Mineral Rights and Royalties

What are Mineral Rights?

Mineral Rights are the deeded real estate beneath the surface. The word “mineral” typically refers to commodities like Oil, Natural Gas, Stones, Coal, Phosphate, Sodium, Gold, Silver, and all other deposits. Mineral Rights owners hold interest in this subsurface real estate- “from the crust to the core” -and are entitled to compensation for everything produced from their land. Do keep in mind, Mineral Rights can often be sold separate from Surface Rights which is the land itself, the vegetation on it, the entire surface of the land including any attached structures.

Types of Mineral Rights

In some states, you can own a fee interest in the surface rights without owning the right to mine the underlying minerals. The separate perpetual right to explore, extract and sell minerals under the surface of a specific tract of land is called a Mineral Interest (MI). Certain states refer to this as a Mineral Estate which is typically broken up into lesser rights, such as mineral leases, royalties, production payments and profit interests. Mineral rights are generally considered to be either operating interests or non-operating interests. With an operating interest, you own the right to extract minerals, and you operate the extraction and pay the costs of extraction. A mineral lease is an example of an operating interest. In a non-operating interest, you have the right to certain minerals or payments, but you don’t operate the process of extracting the minerals. Examples of non-operating interests are royalties, production payments and profit interests.

Royalties from owning Mineral Rights

Owners of mineral rights typically have agreements with third parties such as oil, gas and energy companies. Depending on the type of minerals and their abundance, the third party companies would lease the land from the mineral owner and handle all operations such as drilling, mining, extracting and so forth. These companies are required to pay a percentage of gross revenue to the Mineral Owner. This is called a Royalty. The third party companies, known as operators, pay for all costs and operating expenses in addition to assuming all risks and liabilities of the operations. When production is in motion, the mineral owner typically receives monthly royalty payments from the third party companies on the resources produced on their property. While they do not have operational control, Mineral Owners directly hold the deeds and titles for their assets and have complete control and ownership of their holdings.

Are Mineral Rights and Royalties “Like-Kind” Property for a 1031 exchange? (Depends on State)

Only Mineral Rights that fall under the Real Property classification may be exchanged. This depends on the state in which you are selling or buying the Mineral Rights. Different states have different laws defining what type of interest is considered Real or Personal Property. With the guidance of a knowledgeable Attorney, you must examine the nature and classification of the interest(s) being sold as well as the applicable state laws, determining whether the relinquished and replacement properties are “Like-Kind” and whether they are considered to be Real Property for tax purposes.

Deed and Ownership Conveyance

When selling or purchasing Mineral Rights there is typically a unique type of deed recorded which transfers the mineral rights from the Grantor (seller) to the Grantee (buyer). Most escrow attorneys use what is called a Mineral Deed and once a transaction is completed the deed is then recorded with the county recorder’s office. A Mineral Deed like all other deeds will include the basic information like the Grantor and Grantee’s names, addresses, and the Exhibit A Legal Description of the property being conveyed. Mineral Deeds in many cases include further language referring to more specific things like: Title Warranties, Considerations, Perpetual Interests, Specific Minerals, Acres, Interest in Bonuses, Leases, Rents, Royalties, and other benefits which may come with the land. Buyers of Mineral Rights should ask the seller to specify precisely what rights are being conveyed and have an attorney confirm that the seller indeed owns what is being sold. Buyers should also request a title search be ran on the subject property to ensure the title is indeed clear of any liens or encumbrances.

All Cash and No Debt

Mineral Rights in most cases can only be purchased with all cash and zero leverage or debt. It’s important to plan for this when doing a 1031 exchange, as debt can only be offset by cash. If you paid off a mortgage or loan on your relinquished property, you cannot obtain financing to buy the Mineral Rights, therefore you are required to contribute cash out of pocket to cover the purchase and fulfill the value replacement requirements for your exchange.

Oil, Gas, Water and Mineral Disclosure

It’s important to remember, a surface estate of a property may be owned separately from the underlying mineral estate, and transfer of the surface estate may not necessarily include transfer of the mineral estate or water rights. Third parties may own or lease interests in oil, gas, other minerals, geothermal energy or water on or under the surface of the property, which interests may give them rights to enter and use the surface of the property to access the mineral estate, oil, gas or water.

*If you are considering selling or purchasing Mineral Rights in a 1031 exchange, it’s important you obtain professional tax or legal advice from an Advisor or Attorney who understands the applicable state and federal laws. CR Capital 1031 cannot give tax or legal advice and does not intend to under any circumstances.