real estate professionals, CPAs and investors.

 

 

 

Farm and Ranch Exchanges

Farm and ranch exchanges present a host of opportunities and challenges for taxpayers since they often include a mix of different assets with differing requirements and concerns under Code Section 1031. In a nutshell, here are some of the issues involved in farm and ranch exchanges.

Real Estate can be exchanged for like-kind real estate held for business or investment and in most cases is without complication. A sale of “real estate” can include a variety of real estate interests all of which qualify as “real estate” under the like-kind replacement rules, including –

• Land and buildings
• 30+ year leasehold interests
• Oil & Gas, water and mineral rights
• Conservation and use rights
• Grazing rights

Replacement property can be any of the above real estate interests held for business or investment including raw land, improved property and more than one property.

Equipment included in the sale-exchange can be replaced with like-kind equipment. For farmers, almost any farm equipment qualifies as like-kind. The like-kind rules for farm equipment are described in the General Asset Classes of Regulation §1.1031(a)-2(b)(2) and the Product Classes of Sector 33 of the North American Industry Classification System (NAICS).

Center Pivot Sprinkling Systems are usually assumed to be subject to the like-kind replacement rules for equipment. But, there is an argument that a center pivot sprinkler system qualifies as a real estate improvement and, accordingly, can qualify under the like-kind rules applying to real estate when a taxpayer is replacing with real estate with sprinkler equipment on it. This won’t work if the farm that is being sold has a sprinkler system on it and is being exchanged for land without a sprinkler system. In this case Section 1245 depreciation recapture would kick-in if the sprinkler being sold is not replaced with Section 1245 equipment. Farm and ranch owners with sprinkling equipment need to consider these issues and discuss with their tax professional for exchange planning.

Breeding or Dairy Livestock can be exchanged for “like-kind livestock.” Same-sex is required under the like-kind rules; a bull cannot be exchanged for a heifer or cow and vice versa. Steers or feeder stock don’t qualify.

Personal Residence Issues are often a part of an exchange of farm or ranch property. If the owner lives in a personal residence on the farm the gain allocable to the personal residence may be tax free under Code Section 121 limited to $250,000 (single) or $500,000 (married filing jointly). Preferred practice is to bifurcate the sale into two sales with the taxpayer cashing out on the sale of the personal residence and proceeding with a 1031 Exchange of the balance of the farm sale.

Related Party transactions require special attention in a 1031 Exchange of farm and ranch property. “Related parties” include related individuals and related entities such as corporations, partnerships, LLCs and trusts. Deed swaps between related parties require that each party hold the property for 24 months to validate the exchange. A sale to a related party with replacement from an unrelated party is not considered to be a “related party exchange.” A sale to an unrelated party with replacement from a related party is not permitted if the related party is cashing out. It is permitted if the related party is also going thru a 1031 Exchange with replacement of qualifying real estate. Related parties or entities are described in Code Section 267(b) or 707(b)(1).

Talk to your tax advisor when you are anticipating a sale of farm or ranch property. Call us at 888-367-1031 or email us at 1031@1031cpas.com if we can assist with questions about an exchange of your property. See our Exchange Manual and visit us at www.1031cpas.com. 1031 Corporation is the Intermediary of choice for real estate professionals, CPAs and investors.

Do I Need To Do a 1031 Exchange of Machinery, Equipment Or Aircraft If I Can Write-Off The Entire Purchase Price In 2011?

The 2010 Tax Relief Act ramped up the amount of write-off for 2011 equipment purchases. Two provisions of the Internal Revenue Code make it possible for purchasers to deduct the entire purchase cost of machinery, equipment and aircraft.

100% Bonus Depreciation - Taxpayers can deduct the entire purchase price of new equipment purchased in 2011 under the rules for “Bonus Depreciation.” Before 2011 the deduction was limited to 50% of the purchase price of the equipment. The 50% rule will apply again in 2012. The original use of the equipment must commence with the taxpayer – used equipment doesn’t count.

The Section 179 Deduction – Up to $500,000 of the cost of new or used equipment can be deducted in 2011 under Code Section 179. However, there are special rules for the Section 179 Deduction. Certain types of purchases are not eligible for the 179 Deduction, including –

• Property which is not used in a trade or business,
• Property acquired from a related party,
• Property which is leased to another user or lessee,
• Property acquired in a 1031 Exchange

The $500,000 deduction phases out for taxpayers purchasing more than
$2 million in machinery or equipment during the year. The maximum deduction and phaseout levels drop to $25,000 and $200,000 beginning in 2012. The 179 Deduction is limited to income reported for the year from the taxpayer’s trade or business and cannot result in a loss being reported. Excess deductions can be carried forward.

Sales taxes are often a motivating reason a taxpayer may want to structure a 1031 Exchange regardless of the possible first-year write-offs referred to above. For example, if a taxpayer sells an aircraft for $1 million and buys a replacement aircraft for $2 million, sales tax will apply to the $2 million purchase price of the replacement aircraft. If the taxpayer engages the services of an Exchange Intermediary to help him structure a qualifying “exchange,” the sales tax is limited to the “boot paid” - $1 million in this case. The difference in sales tax liability can obviously be significant.

These issues must be discussed with your tax professional for complete information on how these rules may affect you in your circumstances. Call us at 888-367-1031 or email us at 1031@1031cpas.com if we can help with any questions. See our Exchange Manual at www.1031cpas.com. 1031 Corporation is the Intermediary of choice for thousands of real estate professionals, CPAs and investors.

What Realtors Should Know About 1031 Exchanges

Realtors are Often the First to Recognize the Potential Benefits of a Section 1031 Exchange to a seller of real estate. When a seller is going to replace qualifying real estate with replacement real estate, a Section 1031 Exchange should be suggested. It is possible for a seller to employ the services of an Exchange Intermediary at any time after a contract is executed up to the day of closing on the contract. It is too late after the closing has occurred.

Accommodation Language in the Contract. Accommodation language is usually placed in the Contract to Buy and Sell Real Estate wherein the other party to the contract is informed and agrees to cooperate with the 1031 exchange. Typical accommodation language might read as follows:

For a Seller - "A material part of the consideration to the seller for selling is that the seller has the option to qualify this transaction as a tax deferred exchange under Section 1031 of the Internal Revenue Code. Purchaser agrees to cooperate in the exchange provided purchaser incurs no additional liability, cost or expense."

For a Buyer - "This offer is conditional upon the seller's cooperation at no cost to allow the purchaser to participate in an exchange under Section 1031 of the Internal Revenue Code at no additional cost or expense. Seller hereby grants buyer permission to assign this Contract to an Intermediary not withstanding any other language to the contrary in this Contract".

Accommodation language is not mandatory and can be omitted if it puts the taxpayer at a disadvantage for other parties to know about his plan to sell and replace property under IRC §1031 and related closing pressures under the exchange 'time clocks."

Assignment of Contracts. If a Realtor knows that a buyer intends to assign the contract to an Intermediary in connection with an exchange, it is helpful to reference the buyer as "John Doe or Assigns" on the contract.

Paragraph 18 of the standard form Contract to Buy and Sell Real Estate used by Colorado Realtors contains a provision wherein the contract is not assignable by a buyer without the seller's permission unless the seller's permission is so indicated with a check in the "'shall' be assignable" box. The standard form Contract does not limit a seller's right to assign the contract.

Another way to make the contract "assignable" is for an addendum to the contract to be prepared by the Realtor making the contract "assignable." An Exchange Addendum to Contract to Buy and Sell Real Estate issued by the Colorado Real Estate Commission containing all necessary accommodation language is also available. Use of this Addendum makes contract accommodation language unnecessary and automatically provides for assignability of a contract by the buyer in an exchange transaction.

Settlement Statements. Section 1031 of the Internal Revenue Code imposes no requirements and provides no guidance with respect to preparation of settlement statements for an exchange of property. The Colorado Real Estate Commission has no special requirements concerning exchanges involving an Intermediary.

Intermediaries often instruct closers to name the Intermediary as the seller of a property on behalf of their client. This is not required by IRC §1031 and creates additional closing burdens since it requires the Intermediary to sign the settlement statements.

An occasional (but unnecessary) practice is for the title company closing on the transaction to prepare a second set of settlement statements in which the Intermediary is shown as a buyer and seller. The Intermediary's set of statements "mirror" each other as to debits and credits. The thinking here is that the settlement statements should reflect a "chain of title." This practice is not required by IRC §1031.

Our recommendation is to prepare one set of settlement statements in the normal manner which total to zero proceeds due to or from the Exchanger. The settlement statements should be made to total to zero proceeds due to or from the Exchanger by showing a debit or credit for "Exchange Funds - 1031 Corporation" as a transaction item "above the bottom line". The amount of "Exchange Funds" is the amount of funds being transferred to or from the Intermediary in connection with the closing.

Call us at 888-367-1031 or email us at 1031@1031cpas.com if we can help with any questions. See our exchange manual and visit us at http://www.1031cpas.com/. 1031 Corporation is the Intermediary of choice for thousands of real estate professionals, CPAs and investors.

Your 1031 Exchange - The Procedure

1. Contact us to open an exchange file for you before your sale closes. We will consult you on the information we need to obtain from you.

2. Fax or email us a copy of your contract to sell your exchange property. 303.684.6899 or 1031@1031cpas.com

3. We will prepare an Exchange Agreement and other documents necessary for the exchange.

4. We will “step into your shoes” as a substitute seller by virtue of an assignment of your interest in your contract to sell.

5. We will contact and provide your closer with closing instructions. We will open a interest-bearing money market account in our name in trust for you. Your closer will be instructed to wire funds from the sale to this account. The cash will be held in this account until the purchase of your replacement property at which time the cash will be forwarded to the replacement property closing.

6. Search for suitable property to purchase for your exchange replacement property. More than one property can be purchased as replacement property

7. Provide us with a 45-day Identification Letter to identify prospective replacement properties if you have not completed your exchange during the first 45-days after closing on the sale of your exchange property. The letter can identify three prospective replacement properties or more than three if the total value of the identified properties does not exceed 200% of the value of the property that was sold. The letter is due by midnight of day 45. A signed contract to purchase replacement property by day 45 is desirable but not required by the Regulations.

8. Enter into a contract to purchase your replacement property and schedule a closing. Contact us prior to the closing. Fax or email us a copy of the contract. We will provide instructions to the closer and arrange for a wire transfer of exchange funds we are holding for you. The closer will be instructed to directly deed the property to you.

9. Your Exchange is Finished. We will provide you with an Exchange Report with copies of all exchange documents for your reference and income tax reporting.

10. See our Exchange Manual and Visit us at www.1031cpas.com

The Foreign Investment in Real Property Tax Act (FIRPTA in a Nutshell)

Federal Requirements -

There are reporting and withholding requirements for sales of property to or by foreign persons or corporations (IRC §1445). Exchange Intermediaries should be familiar with the basic rules.

Any person who acquires an interest in U.S. real property from a foreign person or corporation must withhold and remit to the Internal Revenue Service a tax in the amount of 10% of the sales price. Form 8288 is used to report and remit the withheld amount.

Although the closer may perform the withholding and preparation of Form 8288, the burden of responsibility is on the buyer of the property. Often closers are not acquainted with these withholding requirements. Failure to withhold the tax may result in the buyer of the property being held liable for the payment of the tax and any applicable penalties and interest. A lien could be placed on the property if it is determined that the buyer failed to comply with the withholding requirement and is found to be liable for the tax.

There are exceptions to the withholding requirement.

· Withholding is not required if the buyer is acquiring the property for use as a residence and the purchase price is $300,000 or less.

· Notification of Nonrecognition Treatment - Withholding is not required if the seller of the property notifies the buyer of the property that the seller is not required to recognize any gain on the sale under Code Section 1031. It is the buyer’s duty to provide a copy of the notice to the IRS within 20 days of the closing date. However, if the buyer has reason to know that the sale is not qualifying under IRC 1031 for nonrecognition treatment; the buyer is not excused from the withholding requirement.

· Withholding Certificate - Withholding is not required if the buyer of the property files Form 8288-B (Withholding Certificate) with the IRS. This form relieves the buyer of the property from any responsibility for withholding and is the desirable method for assurance of compliance with FIRPTA. The buyer of the property should obtain a copy of this form for his files.

In an exchange involving an Intermediary, it is possible that the Intermediary may be perceived as the buyer of the property and therefore be liable for payment of the withholding tax. Even though the Intermediary does not ordinarily take title to the Replacement Property, the Intermediary can be deemed to take and convey ownership of the property by virtue of its responsibilities under the Exchange Agreement. Therefore, the Intermediary should be attentive to the FIRPTA requirements.

What if the Intermediary is assisting the foreign seller of the property with an exchange and the exchange fails or boot is recognized from the exchange? It seems prudent for the Intermediary to transfer the withholding amount to the IRS. This possibility should be provided for in the Exchange Agreement or an addendum thereto.

State Requirements -

Many states have legislation similar to FIRPTA for nonresident sellers of property. All of the concerns that apply to the federal rules also apply to the requirements of each state. Intermediaries must check the requirements of the appropriate state legislation to determine the FIRPTA requirements of each state.

Colorado requires a tax of 2% of the sale price be withheld by the closer of the property unless an affidavit is filed by the seller with the closer that the sale is exempt for various reasons, including a nonrecognition transaction. Usually the title company or an attorney is the closer of the property. A seller would be deemed to be the “closer” if the services of a professional are not used. It seems that the Intermediary in a 1031 Exchange has very little to worry about in Colorado unless the seller is the closer. In any event, the burden is on the closer and not the buyer of the property.

California requires the Intermediary to withhold and pay tax to the Franchise Tax Board at 3 1/3% on cash remaining in an exchange account at the end of an exchange, or 3 1/3% on the entire sale price if the exchangor cashes out completely from an exchange. This withholding requirement applies to all resident and non-resident individuals of California, and non-resident, non-individual tax entities. Resident non-individual tax entities are excused from withholding tax. Thus, Intermediaries must monitor the exchange closely for compliance with California FIRPTA requirements.

Other states may have similar requirements.

Call us at 888-367-1031 or email us at 1031@1031cpas.com if we can help with any questions. See our Exchange Manual and visit us at http://www.1031cpas.com/. 1031 Corporation is the Intermediary of choice for thousands of real estate professionals, CPAs and investors.