Although tax deferred exchanges involving mineral rights are not as widely known as more routine exchanges of traditional real estate investments, in many cases a farm, ranch, rental property or commercial center can be exchanged for mineral rights or water rights (or vice versa).

As a result, a tax deferred exchange can be used to diversify a real property heavy investment portfolio, or permit an investor to move away from property dependent on rents and maintenance obligations into an investment in which oil, gas or water rights provide investment income. In these uncertain times for traditional real estate investments, many investors are looking for income generating alternatives.

An exchange of real estate for mineral rights is permitted if the mineral rights relinquished or acquired in a tax deferred exchange constitute an interest in real property that is "like kind" to a fees interest in real estate under federal tax law.

The determination of whether a mineral right will be considered like kind to a fee interest in real estate depends on: (i) the specific nature of the rights granted under the mineral contract, (ii) the duration of those rights, and (iii) whether the law of the State in which the mineral interests are located would characterize the mineral rights as an interest in real property rather than an interest in personal property. [Oregon Lumber Co, 20 TC 192 (1953), acq.]

For example, a "production payment" is considered personal property because it is a bare right to receive income rather than an ownership interest in the minerals comprising the underlying real property. [See Com. v. Lake Inc, P.G., 356 US 260 (1958)] On the other hand, a royalty is considered "like-kind" real property and can be exchanged for any other real property. [Anderson v. Helvering, 309 US 645 (1940)]

The primary distinction between these two interests is the term of the respective interest. In the case of a royalty interest, the royalty continues until the oil or gas deposit is exhausted. A production payment usually terminates when a specified quantity of oil or gas has been produced or a stated amount of proceeds have been received.

The following exchanges qualified for tax deferral under Section 1031:

• An "overriding royalty interest" in oil, gas and mineral rights for an undivided one-half interest as tenant in common in a parcel of improved real property. [Crichton, 42 BTA 490 (1940), affd 122 F2d 181 (1941, CA5)]

• An interest in a producing oil lease extending until the exhaustion of the deposit exchanged for a fee interest in a ranch. [Rev. Rul. 68-331 (1968)]

• Perpetual water rights for a fee interest in land. [Rev. Rul. 55-749 (1955)]

The following did not qualify for tax deferral:

• A limited oil payment right exchanged for an overriding oil and gas royalty where the oil payment was a limited interest and the overriding royalty was perpetual [Midfield Oil Co, (1939) 39 BTA 1154, acq; IT 4093, 1952-2 CB 130]

• A leasehold measured in terms of a fixed percentage of oil that might be produced from the leasehold for a fixed number of barrels of oil. [Bandini Petroleum Co, (1951) PH TCM ¶51310, 10 CCH TCM 999]

• Carved out oil payment rights for a fee interest in a ranch, even though local law treated them all as interests in real property. [Fleming, William, 24 TC 818 (1955)].