What Are Oil & Gas Royalties?
A mineral owner holds the sub-surface real estate, from the crust to the core, and is owed a royalty on everything produced from it. That royalty is a percentage of gross revenue, commonly 15% to 25% under the lease, paid before any drilling or operating expense. Several IRS rulings (Rev. Rul. 55-526, 73-428, and 88-78, plus Private Letter Ruling 8237017) treat mineral and royalty interests as real property, like-kind to traditional real estate, so a 1031 exchange can move into them and later back out into any other like-kind asset.
The operator drills the wells and carries every cost and liability. The royalty owner does not. No rigs to run, no wells to repair, no capital call when a pump fails. The check arrives monthly and moves with two things: how much the wells produce and what oil and gas sell for.
How It Works
- Sell the relinquished property. Proceeds go to a qualified intermediary, never to you.
- Identify royalties within 45 days. A packaged mineral fund gives you an identifiable replacement asset.
- Close within 180 days. Your exchange rolls into fractional royalty interests.
- Collect monthly checks. You receive a share of production revenue, free of operating cost.
- Let depletion shield the income. A percentage-depletion allowance offsets roughly 15% of gross royalty income each year.
Own the revenue, skip the drill bit. Royalties pay off the top and never take a capital call.
Why investors choose royaltiesTax Advantages
Perpetual mineral interests count as real property, so a 1031 exchange can roll a real estate gain into royalties and keep it deferred.
A depletion allowance shelters roughly 15% of gross royalty income from tax each year, for as long as the wells produce.
Heirs inherit the interest at a stepped-up basis, which can wipe out the deferred gain entirely.
Who It's For
A good fit
- 1031 investors who cannot find, or do not want, more real estate.
- Owners who want monthly income with zero operating duties.
- Those comfortable riding commodity-price swings.
- Estate planners seeking a step-up on a passive asset.
Not a fit
- Investors who need stable, predictable distributions.
- Anyone uneasy with oil and gas price volatility.
- Buyers who want an appreciating, non-depleting asset.
- Non-1031 cash better served by broader diversification.
Considerations & Risks
Royalty income tracks commodity prices, so distributions rise and fall with the market. Every well declines over time, which means both the income and the underlying reserve deplete unless the fund keeps acquiring new interests. Operators are not obligated to drill or keep wells producing, and there is no public market for the interests. One tax note: royalty income is generally portfolio income, so it does not offset passive losses. Size royalties as one slice of a portfolio, not the whole plate.
Royalties vs. DSTs vs. TICs
| Feature | Royalties | DST | Tenant-in-Common |
|---|---|---|---|
| 1031 eligible | Yes | Yes | Yes |
| Passive cash flow | Yes* | Yes | Yes |
| Debt used | None | Debt often used | Debt often used |
| Ownership | Direct title | Beneficial interest in trust | Pro-rata share of title |
| Liquidity control | Full, held by owner | Controlled by sponsor | Needs consent of all owners |
*Royalty income is generally treated as portfolio income and does not offset passive losses. Not tax advice.
Frequently Asked Questions
Why do royalties qualify for a 1031 exchange?
Do I pay any drilling or operating costs?
Will the income last forever?
How is the income taxed?
Glossary
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