Mineral Interests
Generally all real estate is considered like-kind property to all other real estate for purposes of exchanging under IRC 1031. In Texas oil & gas beneath the surface is considered real estate(1), but when it is removed it is considered personality(2). A lease however by a land owner is not considered a sale but rather a lease and does not qualify for the benefits under IRC 1031(3)
For example: Jones can exchange all of his mineral interests in place with Smith for a city lot(4) as long as he does not retain an interest in the minerals conveyed(5). If on the other hand, Jones retains a royalty interest in the property given up in the exchange, Jones will have a taxable transaction but Smith will enjoy a tax-free exchange. If Jones gives Smith a production payment in exchange for Smith's city lot, neither will benefit Under IRC 1031 as the production payment is not real estate.
Exchange of working interest for working interest
The exchange of one working interest for another working interest is considered both an exchange of leasehold rights and well equipment. "Boot" which is receipt of any cash, relief of indebtedness or other unlike-kind property is allocated to the asset groups exchanged. The tax effect of the boot is first recognized as recapture of depreciation or intangible drilling cost and any excess as capital gain. Generally in order to avoid the receipt of boot, the exchanging party needs to receive replacement property of greater value than what was given up.
For example, if you sold in a tax-free exchange a mineral interest for say $900,000 and related equipment for $100,000 in order to be tax-free you would need to receive a mineral interest with a value of $900,000 or greater and well equipment with a value of $100,000 or more. Also to be tax-free in this example, you must not receive anything that is not like-kind property such as cash, note of indebtedness, net relief of indebtedness or say as an airplane. If you did not replace the well equipment and your adjusted basis of the well equipment was $100,000 or more, there would be no gain.
Royalty for Real Estate
The exchange of royalty interests for land and improvements is a like-kind exchange.(6)
Intangible drilling costs
Intangible drilling and development costs include those costs incurred to: 1) drill, shoot, or clean a well; 2) prepare the site for drilling, including ground clearing, drainage, road construction, and surveying and geological work; and 3) construct the physical facilities necessary to drill and prepare the well for production. In general intangible drilling cost expenditures are those which in and of themselves have no salvage value. If qualified natural resource properties are not acquired in an exchange the intangible drilling costs previously deducted are recaptured.
Working interest for Royalty
The exchange of a working interest for a royalty interest appears to qualify as like-kind property. Apparently, the IRS is of the opinion that a working interest and a royalty are property of like kind and an exchange therein constitutes a nontaxable transaction except to the extent that equipment is involved in the exchange.
Net profits interests
Since the supreme court considers a net profits interests to be a royalty(8), the rules applying to Royalties should apply to net profits interests as long as the net profits interest qualify as an economic interest.
1. 55 Tex. Jur. 3d, Oil & Gas 8 n.84(1987)
2. 55 Tex. Jur. 3d, Oil & Gas 8 n.84(1987)
3. Burnet v. Harmel, 287 U.S. 103 (1932)
4. Commissioner v. Crichton, 122
F2nd 181 (5th Cir. 1941)
5. Crooks v. Commissioner, 92 T.C.
816
6. Letter rulings 7935125, 7935126, 8135048
7. Rev. Rul. 72-117, 1972-1 CB 226,
and Letter Ruling 8134134
8. Burton- Sutton Oil Co. v. Comm., SCt, 46-1 UST
9. Reg. Ss 1.612-4(a)
10. Reg. Ss 1.612-4(a)