1031 Exchanges and Mineral Rights
If you are thinking about diversifying your portfolio by trading out of real estate investments and into mineral rights, you’ll need to determine whether the mineral right is exchangeable and whether it is like kind to the real estate you plan to sell. Because this is a complicated field, we recommend you talk to your tax advisor, but this article can give you an introduction into the topic.
There are many types of mineral rights, and some, but not all, can be exchanged in a 1031 exchange. Starting in 2018, only real property can be exchanged, so whether you can exchange a mineral right for either another mineral right or for a more traditional real estate investment first depends on whether the right is considered to be real estate rather than personal property.
Types of Mineral Rights
In some states, you can own a fee interest in the surface rights without owning the right to mine the underlying minerals. The separate perpetual right to explore, extract and sell minerals under the surface is called a mineral estate. In many cases, the mineral estate is broken up into lesser rights, such as mineral leases, royalties, production payments and profits interests.
Mineral rights are generally considered to be either operating interests or non-operating interests. With an operating interest, you own the right to extract minerals, and you operate the extraction and pay the costs of extraction. A mineral lease is an example of an operating interest. In a non-operating interest, you have the right to certain minerals or payments, but you don’t operate the process of extracting the minerals. Examples of non-operating interests are royalties, production payments and profits interests.
A mineral lease is a right to extract minerals that is either for a set period of time or until all of the minerals are extracted. Mineral leases are also called operating interests or working interests. The lessee has the obligation to pay for the costs of extraction, and the lessor usually retains a royalty. A mineral lease is considered to be real estate, so it can be exchanged by the lessee in a 1031 exchange. If the term is at least 30 years or until all minerals are extracted, the mineral lease can be like kind to a fee interest. It is important to note, however, that when selling the lessee’s interest in a mineral lease, the lessee cannot retain a royalty interest, or the transaction will not be exchangeable.
In addition, it is possible for the owner of the mineral estate to sell the mineral estate in exchange for other real property, provided the owner does not retain a royalty interest. Retaining a royalty interest would cause the transaction to be considered a lease rather than the sale of a capital asset, and therefore would not be exchangeable.
When the owner of a mineral estate leases it, the lessee has a mineral lease, and the owner of the mineral estate retains a royalty. The royalty owner gets a certain percentage of the minerals which are extracted and does not pay any of the costs of extraction. This right should also be considered real estate for tax purposes and is exchangeable.
A profits interest is similar to a royalty, but the cost of extracting the minerals is subtracted from the amount due to the underlying mineral estate owner. A profits interest can sometimes be considered real estate if it is not limited by time or quantity of minerals to be provided.
A production payment is the right to receive a certain percentage of the minerals which are extracted over a limited time or up to a limited quantity. A production payment is generally not considered real estate for tax purposes and therefore cannot be exchanged.
Mineral rights that are considered real estate may be exchanged. You have to examine the nature and duration of the rights granted, whether the relinquished and replacement properties are like kind and whether they are considered to be real estate for tax purposes.
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