Among real estate owners and investors, section 1031 of the IRS tax code is a well known and often used way of exchanging one asset for another, while forestalling any tax consequences. Less well known and far less common is the use of the 1031 exchange to get involved in subsurface property rights that give the investor access to monthly royalties from the production and sales of oil, natural gas and mineral rights. Angus Baker of Montego Capital Partners offers his experience in 1031 oil and gas exchanges in this Q&A excerpted from a podcast interview he recently did with Real Assets Adviser editor Mike Consol. Listen to the podcast at this link: https://bit.ly/2ufaWRi
I was surprised to learn from you that the United States is the world’s only country that allows private ownership of mineral rights. How did this come to pass?
If you think about it, as a land owner back in 1920 when it all started, there had to be some motivation for a person who owned a beautiful piece of property to allow somebody to come in and tear up the property — to build roads, pump jacks, etc. Remember the surface owner does not always own the subsurface, so there has to be a way for the surface owner to allow free enterprise to come in and produce a commercial product from their land, and that was how royalty or mineral rights were established.
Outline how 1031 exchanges work for oil and gas and mineral rights. Maybe you can outline a typical deal.
There were 1031s going on for many decades, but people were going from bricks and mortar real estate. Well when you look at the IRS qualifications for the subsurface, it is considered non-possessory real estate and the fact that it’s real estate qualifies someone to sell an apartment complex or a strip center or a rental house and use the tax code’s 1031 exchange to defer the gains on the sale and rollover into another real estate venture. There were people all over America that had $2 million real estate properties that they paid $200,000 for 20 years ago and all of a sudden they were looking down the barrel of Uncle Sam’s gun at a $1.8 million tax burden because they had depreciated their cost basis down to zero, and now they were looking at long-term capital gains on $1.8 million, so that really motivated a lot of people — not to mention the advantage of rolling it over into minerals and royalties, which at that time were consistently producing returns of 10 percent and upwards. All of a sudden people were realizing they could defer the tax, roll their asset into a monthly income-producing asset. So there was cash flow, not only on the principal, but also on the dollars that they would have paid Uncle Sam. That became a very highly motivated movement for people to go from surface real estate to subsurface minerals.
Fossil fuels go up and down in price and, as we have seen, prices can go quite low. I would imagine some investors feel oil, gas and minerals is a risky space.
I get this question a lot. The royalty and minerals space is a very conservative place. As a matter of fact, institutions and endowments such as Stanford and Harvard and Yale have hundreds of millions of dollars worth of minerals and royalties. The investment mentality of those institutions is that risk is not an option. They are looking for something very low risk.
Where are these properties? Are we talking about U.S. shale basins?
We focus 100 percent of our time in the Permian Basin — that’s our home, that’s what we know. That’s the most expensive place to buy in the United States, but we like to stay in our neck of the woods. However, we like to venture over to East Texas as well because that’s a natural gas play, and we see some very good, stable properties that are diversified and that have longevity and growth components.
These investments are accessible to both institutional and individual investors, correct?
Absolutely.
If I’m a high-net-worth individual, what is the minimum I’m going to end up spending to play in the 1031 oil, gas and minerals market?
I would turn around and ask somebody a question: How much do you want to get out of it? Let’s just say, you want cash flow of $500 a month or $5,000 a year, then you need to invest $50,000 to achieve that. Most of the clients that come to us are in wealth preservation mode; they have already made a lot of money and now they want to figure out how to save it. There are people who use this asset class as an estate-planning tool.
Talk about its use for estate planning. Give us a scenario, how a typical high-net-worth family would take advantage of a 1031 exchange for mineral rights for that purpose.
I have a perfect example, but before I tell you the example I want to name a few families who are among the largest mineral and royalty owners in America today. The Rockefellers are number one, the Hearsts, the Vanderbilts, the Kennedys, the Fords, Ted Turner — these are people who gobbled up mass plots of land over time by thinking that their real estate investment was going to preserve their wealth, and it ended up that their minerals and royalties were more valuable than the surface itself.
But let me give you one specific client. It was a family of seven, and the father built a retail chain of five or six stores. As that family learned more about royalties and minerals, they started making investments back in 2003. They ended up selling their businesses and they kept the real estate. They got a lump sum from the sale of the business and used that to start investing in minerals and royalties. Years down the road they ended up selling the real estate, and they used the 1031 code to defer their tax, so now they have approximately $3 million invested into royalties and minerals. The father, knowing he was close to passing away, put all these minerals and royalties into a trust so when both parents pass the heirs will be owners of the trust and the minerals. They have over 25,000 producing wells across the U.S. that are producing income every single day, and those wells are sitting on 1.5 million gross acres that are geographically diversified across 21 states. Some of that land is not producing today but will produce as oil and gas prices increase, so there is a huge growth component to their holdings. They are very well diversified with over 500 different operators maintaining and exploring on their 1.5 million acres. So their $3 million throws off around $30,000 a month; it goes down when the prices go down. It’s been down as low as $15,000 a month; it’s been as high as $50,000 a month. But their main concern was that upon death of both parents the kids would not get a lump sum because it took them 30 years to build their wealth. As a matter of fact, they even told me that two or three of the kids would be broke within a year if they got their hands on the principal or the lump sum, so it’s all sitting in a trust. They are welcome to enjoy the revenue after the parent pass away, and the executor of the trust will distribute the income to each sibling each month, and upon the death of the children it will be passed on to the grandchildren. From the very beginning, 100 percent of their motivation was to preserve the family’s wealth.
How does the investor actually get paid? If an investor is drawing royalties as income, he or she is paying taxes on that income, I assume.
In the 1031 world there is what’s called a qualified intermediary, and if a person knows they are about to sell a piece of real estate, they contact or they fill out a form that says to the IRS, I’m going to invoke my rights of using a 1031 exchange upon the sale of the real estate that I’m about to put on the market, okay? So once that real estate sells they have, by law, 45 days to identify the replacement property that they’re going to take the proceeds from the sale and roll into something new. If any of that money comes off the table, it’s a taxable event, at long-term capital gains, assuming they’ve held it that long and assuming that there’s no depreciation left; so any money coming off the table is a taxable event. Any money going to the qualified intermediary sits and waits until the sale of the property closes, then the funds go to the QI or they sit in an escrow account and then the new property is identified and the money goes from the escrow of the QI to the person who is the seller of the new replacement property — and it doesn’t mean it has to be one property. When you use the 1031 code you can identify up to three properties or you can identify up to 200 percent of the total amount of money being exchanged. Then after you’ve identified, you have 180 days to close on the new property. Once that closes and the person selects the replacement properties, the funds are then sent to the seller of the replacement properties, and then whatever income is coming off of the replacement properties flows into whatever is holding the asset. If it is an individual person, then it goes right straight to their bank account. It’s paid monthly typically on gas or minerals. Some people will pay quarterly only because that helps save the expense of consolidating a lot of checks and distributing a lot of checks. It sometimes can be an accounting nightmare if there are hundreds of investors in a property, so it might be easier and more efficient economically to do it quarterly, but the operators pay the royalty and mineral owners every single month.
How do I know a property is not going to run out of the minerals it’s producing? At some point a well runs low or dry.
If a well is new and it only lasted six months, they won’t be drilling there much longer. Typically, U.S. operators are drilling where they know that the production is going to last decades. If someone is drilling in an area where the production has not been verified to produce for decades, they are more in the exploration mode than development mode. The first step on a piece of property is to look back at a production curve to see, how long has it been lasting? And you look to see how many wells it’s grown to, what has been the well count from the inception of the property. You also investigate the property’s growth component to help offset decline of its currently operating wells. We work the Permian Basin, which has the second-largest reserves in the world today behind Saudi Arabia.
How long does a typical investor hold those properties before divesting?
I’ve been directly or indirectly involved in placing more than $1 billion into the market over the past 15 years on behalf of more than 3,000 clients. I’ve had three people sell.
If a landowner has a 1,000-acre tract of land and they are selling mineral rights, how many investors can buy into that property? If I have invested, do additional investors diminish my stake at all?
Whatever you invest, the day you invest, is your total percent of the property. Once the property is fully funded it’s closed. There are no new investors coming in and out, so you can never be diluted in minerals and royalties by more investment dollars. There is a set dollar amount that is investable, and once that dollar amount is reached, the property is closed and not available until somebody else who owns that property is willing to sell. Whatever you own day one is what you own for life — or however long you decide to retain it — and you can expect to continue receiving your undivided interest each and every month for the life of the property.