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Mineral Interests and 1031 Exchange

Andy Gustafson 04/16/2012 @ 9:14am

In most transactions for the sale of real property, capital gains taxes are levied on any realized gain as a result of the sale. One way to defer the payment of capital gains taxes is to enter into a Section 1031 Exchange instead of completing a conventional sale of the property. In order to qualify for 1031 Exchange consideration, the property exchanged must meet very strict guidelines, including the requirement that the property exchanged be “like-kind”. While the exchange of some types of real property clearly meet the Internal Revenue Service guidelines, determining whether other types of property interests qualify can be more complicated. For example, certain oil, gas and mineral interests are potentially eligible for Section 1031 Exchange treatment, while others are not eligible.

Operating Interests

Palmer v. Bender, 257 U.S. 551 (1933) firmly established that mineral rights do qualify as an economic interest in property, thereby creating the foundation for the possibility of entering into a 1031 Exchange transaction when selling, or exchanging, an interest held in minerals, gas or oil. Determining precisely what types of interests qualify, however, is somewhat more complex. An interest in minerals, gas or oil can be considered either an operating interest or a non-operating interest. As the name implies, operating interests convey the right to develop and produce the minerals, oil or gas. An operating interest is commonly referred to as a lease. Non-operating interests include the rights to any minerals, oil or gas produced, or the rights to income from the minerals, gas or oil produced. Operating interests are always eligible for 1031 Exchange treatment. Non-operating interests may, or may not, be eligible.

Non-Operating Interests

Non-operating interests fall into three basic categories -- royalties, profit interests and production payments. A royalty is an interest received, or reserved, from the production of minerals, gas or oil. Royalties qualify for 1031 Exchange treatment provided all other criteria are met. Profit interests may qualify for 1031 Exchange consideration. A profit interest is an interest in the profits made from the extraction of the oil, gas or minerals. A profit interest may be eligible only if it is not limited in time or quantity. A production payment is an interest that allows the purchaser to receive payment at a future date based on production in exchange for an up front cash payment. This is referred to as a “carve out” and is not considered an economic interest in the property. As such, IRC Section 636 specifically disallows this type of interest from qualifying for 1031 Exchange treatment.

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