1031 Exchange Into Oil and Gas Royalties: Buying Royalty Interests

A perpetual royalty is real property; a fund unit or a production payment is not

Reg. section 1.1031(a)-3 treats unsevered natural deposits, including mines and wells, as real property, and looks to state law for interests not otherwise listed. The same regulation says interests in a partnership and certificates of trust or beneficial interests are never real property, whatever state law says, which rules out mineral fund units, royalty LLC interests and publicly traded royalty trust units.

Duration decides whether a real-property mineral interest is like-kind to a building. In Peabody Natural Resources Co. v. Commissioner, 126 T.C. 261 (2006), the Tax Court described Commissioner v. Crichton, where an overriding royalty was exchanged for a city lot, and Rev. Rul. 68-331, where a producing oil lease was exchanged for a ranch, as like-kind exchanges. It contrasted Fleming, where carved-out oil payments failed even though state law called them real estate.

The difference, in the court's words from Koch, is that an overriding royalty continues until the deposit is exhausted, while a carved-out payment ends when a set quantity is produced or a set amount is paid. Buy perpetual interests by recorded deed, and read the instrument for any term, volume cap or reversion before you identify it.

Your income is volume times price minus severance tax, and all three move

The U.S. Energy Information Administration's annual WTI spot prices show the range a royalty owner lives with: $39.16 a barrel in 2020, $94.90 in 2022 and $65.39 in 2025. Henry Hub gas averaged $2.03 per million Btu in 2020, $6.45 in 2022 and $3.52 in 2025. A royalty check can halve or double from one year to the next with no change in the wells.

Volume falls as wells decline, and new drilling depends on an operator you do not control. Production taxes come off the top in most states; Texas, for example, taxes crude oil at 4.6% and natural gas at 7.5% of market value, and operators often deduct post-production costs as the lease allows.

Hypothetical: a royalty paying $60,000 in a year with $65 oil pays about $36,000 at $39 oil with the same production, before any decline. If you are replacing a rental with stable rent, underwrite the low years, and run your own numbers with your CPA.

Depletion replaces depreciation, and your carried-over basis limits cost depletion

Royalty owners recover their investment through depletion, the greater of cost depletion on basis or percentage depletion. Under section 613A(c), percentage depletion for independent producers and royalty owners is 15% of gross income from up to 1,000 barrels of oil a day or the gas equivalent, limited to 65% of taxable income.

In an exchange your basis in the royalty is largely the carried-over basis of the building you sold, so cost depletion may be small; percentage depletion is not limited by basis in the same way, which is why it often matters more to exchange buyers. Depletion is reported on Schedule E line 18 and the royalties on line 4, per the Schedule E instructions.

Depletion that reduces basis comes back later. Section 1254 treats gain on a later disposition as ordinary income up to the depletion deductions that reduced basis, and it applies notwithstanding any other provision, so plan the next exchange with that in mind. Royalties are also net investment income under section 1411.

Sponsor quality: who sells royalties, what they owe you, and what you actually receive

Royalties reach exchange buyers in three ways: a direct deed from a mineral owner, a deed of an undivided interest carved from a larger package assembled by a seller, or units in a fund. Only the first two can be replacement property, and the package seller's diligence is what you are paying for.

Ask for the title opinion or run sheet, the division orders showing your decimal interest in each well, 24 months of check stubs, the operators and their drilling plans, and a reserve report with its assumptions about price and decline. A seller who will not provide division orders or who prices on a single high-price month is pricing the market, not the asset.

If an offering is structured as an interest in an entity, it is a security and not real property; it may suit cash outside the exchange, but it cannot receive exchange funds, as our page on exchanging into fund or LLC interests explains.

Where royalties fit in an exchange and where a DST does the same job

Royalties suit an owner who wants no tenants, accepts commodity risk and has other income to smooth the swings. A split is common: part of the exchange into royalties and the rest into buildings, which also supplies section 1250 property if you are selling a building with bonus depreciation.

If the goal is passive income with less price volatility, a traditional DST holding net-leased or multifamily property is the comparison, and DST asset classes lays out the choices. The mineral rights sale page covers the reverse trade, out of minerals and into buildings.

Buying royalties as replacement property: what to settle before day 45

Confirm with counsel that the interest is real property under the law of the state where the minerals lie, because the regulation follows state law for mineral interests. Get the deed form, confirm it conveys a perpetual royalty or overriding royalty without a term, volume cap or reversion, and confirm title through a title opinion or a landman's run sheet.

Identify carefully. A royalty package spread over many wells and counties should be described so it is unambiguous, and Reg. section 1.1031(k)-1(c)(4) limits you to three properties or 200% of what you sold; name a building or DST as a backup in case title work fails. Price on the reserve report at a conservative strip, net of severance tax, and not on the last 12 months of checks.