Oil, Gas, and Mineral Rights 1031 Exchanges: A Complete Guide

Oil, gas, and mineral rights 1031 exchanges allow investors to defer taxes when exchanging resource interests such as water rights, ditch rights, and timber leases.

However, their tax deferral status may depend on where you live and the exact contract terms of the agreement. Understanding these nuances is critical to ensuring you 1031 exchange remains compliant with IRS regulations.

Understanding 1031 exchanges and the broad definition of like-kind property

One of the most useful aspects of IRC Section 1031 is the rather broad definition of like-kind property. Because virtually all types of real estate held for business or investment purposes are considered of like kind to one another, it’s possible exchange between classes of real estate, such as from a single-family rental property to a warehouse, or from a retail storefront to a farm. So long as both properties are held for business or investment purposes, there’s a good chance of being able to defer taxes through a 1031 exchange.

This can include investments outside of what may immediately come to mind when one thinks of property ownership. For example, an interest in a Delaware Statutory Trust (DST), which involves fractional ownership of a large-scale commercial real estate portfolio, is considered a like-kind property under Section 1031, meaning it’s possible to exchange a whole property for a series of DST interests, and vice-versa.

Resource rights as 1031 exchange properties

The same is true for certain investments in oil, gas, and mineral extraction. Even if the investor doesn’t own the actual land on which exploration is being done, rights and leases for oil, gas, minerals, water, and other resources can qualify as 1031 replacement properties.

Purchasing these oil and gas rights or other resource rights can create passive income streams without the headaches of property management. Those who own land and wish to sell resource rights could use the proceeds to purchase another investment property and defer taxes in the process through a properly structured 1031 exchange.

However, not all land rights are eligible for tax deferral under Section 1031. It’s important to understand the rules for what qualifies as eligible resource rights and what doesn’t so you don’t end up with an unexpected tax bill.

1031 exchanges and the definition of “real property”: key changes since tax cuts and jobs act

For much of its history, Section 1031 applied to a wider range of property types than it does now. The Tax Cuts and Jobs Act of 2017 amended Section 1031 so that instead of “property,” it now applies only to “real property.”

What qualifies as real property for 1031 exchanges?

As the IRS explains, “Real property, also called real estate, is land and generally anything built on or attached to it.”

In the opinion of the IRS, “real property” and “real estate” are interchangeable terms. While in the past, it was possible to perform a 1031 exchange with aircraft, farm equipment, or other personal property,  today’s 1031 exchanges are now restricted to real estate.

But don’t let the term “real estate” fool you. As mentioned, your conception of what qualifies as “real estate” may leave out some eligible property types. Partial interests can be eligible for like-kind treatment, including tenancy-in-common (TIC) relationships and DST interests.

Note that the IRS definition includes “generally anything built on or attached to it.” Resources found underground on a piece of land count as something “attached to it,” and therefore the ownership of those resources can qualify as ownership of real property, even when the land itself is owned by someone else.

Can an oil, mineral, or gas lease be considered real property for a 1031 exchange?

Unfortunately, not all oil and gas leases are considered real property. The duration of the lease, the type of interest, and the status of the resources all affect eligibility. The 1031 eligibility of oil and gas rights depends on several factors: the duration of the lease, the type of interest held, and the current status of the resources. Understanding these factors is essential for any 1031 exchange involving resource rights.

Natural products and the severance rule

A 2020 update to the definition of real property included “unsevered natural products of land, and water and air space superjacent to land.” As defined in Regulation 1.1031(a)-3(a)(3), these natural products include “growing crops, plants, and timber; mines; wells; and other natural deposits,” with the caveat that “Natural products and deposits, such as crops, timber, water, ores, and minerals, cease to be real property when they are severed, extracted, or removed from the land.”

In other words, while the oil or gas is in the ground, it is real property; once it is extracted, it no longer counts as real property. This severance rule distinction could matter if an operating mine or well is for sale, as anything already extracted cannot be purchased with 1031 exchange funds without resulting in taxation.

Lease duration requirements for 1031 eligibility

A further complication in evaluating 1031 eligibility comes from the duration of the contract: a perpetual interest is considered ownership, so leases, royalties, and production payments that are in perpetuity can qualify under Section 1031 regulations. Leases of limited duration are not considered to be of like kind to fee ownership of real property, preventing exchanges between limited-duration leases and other property types.

How long must a lease be in order to be exchangeable? Generally, leaseholds of 30 years or more qualify, but often resource rights are leased not based on a period of time, but according to volume. If the lease extends “until the well is exhausted,” it should qualify as perpetual, even if the well is not expected to be actively producing for 30 years.

Income limitations and like-kind property requirements

Contract terms which limit income received can also lead to 1031 ineligibility. In Fleming v. Commissioner, the court ruled that “limited overriding royalty or oil payment interests (carved by them out of larger oil and gas interests)” were not of like kind to a fee interest in real property.

What made these carved-out interests ineligible was that “The limited overriding royalties and oil payment rights entitled the taxpayer to receive production from certain oil and gas leases up to a fixed amount plus interest. Once this amount had been received, the interests would revert to the owner of the leases.” This limitation is what made them not of like kind, whereas a lease that entitled the holder to a certain percentage of profits with no limit would be considered a perpetual interest.

Working interests vs royalty interest in oil, gas and mineral rights 1031 exchanges

There is a distinction between working interests and royalty interests when structuring oil, gas and mineral rights 1031 exchanges.

A working interest involves the exclusive right to extract resources, and operating expenses lie with the lessee. Rev. Rul. 68-226 allows for an owner’s “entire leasehold interest (or an undivided portion thereof)” to be treated as real property for federal income tax purposes. Usually, this is an agreement between a tenant and the owner of the land on which the oil or gas is being extracted.

A royalty interest is an investment that does not involve ownership, and may be limited to a specified return. A working interest includes obligations and rights of ownership in the event of a bankruptcy, while a royalty interest would be seen as a loan or payment for services. If a royalty interest is for a specified return, then it would not qualify as real property. A royalty agreement can be made between an investor and the holder of the working interest. The owner of the land could also receive a royalty interest as part of the agreement to drill on the land.

Rev. Rul. 73-428 held that a royalty interest was considered real property held for business or investment use if it was “for so long as oil or gas is produced from the lease,” (in other words, perpetual rather than fixed-term), and if the individual was not a dealer of such interests holding them primarily for sale. A company selling individual interests in order to finance drilling likely could not count them as like-kind property, but the purchasers of individual interests could.

If you are purchasing a fractional interest in oil and gas extraction, make sure you understand the precise terms so you can properly plan your 1031 tax deferral strategy. These situations are complicated, and require competent tax and legal advice.

Can an overriding royalty interest (ORRI) qualify for a 1031 exchange?

Another type of oil and gas royalty is an overriding royalty interest (ORRI) which is an undivided interest that gives the holder rights to a proportional share of the revenue received from the sale of the oil or gas extracted from the land. An ORRI is not deeded as real property, and ORRI owners have no claim of ownership to the unsevered resources, only to the profits derived thereof.

In Rev. Rul. 72-117, it was ruled that an ORRI can qualify for Section 1031 tax deferral. Though an ORRI isn’t technically ownership of the resources, it is nonetheless considered real property. But once again, sale of these interests in the normal course of business is not considered like-kind, so the owner of the original working interest selling proportional shares likely cannot defer taxes on their sale.

Are mineral rights eligible for 1031 exchanges?

As with oil and gas rights, mineral rights are generally divided into working interests and production payments, with the latter often viewed as personal property if they involve passive investing without ownership rights or responsibilities. However, unlike with most issues of real vs. personal property, the IRS has occasionally deferred to states when it comes to the treatment of mineral rights.

State law treatment of mineral rights

In Commissioner of Internal Revenue v. Crichton, the ruling stated that “The commissioner concedes, as he must, that under Louisiana law, mineral rights are interests not in personal but in real property, and that the rights exchanged were real rights,” deferring to state law when determining the status of a resource interest.

This means that whether your property is eligible for 1031 exchange involving mineral rights may come down to the state in which it is located. Most states treat mineral interests as real property in the same way they treat oil and gas leases. However, this is subject to change, especially with the Tax Cuts & Jobs Act altering the treatment of personal property; in the past, whether something was real or personal property didn’t matter as much because both were eligible for 1031 exchanges. But now, only real property is eligible, and the IRS has not ruled on every complex situation, meaning state courts and legislatures could play a large role in determining 1031 eligibility for mineral rights in future cases.

The nature of the transaction

In Crooks v. Commissioner, it was determined that the sale of a mineral deed was not of like kind to an acquired property because the seller retained an economic interest after the sale. When determining if properties are of like kind, the nature, character, and class of the properties is considered, and in this case, the court “concluded that the nature of the transaction constituted a lease, rather than a sale, meaning that not only must the property exchanged be of like kind, but the nature of the transaction itself must be of like kind.”

When it comes to mineral rights and other resource interests, whether a transaction will be seen to involve real property of like kind is not as simple as it is when dealing with other types of real estate. Things can be further complicated when one state treats an interest as real property while another treats it as personal property, making state-specific mineral rights analysis crucial before executing a 1031 exchange.

Water rights, timber rights, and ditch rights: state-specific 1031 exchange rules

Following the changes of the Tax Cuts & Jobs Act of 2017, it is generally held that “perpetual water rights” and “Mutual ditch or irrigation companies remain eligible for like-kind exchange treatment so long as the company is treated as exempt from income tax under 501(c)(12)(A).”

Types of water rights and their 1031 eligibility

There are many types of water rights, each with different eligibility considerations for 1031 exchanges:

• Perpetual water rights are those that do not have an expiration date. They grant access to a water source and may specify a volume limit, but because there is no fixed term, they are generally considered real property for 1031 exchanges.

• Temporary water rights are limited to a fixed term, and because of their limited duration, are often considered personal property.
• Ditch rights are generally treated the same as water rights, with those of a fixed term classified as personal property while perpetual rights are real property. However, in some states, ditch rights are an easement appurtenant, which means they are tied to the land and not severable.
• Groundwater rights can be treated differently than surface water rights depending on the laws in a given state.

Whether a particular classification of water rights is severable, and if it will be treated as real property for 1031 purposes, can vary by state, and is subject to change. As such, exchangers always need to check local and state laws regarding the legal treatment of these resources before proceeding with any water rights exchange transaction.

Timber rights and state classification variations

State classification of timber rights can vary widely: in Minnesota, the right to enter land to remove standing timber is clearly defined as real property, whereas in Pennsylvania, it is personal property. In Oregon, standing timber has been defined as real property, but was deemed personal property in relation to a 1031 exchange.

Cross-state 1031 exchanges: federal vs state property classification

Because states have different rules, what happens if you’re exchanging resource rights from one state to another? According to the IRS, “State law property classifications, while relevant for determining if property is real or personal property, are not determinative of whether properties are of the same nature and character.”

The above memorandum makes it clear that while the IRS may use state classifications as guidance, it will still evaluate the nature, character, and class to avoid “absurd” rulings. If your property qualifies in one state but not in another, it may be possible for you to perform a state-to-state exchange, so long as you believe the exchange would pass federal criteria.

Unique risks of oil, gas, mineral, water, timber, or ditch rights as 1031 replacement properties

Property owners seeking passive income may be interested in resource royalties as replacement properties. But when compared to other passive income streams from real estate such as those provided by triple-net (NNN) leases or Delaware Statutory Trusts (DSTs), resource rights investments have unique risks that must be carefully considered before committing capital.

Income volatility and commodity price risk

The income derived from these resource rights is tied to commodity prices and market fluctuations, and could fluctuate far more than rental income. In addition, production will naturally decline over time, whereas with other types of property ownership, income may not decrease over time in the same way.

Management and due diligence challenges.

As with DSTs, royalty interests rely on the operator for day-to-day management. Many property owners may find due diligence easier with a DST or NNN lease because of a greater familiarity with the sector and with real estate ownership in general as opposed to the oil, gas, or mineral industries. That’s why getting the right advice is crucial when evaluating potential replacement properties.

How to ensure your 1031 exchange with resource rights will be ruled valid by the IRS

Even if you’re certain your chosen resource acquisition will make a solid investment, you still need to be sure your 1031 exchange will be ruled valid to continue tax deferral. Whether buying or selling resource rights, you need to consult with your tax and legal advisors, and retain an experienced Qualified Intermediary (QI).

Every 1031 exchange requires a Qualified Intermediary to hold funds until they are used to acquire replacement property. While there are not many requirements for who can be your QI, few QIs have experience with exchanges involving these kinds of complex resource agreements, and you don’t want to trust your tax deferral status to someone unfamiliar with the sector.

If you’re looking to perform a complex 1031 exchange and want to ensure compliance with IRS rules, consider a trusted name like JTC. Our team has experience with many types of exchanges that other QIs have never dealt with before, and we’ve pioneered a set of 1031 best practices to provide transparency and security for your funds. With JTC, you’ll have the confidence that your exchange is in good hands.

Learn more about JTC’s 1031 exchange services