There are several types of oil, gas and mineral rights (hereinafter collectively referred to as “minerals”). A mineral estate is the perpetual interest in all the minerals in or on the land. The mineral rights can be sold as a whole (separate from the fee interest) but frequently they are divided into lesser interests such as mineral leases, mineral royalties and production payments.
Mineral Lease A mineral lease (sometimes called a working interest or operating interest) gives the lessee the right to extract the minerals. The lessee bears the costs of exploration and extraction. This right may be limited to a set period of time (or amount) or may extend until the minerals are exhausted; any limitation of amount is likely to impact its eligibility for a 1031 exchange. The limitation of amount referred to above does not refer to the sale of a fractional interest (eg. 50% undivided interest of the oil or gas); it refers to a limitation in the amount that can be extracted (eg. “x” barrels of oil or “x” cubic feet of natural gas, etc.). The lessee’s interest in a mineral lease is considered to be a real estate interest for federal tax purposes. Accordingly, provided the lessee has the right to extract the minerals without being limited in the amount that may be extracted, it is considered to be like-kind to real estate for 1031 purposes.
Mineral Royalty A mineral royalty is a non-operating interest in the minerals and the holder bears no cost of production. The holder of it has the right to receive a designated percentage of all minerals produced for the life of the mineral lease. Similar to a mineral lease, a mineral royalty is also considered to be real property for federal tax purposes and is exchangeable.
Production Payment A production payment is a right to the mineral in place for a specified sum of money. It is considered to be a “carved out” payment and is not considered to be real property for federal tax purposes. Accordingly, the exchange of a production payment for an interest in real estate will not qualify under Section 1031.
To summarize, a mineral lease and mineral royalty are considered real property for federal tax purposes and may be eligible for a 1031 exchange; whereas, a production payment is not like kind to real estate and is not eligible for 1031 treatment.
Whether a mineral lease is eligible for 1031 treatment depends on whether the party is the lessor or the lessee. Since a mineral lease is an interest in real property, the lessee can receive the mineral lease as replacement property in the 1031 exchange after selling an interest in other real property. Because the lessor retains a royalty interest (but does not convey the entire real estate interest) the mineral lease is not eligible for 1031 treatment for the lessor. However, the lessor can subsequently sell the entire royalty interest and do a 1031 exchange with the proceeds.
Exchanges involving mineral interests, mineral leases and mineral royalties can be very beneficial for land owners by allowing them to better utilize the value of their asset. Let’s assume that Bob Jones farms or ranches a tract of land. Bob can sell his mineral rights (or royalty interest) without selling the fee to the property, do a 1031 exchange and acquire, as replacement property, additional acreage to farm or ranch or acquire other income producing property which can supplement his income or prepare for his retirement.
In addition, the replacement property could be a mineral lease or mineral royalty interest in a different property. All of this can be achieved legally without paying taxes. In addition to benefiting land owners, 1031 exchanges can be beneficial to companies that own mineral leases and/or mineral royalty interests. A company can reposition its assets by selling mineral leases and exchanging them for other mineral leases or mineral royalty interests. The sale of mineral leases may also involve the transfer of equipment and other tangible personal property. By doing a multi-asset exchange they can defer paying taxes on any depreciation recapture as well as any appreciation of the lease interest.
Although the applications are numerous and the process of doing a 1031 exchange does not need to be complicated, taxpayers are always advised to seek the advice of competent tax and legal advisors.
If you have more questions consider coming to our 1031 Exchange Seminar this Thursday February 16, 2023 at 6pm. Be sure to RSVP. IPX1031 will be teaching the class and will be on hand to answer any questions.