Mineral Rights, Water Rights and Easements: The Real Property You Forgot You Owned

When people think about 1031 exchanges, they picture buildings and land. But real property includes a range of interests that many owners never think of as tradable assets: mineral rights, water rights, easements and similar interests.

Under the right circumstances, selling one of these interests can be part of a 1031 exchange, and the proceeds can be reinvested into more conventional real estate. That can turn an overlooked asset into a tax deferred reinvestment.

What makes these interests real property?

The key questions are whether the interest is treated as real property under the applicable rules and state law, and whether it is permanent or long lasting enough to be like kind to a fee interest in land or buildings.

Temporary rights, such as a short term lease or a right that expires after a few years, generally are not like kind to real estate owned outright. Permanent or perpetual interests are more likely to qualify.

Can mineral rights be exchanged?

Often, yes, depending on the type of interest.

• ›Fee mineral interests, where you own the minerals themselves, are generally treated as real property.
• ›Royalty interests that continue until the minerals are exhausted are often treated as real property.
• ›Working interests in oil and gas can also qualify in many cases.
• ›Production payments or interests limited to a set time or amount may not be like kind to fee real estate.

Owners who sell mineral rights, for example after years of receiving royalties, can sometimes exchange the proceeds into rental property, net lease buildings or other real estate.

Can water rights be exchanged?

In some states, water rights are treated as real property, particularly perpetual rights appurtenant to land. Western states with established water rights systems are where this most often arises.

The analysis depends on state law, the nature of the right, and whether it is perpetual or limited. A permanent right to use water may qualify, while a temporary lease of water may not.

Can a conservation easement be exchanged?

A permanent conservation easement sold for cash can, in appropriate circumstances, be treated as a sale of an interest in real property eligible for 1031 treatment. Proceeds may then be reinvested in other real property.

This is separate from donating a conservation easement for a charitable deduction, which has its own rules and has been an area of IRS enforcement. A sale for fair value is a different transaction.

What about other easements and rights?

Perpetual easements for utilities, access or pipelines sold to a company or government body can also be real property interests. Air rights and development rights may qualify depending on state law and permanence. Timber rights raise their own questions, particularly whether standing timber is treated as real property or as a product being sold.

What about condemnation of these interests?

When a government takes an easement or right through eminent domain, Section 1033 involuntary conversion rules may apply instead of, or alongside, Section 1031. Those rules have longer replacement periods and allow proceeds to be received directly.

What are the practical steps?

The ordinary exchange rules still apply. A Qualified Intermediary must be engaged before the sale closes, replacement property must be identified within 45 days and acquired within 180 days, and all net proceeds must be reinvested to defer fully.

Valuation and documentation are especially important. Buyers of mineral or water rights may structure payments in unusual ways, including bonuses, royalties or installments. Make sure the payment structure fits the exchange.

What does an example look like?

A family owns farmland in a western state with perpetual water rights attached. A nearby city offers to buy the water rights for 1.5 million dollars, leaving the family with the land. If state law treats the perpetual water rights as real property, the family may be able to exchange the proceeds into a net lease building or apartment property, deferring the gain.

Similarly, an owner who receives an offer from a pipeline company for a permanent easement across their land might exchange the easement proceeds into other real property, rather than paying tax on what may be almost entirely gain.

Why is the gain often so large?

Because these interests frequently have little or no tax basis. Mineral rights inherited decades ago, water rights attached to land bought long ago, or an easement carved out of a property all tend to have minimal basis allocated to them. That means almost the entire sale price can be taxable gain, making an exchange particularly valuable.

What about depreciation and depletion?

Mineral interests may have been subject to depletion deductions, which can be recaptured on sale. Understanding past depletion and how it affects the gain is part of the analysis. Easements and water rights usually are not depreciable, so recapture is less often an issue for them.

What to do first

List any mineral, water, easement or similar rights you or your family own, along with how they were acquired and whether they are permanent. If you receive an offer to buy one, involve a CPA and attorney familiar with that type of interest in your state before accepting, and engage a Qualified Intermediary before closing.

Nothing here is tax, legal or investment advice. Whether these interests qualify depends heavily on the facts and on state law. Confirm your position with specialist advisers before acting.