Land and mineral interest ownership presents special opportunities for long-term, multi-generational income and asset growth. To realize the full potential of these opportunities, careful planning and management decisions must be taken into account when transferring these assets to future generations. A key estate planning objective is the reduction of any possible tax burdens placed on your estate and the estates of your family members. One way to reduce or avoid a heavy tax burden on your estate is to decrease your estate’s assets during your lifetime by giving gifts to your family.
Gifts reduce the total value of your taxable estate and have other benefits, like providing an opportunity for family members to manage certain land and mineral interests before inheriting a large estate. While the donor’s estate may benefit from this form of asset protection, gifts can have negative tax consequences for the donee. If the land and mineral interests gifted are income-producing, the donee’s income taxes may increase. Another disadvantage in receiving a gift before the time one would normally inherit the asset is that there is no step-up in basis at the later inheritance date to reduce possible capital gains taxes. A well-thought-out estate plan will weigh the benefits of gifting against any negative tax consequences for the donee and may employ alternatives, like gifting to a trust, to alleviate those consequences.
Utilizing gifts as an estate planning tool requires understanding the relationship between the gift tax exclusion and the estate tax exemption. While the lifetime gift tax exclusion and the lifetime estate tax exemption limit are one and the same, you can make an unlimited number of gifts at a prescribed amount, tax free, every year. The lifetime gift tax exclusion and the estate tax exemption limit are $11.58 million per person, or $23.16 million per couple, in 2020. The annual gift tax exclusion allows gifts of $15,000 individually and $30,000 per couple in 2020. This means you may give a gift worth up to $15,000, or you and your spouse may give a gift worth up to $30,000, to as many people as you like in 2020, and those gifts will not be counted against your lifetime gift and estate tax exemption limit.1 A gift tax return, Internal Revenue Service (“IRS”) form 709, must be filed for gifts valued over $15,000, or over $30,000 from a couple. Each form 709 you file is tracked by the IRS and reduces your lifetime gift and estate tax exemption by the amount exceeding the annual exemption. In most instances, an individual does not pay any gift (or estate) tax unless and until the total value of all gifts filed with the IRS is more than the lifetime exemption limit.
When it comes to gifts of real property and different types of mineral interests, an important question is what the gifted property is worth. Is the value of the property below the annual gift tax exemption? The valuation of real property mineral interests is made in accordance with principles set forth in the Internal Revenue Code. The IRS will apply the “fair market value” standard of appraisal differently depending on the nature of the interest at issue. The fair market value of real property is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.2
When mineral rights are bundled with the surface estate, the surface and mineral estate will be appraised as one unit. However, if mineral rights are split from the surface estate, the mineral rights will need to be appraised as a separate real property interest. The valuation of an undeveloped mineral estate is based on factors like the examination of comparable sales and list prices of adjacent mineral rights, the oil and gas market, and the cost of development needed to extract the minerals. Appraisals of currently producing mineral interests, such as royalties and overriding royalties, must individually value each separate mineral interest. Factors used in these valuations may include evaluating similar nearby mineral interests, as well conducting a discounted cash flow analysis for the producing interests, analyzing production statistics, and accounting for area-specific circumstances. Other considerations for all types of mineral interests include the impact of a buyer’s transactional costs in purchasing fragmented and fractional interests and any risks involved in drilling for, pumping, and transporting oil and gas from the area.3 In most cases, an appraisal of the land or mineral interests to be gifted will need to be performed by a professional.
Certain kinds of trusts, such as a “Crummey Trust,” can be used to remove income-producing land and mineral interest from your estate while avoiding increases in the donee’s income taxes.4 In addition, with an appropriately designed trust, the assets gifted to the trust can receive a step-up in basis to the fair market value when the trustor passes and the trust dissolves. The Crummey Trust and other similar trusts need to be carefully fashioned and managed; however, if administered correctly, the benefits in certain types of estate planning can be enormous.
If you are considering gifting a portion of your land or mineral interests as a part of your estate planning strategy, consult a knowledgeable expert who understands mineral interests and the oil and gas market in your region.
Tjornehoj & Hack LLC, 2020
- Tax Forms and Instructions, 26 C.F.R. § 601.602, Rev. Proc. 2019-44, https://www.irs.gov/pub/irs-drop/rp-19-44.pdf.
- Valuation of Property, 26 C.F.R. § 20. 2512-1.
- See Internal Revenue Manual, Real Property Valuation Guidelines, Part 4.48.6 (07/01/2006), https://www.irs.gov/irm/part4/irm_04-048-006; see also Estate of Smith v. Commissioner, Docket No. 7839-91, 1993 Tax Ct. Memo LEXIS 239 (T.C. May 26, 1993) (court review of a valuation of mineral interests).
- See Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968).