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Oil and gas royalty and 1031 exchange glossary
Plain-English definitions of the terms you will see when you buy royalties through a 1031 exchange, from decimal interests and division orders to the 45- and 180-day deadlines.
Ownership
- Mineral rights
- Ownership of the oil, gas and other minerals beneath a tract of land. A mineral owner can lease those rights to an operator and receive a bonus, any delay rentals, and a royalty on production.
- Royalty interest
- A share of production, or of the revenue from it, that is free of drilling and operating costs. Royalty payments can still carry severance taxes and, depending on the lease and state law, post-production deductions.
- Overriding royalty interest (ORRI)
- A royalty carved out of the working interest under a lease rather than out of the minerals. It bears no drilling or operating costs and generally ends when the lease it burdens expires.
- Non-participating royalty interest (NPRI)
- A share of production that does not include the right to sign leases or to receive bonus payments or delay rentals. The owner is paid only when there is production.
- Working interest
- The operating interest under an oil and gas lease. Its owners pay the costs of drilling, completing and operating wells and receive the revenue left after royalty burdens.
- Oil and gas lease
- A contract in which a mineral owner grants an operator the right to explore for and produce oil and gas, usually in exchange for an up-front bonus and a royalty on production.
- Held by production (HBP)
- A lease that has continued past its primary term because a well on it, or on a unit that includes it, is producing in paying quantities.
- Pooled unit
- Tracts combined so that one or more wells can produce from all of them. Each owner in the unit is paid according to their tract's share of the unit.
- Direct deed
- Ownership recorded in the investor's own name in the county records, rather than held through a fund or trust. Peregrine's investors own their royalty interests this way.
Revenue and production
- Net revenue interest (NRI)
- An owner's share of a well's production revenue, expressed as a decimal. For a working-interest owner it is the share left after royalty and overriding royalty burdens.
- Decimal interest
- An owner's share of a well's revenue written as a decimal, for example 0.00390625. It appears on the division order and on each check stub.
- Division order
- A document from the operator or the purchaser that states each owner's decimal interest in a well and directs how revenue is paid. Owners usually sign one before payments start.
- Check stub (revenue statement)
- The statement that comes with each royalty payment, showing volumes, prices, taxes and deductions for each well.
- Decline curve
- The rate at which a well's production falls over time. Horizontal shale wells typically decline steeply in their first years and then level off.
- Flush production
- The high initial output of a newly completed well, before its early decline. A valuation that leans on flush production overstates what the well will pay later.
- Proved developed producing (PDP)
- Reserves expected to be recovered from wells that are already drilled, completed and producing.
- Severance tax
- A state tax on oil and gas as it is produced. Operators usually withhold it from royalty payments.
- Post-production deductions
- Costs such as gathering, compression, processing and transportation that some operators subtract from royalty payments. Whether they can be deducted depends on the lease language and state law.
- Depletion
- A tax deduction for the using up of an oil and gas reserve as it is produced, similar to depreciation. Royalty owners may be able to take cost or percentage depletion; your tax advisor determines which applies.
1031 exchanges
- Like-kind exchange (Section 1031)
- A transaction under Section 1031 of the Internal Revenue Code that defers tax on the gain from selling real property held for investment or business use, when the proceeds are reinvested in other like-kind real property.
- Relinquished property
- The property an investor sells to start a 1031 exchange.
- Replacement property
- The property an investor buys with the exchange proceeds. Producing oil and gas royalties may qualify, depending on how they are held and the facts of the transaction.
- Qualified Intermediary (QI)
- An independent party that holds the sale proceeds during a deferred exchange so the investor does not receive them. Peregrine is not a Qualified Intermediary.
- 45-day identification period
- In a deferred exchange, replacement property generally must be identified in writing within 45 days after the relinquished property is transferred.
- 180-day exchange period
- Replacement property generally must be received by the earlier of 180 days after the transfer or the due date, including extensions, of the tax return for that year.
- Boot
- Cash or other property received in an exchange that is not like-kind. Boot is generally taxable to the extent of the gain.
- Delaware Statutory Trust (DST)
- A trust that holds real estate and sells fractional interests in it to investors. DST interests are a common 1031 replacement option; the investor owns a beneficial interest in the trust rather than the property itself.
These definitions are general. Whether a particular interest or transaction qualifies depends on its facts; review it with your tax advisor and Qualified Intermediary.
Read the complete guide