Can I keep the mineral rights and still 1031 the surface?

A surface estate is land, and a mineral reservation is not something you receive

The 2020 regulations define real property for section 1031 as "land and improvements to land, unsevered natural products of land," and add in paragraph (a)(6) that property is real property if the law of the state where it sits treats it that way on the date of transfer. A deed that conveys the surface and reserves the minerals transfers an estate in land, so the sale qualifies like any other land sale.

Boot is defined by what comes to you. Section 1031(b) taxes gain only up to the money and the fair market value of other property you receive. Minerals you keep are not received from the buyer; they never left you, and the exchange is measured on the surface price alone.

The rest of the exchange is ordinary. The intermediary is assigned into the contract before closing, the buyer's money goes to the intermediary, and the identification and exchange periods run from the day the surface deed transfers.

Split your basis by value before closing, because the surface carries only its share

Reg. section 1.61-6(a) states the rule: "When a part of a larger property is sold, the cost or other basis of the entire property shall be equitably apportioned among the several parts." The usual method is relative fair market value on the sale date, which means you need a value for the minerals as well as the surface.

Buildings, fences and other depreciable improvements sit on the surface, so their adjusted basis and any depreciation recapture go with the surface sale. The minerals keep the slice of land basis allocated to them and become a separate asset on your books.

Debt matters too. If a mortgage covers the whole tract, the lender has to release the minerals or be paid at closing, and any loan paid off counts toward the debt you must replace to avoid boot, as explained on replacing debt in an exchange.

Hypothetical: a $2,000,000 ranch with the minerals reserved

Assume a ranch worth $2,000,000, of which an appraiser assigns $1,700,000 to the surface and $300,000 to the minerals. The owner's total basis is $500,000, so 85% of it, $425,000, goes to the surface and $75,000 stays with the minerals. All numbers are round and hypothetical; run your own with your CPA.

The owner sells the surface for $1,700,000 through an intermediary and buys $1,700,000 of replacement property. The $1,275,000 surface gain is deferred and the replacement takes the $425,000 carryover basis. Nothing is recognized on the minerals because nothing happened to them.

Two years later an operator leases the minerals and the owner receives $30,000 of royalties in a year. That income is ordinary. If it is oil or gas, section 613A(c) allows percentage depletion at 15% of gross income for royalty owners within the depletable quantity, or $4,500 here, limited under section 613A(d)(1) to 65% of taxable income; cost depletion against the $75,000 basis is the alternative.

Royalties are ordinary income, and a later sale of the minerals recaptures depletion

The Schedule E instructions put royalties from oil, gas or mineral properties, other than operating interests, on line 4, with depletion on line 18. They add that royalty income not derived in the ordinary course of a trade or business is in most cases not passive income, so passive losses from a replacement rental will not usually shelter it.

When you eventually sell the minerals, section 1254 treats as ordinary income the lesser of your gain or the depletion deductions that reduced the basis. A perpetual mineral or royalty interest can itself be exchanged if state law treats it as real property; the tests are on our mineral rights page.

What to settle before the surface goes under contract

• Run a title search to see whether the minerals were already severed by a prior owner; you cannot reserve what you do not own.
• Get a mineral valuation so the basis split and the price both stand up.
• Have the deed reservation drafted by a local real estate attorney, since severance, executive rights and surface use are state-law questions.
• Give your intermediary the surface-only legal description and your CPA the allocation.
• Expect some buyers to discount the price or walk away when minerals are reserved, and plan the replacement around the net surface price.

A DST can take the surface proceeds while the minerals stay with you

Reserving the minerals and exchanging the surface leaves you with two income streams: royalties if and when the minerals produce, and whatever the replacement property pays. A traditional DST is one way to hold the second passively, because Rev. Rul. 2004-86 treats each beneficial owner as owning an undivided interest in the trust's real estate. DST interests are illiquid, distributions are not guaranteed, and the sponsor controls the property, so weigh those against managing land yourself.