Can You 1031 Exchange Into Texas Mineral Rights?

If you have sold investment real estate and need a replacement property within the 1031 exchange deadlines, mineral and royalty interests are an option many people in that position have not considered. In many cases they can qualify as like-kind replacement property.

In our experience, they can often be sourced within the exchange window more readily than another building, since there is no tenant to vet and no building to inspect. Title examination and an independent evaluation of the reserves still take time, though, and the deadlines do not move to accommodate them. Minerals also come with their own pitfalls: what exactly you are buying, who you are buying it from, and what you pay.

This article covers when minerals qualify, the choices that matter, and where exchanges into minerals go wrong. It builds on our earlier pieces on selling a major real estate asset and on managing mineral rights income.

Why Minerals Can Qualify

Since 2018, Section 1031 applies only to exchanges of real property held for business or investment. The Treasury regulations define real property to include “unsevered natural products of land,” and say that mines, wells and other natural deposits “generally are treated as real property.” They also treat property as real property if it is real property under the law of the state where it is located, subject to federal exclusions. Texas law treats minerals in place as real property. Its property tax code, for example, defines real property to include “a mineral in place.”

The IRS and the courts have long treated certain interests in oil and gas in place as like-kind to land:

• In 1941, a federal appeals court allowed an exchange of oil, gas and mineral rights for an interest in improved real estate.
• In Revenue Ruling 68-331, the IRS ruled that a producing oil lease running until the deposit was exhausted was like-kind to a ranch.

What generally qualifies: fee mineral interests, and royalty interests that last as long as the minerals are produced. An overriding royalty can also qualify. In Texas, though, an overriding royalty generally ends when the lease it is carved from ends, so its duration deserves a close look.

What generally does not:

• Rights limited to a set amount or a set period, such as production payments and term royalties.
• Shares of a company.
• Interests in a partnership or fund.
• Royalty income that has already accrued or been held in suspense. Once produced, oil and gas is no longer real property.

The regulations exclude stock and partnership interests whatever state law says. Whether a particular interest qualifies depends on how it is written. Your tax adviser should confirm it before you identify it.

Royalty or Working Interest?

This is the first real choice, and it changes what you own.

A royalty interest pays you a share of production. You don’t pay drilling or operating costs. You generally do bear severance and property taxes, and depending on the lease, some post-production costs. It involves far less hands-on management than a working interest.

A working interest carries a share of the costs of drilling and operating the wells, and the responsibilities that come with them. That can mean larger potential income. It also means more risk:

• costs can exceed income in a given year;
• owners can bear the costs of plugging wells and environmental obligations.

Whether a working interest qualifies for an exchange depends on its terms, including whether the co-owners are treated as a partnership for tax purposes.

Either way, the income depends on commodity prices and on how much the wells produce. Production from a well declines over time. Neither is under your control or ours.

Public Companies and Private Sponsors

Mineral and royalty exposure is available in two very different forms:

Publicly traded mineral and royalty companies. You can buy and sell their shares on any trading day at a visible price. Shares are stock, though, and stock does not qualify as 1031 replacement property.

Private sponsors and aggregators. Some sell interests conveyed to you directly by deed. These can qualify. Others sell interests in a fund, which do not. With either, there is no daily price, and selling later can take time.

A separate category is exchange offerings structured as Delaware statutory trusts. The IRS has ruled that interests in a trust structured the way it described can be treated as direct interests in real property. That ruling addressed net-leased rental real estate, and its limits on new leases can be hard to apply to minerals. Whether a particular offering meets the standard depends on its documents.

Where Exchanges Into Minerals Go Wrong

1. The calendar. You have 45 days from the sale to identify replacement property in a signed, written notice. You must then close within 180 days of the sale, or by your tax return due date including extensions if that comes first. The identification rules limit how many properties you can name. The two common ones are the three-property rule and the 200 percent rule. You cannot receive or control the sale proceeds, so most people use a qualified intermediary to hold them. Missed deadlines usually cannot be fixed.

2. Ownership on both ends. Generally, the taxpayer who sells must be the taxpayer who buys. A single-member LLC that is disregarded for tax purposes usually counts as its owner. If an LLC taxed as a partnership sold the building, the partnership generally has to acquire the minerals. The individual partners can’t. Changing ownership structure shortly before or after an exchange can put the deferral at risk. Have counsel review the title on both sides before you list the property for sale, not after.

3. Reinvesting the full amount, and the mortgage you paid off. To defer all of the gain, you generally must do two things:

• buy replacement property that costs at least as much as the property you sold;
• reinvest all of the net proceeds.

If the property you sold had a loan, the debt that was paid off counts as money you received unless you replace it. You replace it with new debt on the replacement property or with additional cash. If the mineral purchase carries no debt, plan on adding cash to defer the full gain, or expect to owe tax on the difference.

4. Price, and who is on the other side. There is no exchange quoting a price for a royalty interest in a given county. Price discovery is hard. The spread between what a seller paid and what you pay can be very large. Ask how the price was set. Ask what the sponsor paid. Ask whether an independent engineer’s evaluation of the reserves supports it. Be wary of anyone whose main selling point is how fast they can close inside your window. And if the seller is a family member or a related entity, which is not unusual in Texas, additional rules and holding periods apply.

5. Title and records. A royalty check is not an inventory. Before you buy, confirm the following:

• Title has been examined.
• The interest is recorded in the county.
• The operators’ records show the seller as the owner.

After you buy, the same follow-through applies. Your deed, the county records and the operators’ records all need to match. If you hold the interest in a trust or LLC, it must actually be conveyed there. Someone in your family also needs to know what you own and how to manage it. Planning who will own the minerals is not the same as planning who will manage them.

6. Different asset, different risks. There is no building to improve and no lease to renegotiate. Your basis generally carries over from the property you sold. The income will move with prices and production. These are generally long-term holdings. They are not liquid, and they are not a substitute for liquidity elsewhere in your portfolio.

How We Work on These

When a client tells us a property sale is coming and minerals are on the table, we start with the calendar. The best time to plan an exchange is before the sale closes, because the 45 days begin at closing.

From there, we:

• bring in qualified minerals specialists and experienced title counsel;
• seek opportunities through our long-standing relationships with mineral sponsors;
• coordinate with the client’s legal and tax counsel and the qualified intermediary;
• follow the transaction from identification through closing.

Afterward, we fold the interests into the client’s broader plan, including estate documents and who will manage the minerals.

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