Information about Tax Deferred sales of Oil and Gas Interests via 1031 Exchange

Oil and Gas Interests-Exchanging under Section 1031

I.R.C. Section 1031 provides that neither gain nor loss is recognized if property held for investment is exchanged for like-kind property held for investment or productive use in a trade or business. For taxpayers exchanging real property, the oil and gas interests must qualify as real property interests to satisfy the like-kind requirement. Please use the summary below to help you determine whether the oil and gas interest you are considering will be like-kind to real property:

1. Working Interest (a.k.a. mineral lease, operating interest). Yes. This qualifies as real property for Section 1031 purposes. (Rev. Rul. 68-226, 1968-1 C.B. 362; Rev. Rul. 68-331, 1968-1 C.B.352). This is a right to develop and extract minerals and an obligation to incur the capital expenditure to develop the mineral resources from the property.

2. Royalty interest – Yes. This qualifies as real property for Section 1031 purposes. It is a reserved mineral interest in future production; not limited in time or quantity; not subject to the burden of paying costs of production.

Types of Royalty Interests:

i. Underlying Royalty: Yes. Qualifies as real property for Section 1031 purposes. [Palmer v. Bender, 287 U.S. 551 (1932), Rev. Rul. 73-428, 1973-2 CB. 303.] Created when owner of the mineral fee conveys a leasehold, reserving a fractional interest in the minerals in place.

ii. Overriding Royalty: Yes. Qualifies as real property for Section 1031 purposes. [Rev. Rul. 73-428, 1973-2 C.B. 303.] Created when a lessee conveys a working interest (sublease) and reserves a fractional interest in the minerals in place

iii. Profits Interest: Depends. If limited in terms of dollar amount or time, it will not qualify as real property for Section 1031 purposes. This is an interest in minerals in place, where the amount paid is subject to offset by the cost of production.

iv. Production Payments: No. Does not qualify as real property for 1031 purposes. [IRC Section 636.] A right to minerals in place is limited to a certain production, typically in dollar amount or volume.

Your 1031 exchange intermediary cannot make the determination as to which category a mineral right may belong. Please consult with your legal or tax advisor for assistance in this regard.