Oil, Gas and Mineral Interests
Interest in oil, gas and mineral estates are eligible for 1031 tax deferred exchanges given the existence of a perpetual interest. Leases, royalties and production payments are often how the perpetual interests are conveyed. Leases provide the lessee 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 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, mineral leases are considered a real property interest and eligible for 1031 tax deferred treatment.
Oil, gas or mineral royalties do not represent an operating interest and do not incur or is responsible for production costs. Instead the holder of the royalty receives a percentage interest in the materials removed for the life of the property. For Federal tax purposes, royalties are considered a real property interest and eligible for tax deferral treatment. As with any mineral, oil, gas interest and water right exchange, 1031 exchange guidelines are followed in either a forward exchange or reverse exchange.
Production payments are not eligible for tax deferrals 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.
Water Rights
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) a 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 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.
Ditch Rights
In 2008, the IRS provided guidance that stock held in a mutual ditch, reservoir or irrigation company is eligible for §1031 consideration. 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 represents real property. A mutual ditch company are non-profit organizations 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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