Exploring Oil, Gas and Mineral Exchanges

BY: George Barlow., Esq.

We are starting to see more real estate investors seeking oil, gas and mineral properties as replacement properties in 1031 exchanges. Investor interest is rising due to world market demand for petroleum. Also, owners of mineral properties are actively seeking real estate investors and are structuring their offerings to simplify their use in 1031 exchanges.

 

Are minerals like-kind with real estate?

A replacement property must be like-kind with the investor’s relinquished property. If an investor has a real estate investment and seeks to exchange for oil, gas or other mineral property, he should exchange for a long-term mineral interest. The following are examples of qualifying like-kind mineral properties:

• Royalties and overriding royalty interests, in oil, gas and mineral rights
• Fractional interests in producing oil lease which run until the exhaustion of the deposit.
• Oil and gas working interests.

Remember, all real estate is like kind with all other real estate, so the investor may exchange improved or unimproved real property for these mineral properties.

 

Is it that simple?

 

Nothing is that simple! Some mineral interests are not like-kind with real estate. They are limited in duration, or have been otherwise disqualified by the IRS as non-like kind with real property. These types of interests are not qualifying property for 1031 exchanges:

• Limited oil payment right
• Production payments which are a mere assignment of income.
• Leaseholds for a fixed percentage exchanged for fixed number of barrels.

This is entirely consistent with the IRS’s position in other areas. For example, short term leases don’t qualify for exchange with fee simple ownership, but longterm leases do.

 

What about recapture items?

 

I used to joke about oil and gas investments being the Hotel California of investments – You could check in, but you could never check out! Actually, it’s not that different from an investor seeing to exchange from an improved property to raw land. The depreciation will be recaptured upon the sale of the depreciable property; if the replacement property is not depreciable (raw land is not.)

 

Oil and gas investment enjoy particularly generous “depreciation” features. For individual investors and small producers, working interests and royalties are entitled to a percentage depletion allowance which is currently set at 15% of gross revenue from the property. This is not capped by the investor’s cost basis, so the investor may eventually have depletion in excess of his basis in the investment. This is very favorable compared to the longer straight line depreciation allowed on conventional real estate.

 

But when an investor seeks to exchange a mineral property for a surface property, the depletion items are recapturable. Only when a qualified natural resource property is the replacement property may the recapture be deferred.

 

What should I do next?

 

Always consult with your tax adviser when you are thinking of using a 1031 exchange. If you are thinking of acquiring mineral properties to complete an exchange, ES Group can work with you and your tax adviser to assist you to make your exchange simpler, and leave you smiling.