Capital gains tax can be deferred when entering into a 1031 exchange for oil, gas, mineral, water and ditch rights. As with any tax deferred exchange, 1031 exchange rules are followed in either a forward 1031 exchange or reverse 1031 exchange.
Oil, Gas and Mineral Rights
Interest in oil, gas and mineral estates qualifies for 1031 exchange tax deferrals given the existence of a perpetual interest. Leases, royalties and production payments are often how the perpetual interests are conveyed.
For federal tax purposes, mineral leases are considered a real property interest and eligible for 1031 tax deferred treatment. Leases provide the lessee with the right to remove minerals for a specific period of time or until depletion, along with incurring the costs of discovery and removal. Leases are also known as a working or an operating interest. The lessee may deduct the intangible drilling costs (IDCs) for removing the mineral. IDCs include labor, repair and maintenance, fuel, transportation, supplies and other related production expenses.
For federal tax purposes, royalties are considered a real property interest and qualify for 1031 exchange tax deferral treatment. Oil, gas or mineral royalties do not represent an operating interest and neither incur nor are responsible for production costs. Instead, the holder of the royalty receives a percentage interest in the materials removed for the life of the property.
Production payments are not eligible for 1031 exchanges given they are a right to the oil, gas or mineral at a specific value, produced and paid from a percentage of removed minerals. Unlike royalties, production payments are finite based upon a specified production versus royalties that are perpetual, or until the mineral is exhausted.
Water Rights
Dependent upon state law, perpetual water rights are like kind to real estate. If the water rights are limited in duration or amount, they are not under section 1031 considered like kind to real property. In Donald Wiechens, et al. v. U.S., 228 F. Supp. 2d 1080 (D Ariz 2002), the Court ruled water rights limited in priority, quantity, and duration for a 50-year term were not like kind to a fee interest in real property even though the water rights were real property under state law. The Court denied the 1031 exchange on the basis the water rights were restricted as opposed to unlimited use of real property. In Private Letter Ruling 200404044, the Court ruled in favor of a decision where water rights were limited to a maximum diversion rate and quantity per calendar year but not duration to be like kind to a farm.
Ditch Rights
Congress approved the Food, Conservation and Energy Act of 2008 providing that stock held in a mutual ditch, reservoir or irrigation company is eligible for 1031 exchanges. Shares can be exchanged, if the ditch, reservoir, or irrigation company is an organization described in Section 501(c)(12)(A) and the highest Court in the State in which the company was organized or applicable State statute recognizes the shares as either interest in real property or real property. A mutual ditch company is a non-profit organization created for the single purpose of providing their members the management of a joint water distribution service. Ranchers and farmers are the typical shareholders that have an exclusive right to use the ditch company’s water in proportion to the number of shares owned.
Excess Funds in Your 1031 Exchange? Consider Royalties
Oil royalties or gas royalties can be helpful in allocating the “left over” dollars you may have in a 1031 exchange. Let’s say you have a $500,000 1031 exchange from selling farmland. No debt, just a simple sale, producing a significant capital gains tax if you don’t utilize a 1031 exchange. You have already found a nice multi-tenant complex for your replacement property but it’s only a $450,000 acquisition. The “left over” $50,000 also known as “boot” is subject to taxes if you do not find an additional replacement property.
That’s where oil & gas minerals or royalties can really be a benefit. Eligible for like kind exchanges, oil & gas minerals and royalties are considered “real property.” Interestingly, minerals can be legally severed from the surface property allowing for the purchase of just the minerals. Those severed mineral assets may be bought (or exchanged for) in any amount of acreage a seller might be willing to part with. For example, you can buy just 10 Net Mineral Acres from a property owner who owns 100 acres of surface and mineral acres. Essentially, you can buy 10% of his minerals and the land owner would be left with 100 surface acres and 90 Net Mineral Acres. Then, as oil and gas are produced from your property, you would be entitled to the Royalties paid on your proportional share (10 acres out of 100) of acreage.
Often available in much smaller investment increments than found in traditional real estate, oil & gas minerals may allow you to utilize the dollars subject to a “boot” while at the same time, potentially benefiting your overall portfolio. Oil and gas royalties provide diversification into commodities based assets and typically create passive monthly income that has historically been a very nice inflation hedge. With the drilling technology that has been developed over the last several years, there is a SHALE oil and gas boom—and resulting aggressive development occurring in many areas of the United States—that could provide you with appreciation.
Peabody Natural Resource Company Case Study
Many transactions meet the exchange guidelines on their face; however, others are less clear. One type of Section 1031 Exchange that has caused much confusion is a transaction where mineral rights are involved. Whether or not this type of exchange results in non-recognition of gain depends on the facts of the case; however, the Internal Revenue Service, or IRS. has provide some guidance through case law and Private Latter Rulings, or PLRs, over the years. Equitable servitudes, for example, were discussed in Peabody Natural Resources Company, et.al. v. Commissioner or Internal Revenue 126 T.C. No. 14 (2006) and were found to qualify for Section 1031 Exchange treatment.
In Peabody, the taxpayer owned an operating gold mine that it exchanged for operating coal mines. The coal mines were under contract to supply coal to two electric utility companies at the time of the transaction. In disallowing the portion of the exchange relating to the supply contracts, the IRS contended that the coal supply contracts were not real property, and therefore, constituted “boot” in the exchange. Ultimately, the U.S. Tax Court, or T.C., disagreed and allowed the contracts in the exchange, effectively allowing the entire exchange to receive non-recognition of gain treatment.
Equitable Servitude
When determining if an asset is real property or personal property, the court looks first to the law of the state governing the transaction. In this case, the contracts were governed by the State of New Mexico. Taxpayer successfully argued that the contracts created an equitable servitude and that the equitable servitude is a real property interest in New Mexico. The IRS argued that the contracts did not create a real property interest but created a contract to sell personal property and, therefore, were not eligible for exchange treatment.
As a general rule, minerals in place are considered real property; however, once they have been severed from the land they are considered personal property. The laws of the State of New Mexico treat a contract for the sale of minerals (or coal in this case) as a contract for the sale of goods. In Peabody, however, the contracts created a transferable obligation to sell the coal. Although the owner of the coal mine could sell the mine, a successor was obligated to honor the contract for the sale of the coal. That obligation, under New Mexico law, can be treated as an interest in land if the obligation amounts to an equitable servitude. In New Mexico, an equitable servitude is created when the following requirements are met:
- The covenant must touch and concern the land.
- The original “covenanting” parties must intend that covenant to run with the land.
- Any successor against whom enforcement is sought must have actual, constructive, or inquiry notice of that covenant.
The T.C. found all three elements to exist. Therefore, the court found that the coal supply contracts were an equitable servitude and, therefore, potentially qualified as an interest in real property.
The final issue was whether or not the coal supply contracts were “like-kind” to the gold mine. Just because the contracts were found to have been an interest in real property does not automatically mean they are “like-kind” to another interest in real property. Ultimately, the court held that the contracts were indeed like-kind, making them eligible for non-recognition treatment. In its analysis of the like-kind issues the court found that:
“ Peabody’s right to mine and extract coal from the Lee Ranch mine land and its supply contracts payment rights for the coal cannot be separated from its ownership of the Lee Ranch mine coal reserves. Those rights are part of the bundle of rights incident to Peabody’s ownership of the Lee Ranch mine land coal reserves.”
Essentially, the court found that since the supply contracts were inseparable from the mine itself they were part of the overall interest in real property represented by the coal mine and therefore, were like-kind to the gold mine. The taxpayer was able to claim non-recognition for the entire transaction as a result of the court’s ruling.
If you are considering a 1031 exchange of oil, gas, mineral, water or ditch rights, Atlas 1031 provides the accommodation services compliant with Internal Revenue Code Section 1031. Click below to begin a consultation or call our office at 1 800 227 1031.
