When we think of 1031 exchanges, we picture investors swapping one property for another. This is the most common scenario, but there are cases when the transactions are a little more unconventional. In fact, you can exchange oil, mineral, gas, water, and ditch rights through a 1031 exchange. Done correctly, such a practice can help you defer capital gains taxes as outlined by Section 1031 of the Revenue Code.
Exchanging these types of assets is complex. Understanding how land use rights, extraction rights, and water rights fit into 1031 exchanges is crucial for property owners and investors looking to defer capital gains taxes. However, eligibility depends on several key factors. These include the nature of ownership, state laws, and IRS classifications.
In this blog post, Realized 1031 discusses these types of transactions. We’ll break down how oil, gas, mineral, water, and ditch rights qualify for like-kind exchanges. Keep reading to learn more.
A 1031 exchange is a tax deferral strategy where you swap a property for another provided they are of the same type — hence, the like-kind exchange. Since there is no sale, no taxable event occurred. This technicality allows you to defer your capital gains taxes until a triggering event happens.
The IRS has many rules for 1031 exchanges to prevent abuse. At the forefront of these requirements is that the asset you’re relinquishing or acquiring must be real property — stocks, bonds, or partnership interests are not allowed. What defines a real property, then? At the most basic level, the IRS calls land and anything built or attached to it real property.
Treasury Regulations (§1.1031(a)-3) issued in 2020 added more clarification to what can be considered real property. Aside from land and permanent structures, the list now includes unsevered natural deposits and certain perpetual interests in land. In this context, perpetual interest refers to land interest that exists indefinitely, such as outright ownership of oil or mineral deposits.
Intangible property and contractual rights, such as short-term leases or royalty payments, typically do not qualify. This distinction is particularly important when evaluating whether oil, gas, water, and ditch rights qualify for an exchange. If an investor incorrectly assumes their resource rights qualify for a 1031 exchange, they could face unexpected tax liabilities.
Oil, gas, and mineral rights present challenges when it comes to their eligibility for 1031 exchanges because they exist in a legal gray area. Some can be qualified as real property thanks to perpetual interest, which can manifest as leases, royalties, and production payments. Other times, oil, gas, and mineral rights can be classified as personal property, disqualifying them from the like-kind exchange.
A key distinction between mineral-related interests is how the rights are structured. In this context, rights refer to the nature and duration of the ownership or contractual interest in the subsurface resources.
This is the most straightforward type of right wherein a landowner holds full ownership of the subsurface minerals along with the land. Given this structure, a fee simple ownership is eligible for 1031 exchanges.
If mineral rights have been separated from land ownership, their eligibility depends on state law. This scenario is common among oil and gas drilling leases. For some states, mineral interests are already considered real property. Others classify them as personal property. These state-level classifications play a significant role on the federal level.
A working interest gives the holder the right to drill, extract, and operate on a mineral property.Depending on how the interest is structured and classified under state law, a working interest may qualify for a 1031 exchange if it is considered a real property interest and is held for investment or business use. However, working interests that are structured as leaseholds or contractual rights may not be eligible,
A royalty interest, on the other hand, provides passive income from resource extraction but no direct ownership. As such, this type of mineral right is considered personal property and does not qualify in a 1031 exchange.
The ORRI is a non-ownership interest that grants a percentage of the production revenue without the investor having direct control over extraction. Given this structure, this type of royalty interest isn’t eligible for 1031 exchanges.
Production payments — income from extracted resources — are not real property and therefore do not qualify for the like-kind exchange.
Since mineral rights classification varies by state, investors must understand how their specific state treats these rights. Here are a few prominent examples.
Water rights are as complex as mineral rights when it comes to 1031 exchanges. Ownership over this resource is not always considered real property rights, depending on specific state laws. In general, perpetual water rights, those that allow indefinite use of water from a specific source, are more likely to qualify as real property. Meanwhile, limited duration or contractual rights may not be eligible.
Water rights must meet IRS criteria for real property to be considered allowable in a 1031 exchange. This determination is hugely dependent on state law. For example, Colorado and California typically treat appropriative water rights as real property and are thus eligible for a 1031 exchange. Appropriative water rights refer to the right of an individual to divert and use water regardless of the relationship between land and water.
On the flip side, some states classify temporary or lease-based water rights as personal property instead of real property. This category disqualifies such water rights from being exchanged.
For those who plan to exchange water rights in a like-kind swap, an important thing to keep in mind is your state’s specific rules. For example, some states will treat water rights as personal property or a usufructuary right, which is a temporary right. These classifications are not generally eligible in a 1031 exchange.
Another consideration is equitable servitude, which is a non-possessory interest in a piece of land. If a water right carries land-use restrictions, it may impact the water right’s classification as real property. If in doubt about your state’s rules regarding water rights, we recommend working with professionals who specialize in these niche areas.
In the context of real estate, ditch rights refer to the right to access and use water through man-made canals, ditches, or pipelines. Ditch rights are critical in irrigation and water distribution as they protect the legal entitlement of landowners to utilize water resources for specific purposes. Although water itself is typically not considered real property under federal tax law, ditch rights can qualify for a 1031 exchange if they meet specific criteria.
Again, the IRS bases eligibility on state law. In many states, ditch rights are classified as an “easement appurtenant.” This means that the right is attached to a specific piece of land and transfers with it upon a sale. In most cases, the easement is recognized as a real property interest, making qualifying ditch rights allowable under a 1031 exchange.
The eligibility becomes more challenging if the ditch right is merely a license to use water infrastructure. In other words, the right is a revocable privilege rather than a property interest.
Based on the facts we shared above, there are three common challenges that investors may face when determining whether their mineral, water, or ditch rights are eligible for a 1031 Exchange or not. Foremost is the classification of the rights. Only those classified as “real property” under state and federal laws can be exchanged. Non-operating interests, such as overriding royalty interests, are often ineligible for exchange.
Second is the variations in state laws. Some consider these rights to be real property, while others categorize them as personal use. Additionally, whether the rights are considered part of the real estate or separate from surface rights differs from one state to another.
The third essential consideration is the type of ownership, whether it’s a lease or full ownership. Short-term leases and royalty interests, which are types of temporary ownership, are not considered real property and are therefore ineligible for 1031 exchanges.
Given these considerations, we recommend the following best practices.
Undergoing a 1031 exchange of mineral rights, ditch rights, or water rights can be a complex process. Given how the determination of eligibility largely depends on state laws, investors must perform in-depth research to determine if their ownership type is eligible. If you’re curious about your state laws and the specific exchange process for each asset type, the Realized 1031 team can provide guidance. Please contact us today to schedule an initial appointment.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Sources:
https://www.irs.gov/publications/p551#:~:text=Real%20Property,cost%20basis%20in%20the%20property
https://www.law.cornell.edu/cfr/text/26/1.1031(a)-3
https://www.bankrate.com/real-estate/what-is-fee-simple/
https://www.pheasantenergy.com/california-mineral-rights/
https://www.watereducation.org/aquapedia/appropriative-rights