Oil, Gas, and Mineral Interests in a 1031 Exchange: Royalties, Working Interests, Retained Overrides, and Production Payments

The short version: An oil, gas, or mineral interest can be exchanged tax-deferred under §1031 when it is a continuing interest in the minerals in place — a mineral fee, a perpetual royalty, an overriding royalty or net profits interest that lasts as long as the lease, or a working interest that runs "for so long as oil or gas is produced." Those interests are generally like-kind to land, rental houses, apartment buildings, and commercial property. Four things go wrong most often: (1) the seller keeps a royalty or override — however small — and the "sale" is taxed as a lease, producing ordinary bonus income that cannot be exchanged; (2) the interest is a production payment or is otherwise limited by amount or term; (3) the interest is held through a partnership, including the tax partnership that joint operating agreements create by default; and (4) §1254 recapture produces ordinary income even in a qualifying exchange if the replacement property is not itself an oil, gas, or mineral property. Sort those out before you sign the sale agreement.

One of the most common calls we get from clients in the Puget Sound area has nothing to do with Washington real estate at all. It goes something like this: "My grandfather left us mineral rights in North Dakota (or Texas, or Oklahoma). A company just offered us a lot of money for them. Can we do a 1031 exchange into a rental here?"

The answer is frequently yes — and the deferral can be substantial, because inherited minerals often have a basis far below today's value, and royalty owners in active basins have watched values climb. But oil and gas law has its own vocabulary, and the label on the interest does not always tell you how it is taxed. This article walks through the interests you are most likely to encounter, how each one fares under §1031, and the deal terms that can quietly take a transaction out of §1031 altogether.

This is a companion to our articles on water rights and on farms, ranches, and timberland. All three turn on the same question: when is a right connected to land treated as the land itself?

First principles: only real property qualifies

Since the Tax Cuts and Jobs Act of 2017, a 1031 exchange (also called a like-kind exchange or tax-deferred exchange) is available only for real property. The final regulations under Treas. Reg. §1.1031(a)-3 (T.D. 9935, 2020) define real property for §1031 purposes. Four parts of those regulations matter most for oil and gas:

Unsevered natural products of land are real property. The regulations expressly include mines, wells, and other natural deposits. Oil, gas, and minerals in the ground are real property; once extracted, they are personal property, and a contract for the production itself is a contract for a commodity.
Intangible interests in real property can be real property. The regulations recognize fee ownership, co-ownership, leaseholds, easements, and similar interests as real property. Mineral interests fit within that category when they are interests in the minerals in place and are not limited in a way that makes them something less than an ownership interest.
State law helps, but it is not the whole story. Property classified as real property under the law of the state where it is located generally qualifies, but the states do not all agree. Some states have treated oil and gas leases as personal property. The IRS, however, has long ruled that oil and gas leases are real property for federal tax purposes regardless of their state-law classification (Rev. Rul. 68-226). Pipelines are another example: Texas treats them as real property and Oklahoma as personal property, while the 2020 regulations list pipelines as inherently permanent structures — real property for §1031 — whatever the state calls them.
Structures versus equipment. The regulations list oil and gas pipelines, offshore drilling platforms, derricks, and oil and gas storage tanks as inherently permanent structures. An example in the regulations on a natural gas pipeline draws the line finely: isolation valves and vents that serve the pipeline as a structure are structural components (real property), but meters and pumps are not (Treas. Reg. §1.1031(a)-3(b), Example 9). Field equipment that comes with a working interest — pumping units, wellhead equipment, separators, vehicles — is generally personal property and must be allocated out of the exchange.

Why perpetual mineral interests are like-kind to a rental building

For depletion purposes, the Supreme Court has long recognized that an owner of an interest in minerals in place who looks to production for a return of capital holds an "economic interest" (Palmer v. Bender, 287 U.S. 551 (1933)). Continuing economic interests — working interests, royalties, overriding royalties, and net profits interests — are interests in the real property itself, and the like-kind authorities follow from that:

Mineral rights for an undivided interest in a hotel qualified in Commissioner v. Crichton, 122 F.2d 181 (5th Cir. 1941). The court held that the difference between minerals and improved real estate is one of grade or quality, not kind — the principle in Treas. Reg. §1.1031(a)-1(b).
A producing oil lease for a fee interest in an improved ranch qualified (Rev. Rul. 68-331).
Overriding royalties for unimproved real estate qualified (Rev. Rul. 72-117; see also GCM 34651).
Working interests exchanged for other working interests, including in a unitization, qualified (Rev. Rul. 68-186).
Part of a working interest also qualifies; the owner need not sell its entire interest. A working interest exchanged for overriding royalties in the same properties has also been ruled like-kind (PLR 8237017 — a private letter ruling, which cannot be cited as precedent but shows the IRS's view).

The minerals in place are not a separate asset from the land. When the fee is sold, the unmined minerals are part of the land (Butler Consolidated Coal Co., 6 T.C. 183 (1946); Beeler, T.C. Memo. 1997-73), and in an exchange of a coal mine for a gold mine, related coal supply contracts were treated as part of the real property bundle (Peabody Natural Resources Co., 126 T.C. 14 (2006)). The flip side: a right to extract only a limited quantity — such as gravel down to a certain level — was a carved-out interest that was not like-kind to a fee (Clemente, Inc., T.C. Memo. 1985-367).

The interests, one at a time

1. The mineral fee (owning the minerals outright)

The owner of the mineral estate owns the oil, gas, and minerals in place, usually separated from the surface estate. A severed mineral fee is a perpetual real property interest. It is the easiest case: sold outright, a mineral fee is generally like-kind to land, a fourplex, or a commercial building. The catch is the word outright — see the retained-royalty discussion below.

2. The royalty interest

When a mineral owner signs a lease, the owner typically keeps a royalty — a share of production (often one-eighth to one-quarter) free of drilling and operating costs. A perpetual royalty, or a royalty that lasts as long as the underlying mineral estate, is a continuing economic interest and generally qualifies.

An overriding royalty (ORRI) — a royalty carved out of the lessee's working interest, often retained by a landman or geologist — is also generally a real property interest, but it lasts only as long as the lease from which it was carved. That is fine when the lease runs until the minerals are exhausted. It is a problem if the override is limited to a set term, volume, or dollar amount.

3. The net profits interest

A net profits interest (NPI) is a share of the net proceeds of production after costs, carved out of the working interest. Like a royalty, an NPI that lasts for the life of the lease is a continuing economic interest (Burton-Sutton Oil Co. v. Commissioner, 328 U.S. 25 (1946)) and is generally treated like an overriding royalty. An NPI becomes a problem only when it is limited by amount or term, in which case it looks like the production payment discussed in item 5.

4. The working interest (the oil and gas lease)

The working interest is the lessee's side of the lease: the right to drill and produce, in exchange for bearing the costs. A typical lease runs for a primary term of a few years and then "for so long thereafter as oil or gas is produced in paying quantities." Because that interest lasts until the resource is exhausted, it is treated as a real property interest of unlimited duration, consistent with the rule that a leasehold with 30 years or more to run is like-kind to a fee interest in real estate (Treas. Reg. §1.1031(a)-1(c)).

Three cautions apply to working interests. First, the wells, pumps, tanks, and gathering equipment must be analyzed separately, and the equipment allocated out. Second, the owner may have deducted intangible drilling costs, which brings in §1254 recapture (below). Third, working interests are often held under joint operating agreements, which raises the partnership issue discussed below.

5. The production payment — not like-kind

A production payment is a right to a specified share of production until a fixed dollar amount (sometimes with interest) or a fixed volume has been paid. Under the regulations, an interest is a production payment if, among other things, its expected life is shorter than the life of the burdened property (Treas. Reg. §1.636-3(a)(1)). The IRS's ruling guidelines treat an interest as a production payment if it is reasonably expected to pay out from no more than 90% of the known reserves, with at least 5% of the burdened property's present value left after it terminates (Rev. Proc. 97-58).

In Commissioner v. P.G. Lake, Inc., 356 U.S. 260 (1958), the Supreme Court held that the sale of a carved-out oil payment was the advance collection of future ordinary income, and in the companion case, Commissioner v. Fleming, decided in the same opinion, it held that an exchange of oil payments for fee interests in real estate did not qualify as a like-kind exchange. The Tax Court reached the same result for production payments in Glenn, 39 T.C. 427 (1962).

Congress then went further. Since the Tax Reform Act of 1969, IRC §636(a) treats a carved-out production payment as a loan from the purchaser to the owner, and §636(b) treats a retained production payment — one the seller keeps when selling the rest of the property — as a purchase money mortgage. Either way, there is no sale or exchange of real property for §1031 to defer.

If an offer is structured as the purchase of a production payment, a "volumetric" payment, or any interest that ends once a target dollar amount or volume is reached, assume it does not qualify until a tax advisor has reviewed it.

6. Term royalties and other limited interests

A term royalty lasts for a fixed number of years regardless of production. The further an interest drifts from "until the resource is exhausted" toward "for a fixed period or a fixed sum," the more it looks like a right to income rather than an interest in land. The water-rights decision in Wiechens, which rejected like-kind treatment for a limited-duration water delivery right, rests on the same reasoning. A long term may survive by analogy to the 30-year leasehold rule; a short one is unlikely to.

7. Interests held through a partnership or LLC — including the one you did not know you had

An interest in a partnership or LLC taxed as a partnership is not real property for §1031 purposes, even if the only asset of the entity is a mineral estate. That rules out exchanging units in a drilling program, a mineral fund, or a family mineral LLC taxed as a partnership. A single-member LLC that is disregarded for tax purposes is not a problem; the owner is treated as owning the minerals directly.

The surprise for many working interest owners is that co-owners who jointly develop and operate a lease are treated as a partnership for tax purposes by default (Bentex Oil Corp. v. Commissioner, 20 T.C. 565 (1953)). Under IRC §761(a) and Treas. Reg. §1.761-2, co-owners under an operating agreement for the production or extraction of oil and gas can elect out of Subchapter K if they own the property as co-owners and reserve the right to take or dispose of their shares of production. With a valid election in place, each co-owner is treated as holding its share of the working interest directly, so it can be exchanged.

Two practical points. The election is generally effective from the first day of the tax year for which it is filed, and it needs the co-owners' cooperation. And co-owners do not always agree: if a partner is funding drilling under a "carry" arrangement that depends on partnership allocations to deduct the drilling costs it paid, it may refuse to elect out, and without the election the working interest cannot be exchanged. Distributions of leases out of an existing tax partnership can also trigger gain under the anti-mixing-bowl rules (IRC §§704(c)(1)(B) and 737).

The retained-override trap: when a "sale" is taxed as a lease

This is the issue most likely to blindside a seller, and it is a matter of deal terms rather than the type of interest.

For federal tax purposes, an owner who transfers a working interest but keeps any non-operating interest in the same property — a royalty, an overriding royalty, or a net profits interest, no matter how small — is treated as having subleased the property, not sold it (Crooks v. Commissioner, 92 T.C. 816 (1989); Rev. Rul. 69-352; GCM 22730). The same principle applies when a mineral owner conveys the minerals but reserves a royalty: the transaction is generally treated as a lease. The consequences are severe:

The cash received is lease bonus, which is ordinary income (Treas. Reg. §1.612-3), not capital or §1231 gain. Percentage depletion is not available against a lease bonus (IRC §613A(d)(5)), only cost depletion.
A lease is not a sale or exchange, so §1031 is not available at all. The owner's basis simply carries over to the retained override.

Picture an owner of a 75% working interest who negotiates a $1 million sale and, as a sweetener, keeps a 1% override. The override converts a sale that could have been fully deferred into ordinary income with no exchange. By contrast, selling the entire working interest qualifies, and so does selling a portion of it — for example, two-thirds of the working interest — because a fraction of a working interest is still an operating interest.

The sale-versus-lease rule also catches "split" deals. Selling the shallow rights while keeping an override in the deep rights is treated as a sale of the shallow rights and a lease of the deep rights, so only part of the price can be exchanged.

Ways to avoid the trap, each of which needs careful drafting and tax advice:

Retain a working interest instead of an override. Keeping a small working interest in the property is not a retained non-operating interest.
Take more cash instead of the override.
Carve the override out first, for a business reason. An owner that conveys the override to a related company well before negotiations begin, for a bona fide business purpose, and then sells the working interest, has the form of a clean sale (see FSA 1999-819; compare Badger Oil Co. v. Commissioner, 118 F.2d 791 (5th Cir. 1941)). A partnership that distributes the override to its partners the day before closing is far more exposed to a step-transaction challenge.
Use a term override on producing property that is expected to end before the reserves are exhausted, so that it is treated as a retained production payment (purchase money mortgage) rather than a retained economic interest (see PLR 9437006). This does not work on speculative acreage with no proven reserves (Watnick v. Commissioner, 90 T.C. 326 (1988)).

Selling the override separately to a third party at the same closing may work but is unsettled. The key point for a seller: the override decision has to be made before the letter of intent, not at the closing table.

The reverse is not a problem. A working interest owner that sells only a royalty carved out of its interest is treated as selling that royalty and allocates basis to it by relative fair market value (Rev. Rul. 68-226; Rev. Rul. 73-428). Whether that royalty sale can be exchanged depends on whether the royalty is a continuing interest rather than a production payment.

The §1254 recapture trap: a qualifying exchange can still produce ordinary income

Owners of oil, gas, geothermal, and other mineral properties often deduct intangible drilling and development costs (IDC) and claim depletion that reduced basis. IRC §1254 recaptures those deductions as ordinary income when the property is disposed of — up to the lesser of the prior deductions or the gain.

In a like-kind exchange, recapture is deferred when §1254 property is exchanged solely for other §1254 property, and the recapture potential carries over to the replacement (Treas. Reg. §1.1254-3(d)). But recapture is still triggered to the extent of boot and to the extent of like-kind property received that is not §1254 property — even though no gain is otherwise recognized under §1031 (Treas. Reg. §§1.1254-2(d) and 1.1254-1(b)(2)).

A simplified illustration: an owner has $500 of prior IDC and depletion deductions on a working interest worth $1,000.

Replacement property	§1031 gain recognized	§1254 recapture (ordinary income)
$1,000 of other producing oil and gas interests	None	None (carries over)
$800 of oil and gas interests plus $200 cash	$200 (boot)	$200
$800 of oil and gas interests plus a $200 ranch	None	$200
A $1,000 ranch	None	All $500

The practical rule: to defer all of the recapture, the replacement property must include oil, gas, or other §1254 property worth at least the amount of the recapture potential. An owner who wants to move entirely into apartment buildings should expect to pay tax on the recapture.

One point is unsettled. Exchanging a producing property for undeveloped leases may not avoid recapture, because the regulations define §1254 property in part as an operating mineral interest for which IDC has been deducted, and undeveloped leases may have none. Compare the §1245 and §1250 definitions, which reach property that "is or has been" depreciable.

A royalty owner who never deducted IDC usually faces little §1254 exposure, but depletion history still has to be checked. This is a calculation to run with your CPA before the sale agreement is signed.

Other practical issues

Identification is property-by-property. Each lease, royalty, or tract is generally a separate property for the 45-day identification rules, so a buyer of several interests will usually be over the three-property limit and must rely on the 200% rule. Whether non-contiguous tracts under a single lease count as one property, and how detailed the legal description must be, are open questions; describe each interest specifically. See our article on identifying replacement property.
Held for investment — and booming markets. Mineral interests are generally held for investment or business use unless the owner is a dealer (H.E. Gerke, T.C. Memo. 1954-30). In a hot basin, though, an owner may get an unsolicited offer for a replacement property soon after buying it. Document the investment intent at acquisition; the cases weigh intent at the time of the exchange against later events (Reesink v. Commissioner, T.C. Memo. 2012-118; Click v. Commissioner, 78 T.C. 225 (1982)). See our article on what "held for" means.
Unitization can itself be an exchange. When a state forces adjoining tracts into a single unit and each owner receives an undivided interest in the unit, the exchange qualifies under §1031 (Rev. Rul. 68-186; GCM 33536). If the owners are related, though, a sale of the unit interest within two years can unwind the deferral under the related-party rule of §1031(f), unless the no-tax-avoidance exception applies.
Publicly traded royalty trusts are uncertain. Units of a royalty trust that is a grantor trust holding royalties are an attractive-looking replacement, but whether they are real property or an excluded security or trust interest has not been resolved (compare Rev. Rul. 2004-86 on Delaware statutory trusts). Do not plan an exchange around them without specific advice.
Reverse exchanges need a management plan. A working interest parked with an exchange accommodation titleholder in a reverse exchange may require operating decisions while it is parked. A common solution is a manager-managed LLC owned by the accommodation titleholder, with the taxpayer as manager.
Inherited minerals usually have a stepped-up basis. If the decedent died recently, the basis may be close to today's value, and the gain to defer may be small. Check the date-of-death basis before building an exchange around it.
Allocate the price in a mixed sale. When a working interest is sold with wells and equipment, the purchase agreement should allocate the price between the real property and the personal property, and between depletable and depreciable basis.
Use a qualified intermediary from the start. The sale proceeds must go to the qualified intermediary, not to the seller. Mineral sales often close through an acquisition company's own closing process rather than a title company escrow, and the exchange documents must be in place before closing. The identification period starts the day the relinquished property transfers, and mineral sales often close quickly once title work is done.

The Washington angle

Washington produces almost no oil or gas, but many Washington residents own mineral interests in other states. Three points are worth keeping in mind:

The producing state may tax the sale. Gain on the sale of real property is generally sourced to the state where the property is located. Oklahoma, North Dakota, and other producing states have income taxes that may reach a nonresident's gain if the exchange fails or boot is received. Texas and Wyoming have no personal income tax.
Washington's capital gains excise tax excludes real estate sales. Whether a particular mineral interest is "real estate" for that exemption, and how the new Washington income tax enacted in 2026 will apply when it takes effect in 2028, should be confirmed for the specific interest.
The replacement property can be anywhere in the United States. A Washington owner can exchange North Dakota minerals for a rental in Tacoma or elsewhere in Pierce County — mineral interests and improved real estate are like-kind. U.S. property and foreign property are not like-kind to each other.

Bottom line

Oil, gas, and mineral interests are among the best candidates for a 1031 exchange that clients do not know they have. A mineral fee, a perpetual royalty or override, or a working interest that lasts until the resource is exhausted is generally real property, like-kind to the rental property and commercial real estate our clients buy around the Puget Sound. Crichton and a line of IRS rulings have stood for decades, and the 2020 regulations confirm the framework.

The risks are in the details: a retained override that turns a sale into a lease, a production payment or term interest, a tax partnership nobody elected out of, equipment that has to be allocated out, and §1254 recapture that can produce ordinary income even in a qualifying exchange. Each of those can be identified before the letter of intent is signed — and that is when they should be identified.

As an attorney-led qualified intermediary based in Tacoma, we help Washington owners and their advisors review mineral interests and structure exchanges before a purchase offer is accepted. If you have received an offer for oil, gas, or mineral rights, call us before you sign.

Disclaimer: This article is for general educational purposes and is not legal or tax advice. The classification of oil, gas, and mineral interests depends on the law of the state where they are located and on the specific terms of each interest and each transaction, and recapture under §1254 depends on each owner's deduction history. Please consult your own tax advisor about your particular situation before acting.

Oil, Gas, and Mineral Interests in a 1031 Exchange: Royalties, Working Interests, Retained Overrides, and Production Payments