If you’re considering diversifying your portfolio by transitioning from traditional real estate investments into mineral rights, it’s essential to understand the complexities of the process. A key question is whether the mineral rights you’re acquiring are exchangeable in a 1031 exchange and if they qualify as “like-kind” to the real estate you’re selling. While this topic can get technical, this guide offers an introduction to help you understand the basics. However, we strongly recommend consulting a tax advisor for personalized advice.
Understanding Mineral Rights and Their Role in 1031 Exchanges
Since the Tax Cuts and Jobs Act (TCJA) of 2018, only real property is eligible for a 1031 exchange, meaning that whether mineral rights qualify depends on if they are classified as real estate. Let’s break down the different types of mineral rights and explore whether they are considered real property or personal property under current tax laws.
Types of Mineral Rights
In some states, you can own surface rights without holding rights to the minerals underneath. Mineral rights, also known as a “mineral estate,” grant the perpetual right to explore, extract, and sell minerals beneath the surface. These mineral rights can be further divided into subcategories, such as mineral leases, royalties, production payments, and profit interests.
The key distinction lies in whether the rights are classified as operating interests or non-operating interests. Operating interests give you the right to extract minerals and bear the costs of extraction. In contrast, non-operating interests involve the right to receive minerals or payments without being responsible for extraction.
Mineral Leases and 1031 Exchange Eligibility
A mineral lease allows the holder (lessee) to extract minerals for a set period or until all minerals are depleted. These leases, also known as operating interests, come with an obligation for the lessee to cover the costs of extraction, while the owner of the mineral estate typically retains a royalty interest.
For 1031 exchange purposes, a mineral lease is considered real estate, making it eligible for an exchange. The lease must have a term of at least 30 years or extend until all minerals are exhausted to qualify as like-kind to a traditional real estate property. However, it’s important to note that a lessee cannot retain any royalty interest upon sale; doing so would disqualify the transaction from being exchangeable.
Similarly, a mineral estate owner can sell their estate in a 1031 exchange, provided they do not retain a royalty interest. Retaining royalties would reclassify the sale as a lease, not the transfer of a capital asset, making it ineligible for the exchange.
Royalties and 1031 Exchanges
A royalty interest is retained by the mineral estate owner after leasing the extraction rights to a lessee. The royalty owner receives a percentage of the minerals extracted but does not pay any extraction costs. For tax purposes, this type of interest is typically considered real property, which means it can be exchanged in a 1031 transaction.
Profits Interests
A profits interest works similarly to a royalty, except the costs of extraction are deducted before payment is made to the mineral estate owner. To qualify as real estate under 1031 exchange rules, the profits interest must not be limited by time or by a specific quantity of minerals to be produced.
Production Payments: Not Exchangeable
A production payment gives the right to receive a percentage of minerals extracted over a set period or up to a certain quantity. Production payments are generally not considered real estate for tax purposes and therefore cannot be included in a 1031 exchange.
Conclusion
Mineral rights that are classified as real estate can be exchanged in a 1031 exchange. However, it’s crucial to understand the nuances of the mineral rights you hold or plan to acquire, including their duration and nature, and whether the properties involved qualify as like-kind real estate. The classification of these rights will ultimately determine whether your transaction meets the requirements for a 1031 exchange.
As mineral rights and 1031 exchanges can involve significant tax implications, we highly recommend consulting with a CPA or tax advisor to evaluate your specific situation. A professional can help you navigate the complexities and ensure your exchange is compliant with IRS regulations.
*Peak 1031 Exchange, Inc. does not provide legal or tax advice. Always consult with your attorney or tax adviser.