Capital gains tax can be deferred when selling oil, gas, mineral, water and ditch rights using a 1031 exchange. As with any tax deferred exchange, 1031 exchange rules are followed in either a forward 1031 exchange or reverse 1031 exchange.
Oil, Gas and Mineral Rights
Interest in oil, gas and mineral estates qualify for 1031 exchange tax deferrals given the existence of a perpetual interest. Leases, royalties and production payments are often how the perpetual interests are conveyed.
For federal tax purposes, mineral leases are considered a real property interest and eligible for 1031 tax deferred treatment. Leases provide the lessee with the right to remove minerals for a specific period of time or until depletion along with incurring the costs of discovery and removal. Leases are also known as a working or an operating interest. The lessee may deduct the intangible drilling costs (IDCs) for removing the mineral. IDCs include labor, repair and maintenance, fuel, transportation, supplies and other related production expenses.
For federal tax purposes, royalties are considered a real property interest and qualify for 1031 exchange tax deferral treatment. Oil, gas or mineral royalties do not represent an operating interest and do not incur or are responsible for production costs. Instead, the holder of the royalty receives a percentage interest in the materials removed for the life of the property.
Production payments are not eligible for 1031 exchanges given they are a right to the oil, gas or mineral at a specific value, produced and paid from a percentage of removed minerals. Unlike royalties, production payments are finite based upon a specified production versus royalties that are perpetual or until the mineral is exhausted.
Dependent upon state law, perpetual water rights are like kind to real estate. If the water rights are limited in duration or amount, they are not under §1031 considered like kind to real property. In Donald Wiechens, et al. v. U.S., 228 F. Supp. 2d 1080 (D Ariz 2002), the Court ruled water rights limited in priority, quantity, and duration for a 50-year term were not like kind to a fee interest in real property even though the water rights were real property under state law. The Court denied the 1031 exchange on the basis the water rights were restricted as opposed to unlimited use of real property. In Private Letter Ruling 200404044, the Court ruled in favor of a decision where water rights were limited to a maximum diversion rate and quantity per calendar year but not duration to be like kind to a farm.
Congress approved the Food, Conservation and Energy Act of 2008 providing that stock held in a mutual ditch, reservoir or irrigation company, is eligible for 1031 exchanges. Shares can be exchanged, if the ditch, reservoir, or irrigation company is an organization described in Section 501(c)(12)(A) and the highest Court in the State in which the company was organized or applicable State statute recognizes the shares as either interest in real property or real property. A mutual ditch company is a non-profit organization created for the single purpose of providing their members the management of a joint water distribution service. Ranchers and farmers are the typical shareholders that have an exclusive right to use the ditch company's water in proportion to the number of shares owned.
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