Background

As you may know, a 1031 exchange is also known as a “like-kind” exchange. This is due to the fact that the IRS has made clear that in order to defer paying capital gains taxes on the sale of an investment property, the proceeds need to be reinvested into a similar investment of equal or greater value. However, it is a little less known that there are multiple asset classes that meet this non-specific guideline. Asset classes such as single family rentals, multifamily or apartments, industrial, office, self-storage, and yes, you guessed it – mineral rights! All of these asset classes can be exchanged one into the other utilizing a 1031 exchange because they are all considered real estate.

We have relationships with many private equity real estate groups that allow investors to diversify their real estate equity into many of these different asset classes. This is typically done via syndications and, more specifically, through a legal structure called a Delaware Statutory Trust (DST). You can read more about the DST’s potential benefits and limitations here. But the point I want you to understand before reading further is that exchanging into mineral rights is not exchanging into a DST, so the trust’s structural limitations do not apply.

Understanding Mineral Rights

A recent client of ours really liked what they heard when we thought it would be in their best interest if they were introduced to the concept of diversifying a portion of their 1031 exchange into the energy sector side of real estate (i.e., mineral rights). Here are a few things we educated them on…

1. Passive income potential through royalties. When a company (think Shell, Exxon, etc.) leases the mineral rights to extract oil, gas, or other minerals, they (our client) can earn any royalty payments based on the value of the resources extracted. Here’s another way to think about it – These companies are like tenants!
2. No management. Unlike rental properties, they don’t have to worry about property management, maintenance, repairs, drilling costs, or exploration costs. The company doing the drilling assumes all of those risks and expenses. As long as drilling is taking place on the real estate that they own, they will get whatever their percentage is of any income.
3. Increasing demand. Just like traditional real estate, mineral rights can experience significant increases in value as demand for them increases. Additionally, owning mineral rights may provide a hedge against inflation, as the price of natural resources has historically risen with inflationary pressures.
4. Diversification. This is a bit more obvious. The energy sector side of real estate acts as another form of potential revenue as our clients institutionalized and diversified the equity they owned in traditional real estate. And once the mineral rights are sold, they can exchange right back into a single-family property or a DST of their choosing.

The “Value-Add” Component

Let’s park on this point because it is highly unique and can be significant. Recall that in a DST that holds ‘traditional’ real estate (say a 250-unit multifamily complex for example) there is only a certain number of ways that a DST Sponsor can increase the value in the property. Utilizing investor money for capital improvements is NOT one of them. The IRS has given very limited authority in regard to capital improvements because they do not want to put the investors’ capital at risk.

Now, think of mineral rights as that 250-unit multifamily complex, and the oil companies like Shell and Exxon as your family tenants. If the mineral rights that our investors own receives double the amount of drilling sites on it then when it was purchased, it would be similar to that 250-unit complex expanding its doors to 500 units through brand new construction. This, we know, is not currently allowed in a DST. However, when investing in and through a company that can find undervalued mineral rights, that kind of value creation potential can be realized, through no capital expenditure/risk to the investor.

Conclusion

Investing in mineral rights has its own potential rewards and risks, just like every other including fee simple real estate, and DSTs. It is vitally important to work with the right advisors who will properly educate you and make sure this asset class is something that you are suitable to invest in, and that achieves your objectives. With this particular asset class, it is also important to work with an advisor that can partner you with the right institution to find the best mineral rights structure. As for our recent 1031 clients, they are stoked to have a portion of their equity now working for them in an asset class that has appreciation potential, and seeks to diversify their income stream.

Mineral Rights

Investing in mineral rights can be complex and involves several important risks, including: Investment Risks: Risks associated with mineral rights investments, include market volatility, regulatory changes, and operational risks. Geological Reports: There is no guarantee of the accuracy of the estimated value of the mineral rights and the methodology used for these assessments. Regulatory Compliance: Mineral operations require compliance with complex local, state, and federal regulations. Failure of an operator to adhere to these requirements may result in civil or legal penalties against the operator, potentially negatively impacting the investment performance. Market Conditions: Mark conditions for the specific minerals involved, including demand, pricing trends, and competition are all subject to change. A change to these variables can positively or negatively impact the investment. Illiquidity: Investments in mineral rights are meant to be held long-term. There is no secondary market for these offerings. Tax Implications: Changes to relevant tax code or a negative finding by the IRS may negatively impact the investment performance.