1031 Exchange: Oil and Gas Options
 

Internal Revenue Code Section 1031 classifies an investment in an oil and gas working interest or royalty interest (production) as like-kind property for 1031 exchanges. Investors can exchange raw land, apartment complexes, office buildings, or any other eligible investment property for an interest in oil and gas production. This alternative opens doors for private investors who are seeking new ways to diversify their real estate holdings.

Qualifications and Tax Treatment
The Internal Revenue Service considers oil and gas production to be a working or leasehold interest that allows the lessee the right to search for and produce oil and gas on a parcel of land. The working interest bears the expense of operating the oil and gas wells on the land and receives a portion of the proceeds of the oil and gas produced. However, royalty interests do not bear these expenses.

Investors must be aware that not all oil and gas investments qualify as like-kind. For instance, while other tax benefits are associated with drilling for oil and gas, the IRS does not consider the investment to be like-kind to real estate. In addition, when selling oil and gas production, part of the sales price is allocated to equipment and machinery. If an allocated amount is 15 percent or less of the total sales price, it is treated as de minimis to the sale and the entire sales amount can be exchanged into like-kind real estate. However, if the amount allocated to machinery is greater than 15 percent of the total sales price, it is treated as personal property and does not qualify.

When calculating taxes, investors can deduct against income the greater of cost or percentage depletion. When exchange investors transfer a low basis into oil and gas production, they typically use percentage depletion. Percentage depletion is calculated as a percentage of the revenue generated by the wells. The cost or adjusted basis has no bearing on the amount of percentage depletion allowed. As a result, depletion deductions can exceed the cost or adjusted basis.

Investment Benefits
While current market conditions make it difficult to accurately predict a profitable exit strategy for many passive real estate investments, oil and gas production can provide a long-term investment with a secure cash flow without the headaches of additional 1031 exchanges for the investor. In addition, oil and gas production is not management intensive, and the investment is wholly owned by the investor, who controls the exit strategy.

Unlike tenancy-in-common investments, there is an active secondary market for oil and gas production. At any time, an investor can sell directly to another investor or liquidate the investment at various auction houses that specialize in selling oil and gas interests.

And, unlike traditional real estate investments where it can be difficult to diversify across different asset types in different geographical locations, it is much easier to diversify with an oil and gas investment. Production is sold on a fractional basis, typically with a smaller minimum investment. Large producing fields can be sold to hundreds of investors where each individual investor owns a fractional interest in all of the producing of oil and gas wells.

Furthermore, oil and gas investments are not subject to the strict requirements of Revenue Procedure 2002-22. There is no maximum investor requirement and sponsors can earn carried and back-end interests as compensation to align their interests with investors.

Another advantage is that oil and gas are global commodities that are not solely dependent on the U.S. economy. As the economies of China, India, and other countries continue to emerge, many analysts agree that demand for oil and gas will continue to rise. If future supply can’t meet the increasing demand, oil and gas prices also will continue to rise.

Similar to TIC ownership, it is important for commercial real estate investors to work with experienced sponsors. A good oil and gas investment depends on good engineering and a thorough understanding of the production life of the wells. An experienced operator has the professionals in place to properly analyze these investments.

Downsides and Risks
Like any investment, there are some disadvantages to consider. Oil and gas distributions include a monthly income and principal return. For 1031 investors, it is difficult to continue exchanging the principal into other replacement properties. And, unlike real estate, oil and gas is very difficult to leverage. Investors needing to replace debt in their exchanges have a difficult time acquiring oil and gas production.

Oil and gas investments are valued based on the amount of potential production and commodity prices. As oil and gas commodity prices increase or decrease, values of oil and gas production fluctuate. If new areas of exploration are discovered, alternative energy sources are developed, or supply begins to exceed demand, the value of an oil and gas investment is likely to decrease. While there are no drilling risks, oil and gas wells require maintenance, and an owner of a working interest pays a pro rata share of the expenses associated with maintaining the wells.

While it presents a different alternative for 1031 exchangers, oil and gas investments require a thorough understanding of IRC rules and regulations. Prior to pursuing this option, commercial real estate investors should consult with a professional tax adviser to learn more about this viable replacement property alternative.