1031 Exchange

One of the more interesting aspects of the 1031 Exchange program is the opportunity to rebalance or diversify the real estate segment of your investment portfolio by relinquishing a property or properties for a “fractional interest” in an oil and gas investment as a “like kind” property. For purposes of a 1031 Exchange, a “fractional interest” is considered comparable to a “tenant-in-common” ownership in real estate by the Internal Revenue Service. Within the provisions of section 1031 of the internal revenue code, oil and gas investments are viewed as “like kind” for each of the following forms of real estate: commercial properties, quarries, mines, multi-family dwellings, residential rental properties, restaurants, timberland, warehouses and undeveloped land. As a result, oil and gas investments are often used as replacement property for real estate and other investments to delay payments on capital gains taxes under section 1031. Furthermore, a great number of energy replacement property alternatives offer a lower investment requirement than traditional real estate or Tenant In Common (TIC) investments. A “fractional interest” in an oil and gas production offers a steady cash flow without tenant concerns. Purchasing a “fractional interest” in a qualified working interest can provide the 1031 Exchange purchaser the stability of a fast closing with a predictable revenue stream.

In today’s economic environment, together with residential and commercial real estate continuing to decrease in value, ownership of a “fractional interest” in an oil and gas investment is an extremely attractive 1031 Exchange as the price of a barrel of oil has doubled in 2009. The energy market is a worldwide focus and we feel that the oil and gas industry is an excellent investment opportunity driven by numerous influences.

Why invest in oil and gas?

  • Oil and gas investments can offer investors with portfolio diversification;
  • Oil and gas investments may also work to hedge against inflation and soaring energy prices
  • Oil and gas tax codes include a 15% depletion allowance from gross income for the majority of investors;  it is strongly suggested to consult with the proper specialist in this area.
  • Oil and gas properties are often used as replacement property for real estate and other investments in order to defer capital gains taxes subjected to IRS section 1031.
  • There are no additional closing costs, points, or expenses to exchange from a real estate property into an oil/gas.

1031 Exchange Oil and Gas Investment Diversity

For the 1031 Exchange this provides a very simple and cost-effective way to diversify a real estate portfolio simply by obtaining highly liquid fractional ownership in one or more qualified oil and gas working interests. Additional diversity hails from carrying out the 1031 Exchange in various real estate markets with predictable oil and gas production in place without the worry of management duties. Moreover, the purchase of energy assets can deliver investors with portfolio diversification, especially if an investor has a considerable portion of their net worth in real estate. This diversification can be recommended because there is low correlation over the years between oil and gas and commercial real estate property value.

Having energy assets in your portfolio can also help diversify risk away from other variables which may decrease the value of certain types of assets. Energy assets may also serve to hedge against increasing energy prices. Other portions of your portfolio would tend to decline as energy prices increase (certain stocks/certain real estate). Additionally, the long-term overall performance history of O&G properties has shown a weak (or even negative) correlation to Wall Street.

1031 Exchanges for Oil and Gas: Tax Free or Deferred?

Presently there are many unique aspects involved inside a 1031 Exchange for a “fractional interest.” Often times the issue arises of whether this type 1031 Exchange is tax-free or simply tax-deferred. The result could be either. In the event the 1031 Exchange replacement oil and gas “fractional interest” is sold at some future date, then the tax benefits are simply deferred. If your oil and gas “fractional interest’ acquired through the 1031 Exchange are kept until death or exchanged at death the deferred tax disappears with the step-up in cost basis and the 1031 Exchange is essentially tax-free. Due to the steady, predictable cash flow and the professional management with the possibility for capital gains as the price of oil increases, many decide to hold oil and gas “fractional interests” for prolonged periods after the original 1031 Exchange. Any time this transpires, for investing purposes and tax problems, the 1031 Exchange can become almost tax-free if held for an extended period due to the effect of inflation, which greatly diminishes purchasing power.

1031 Exchange Oil and Gas Production Liquidity

Often times, a “fractional interest” in an oil and gas investment may offer more liquidity compared to other investments in real estate following the 1031 Exchange. Even though private placements are typically limited to accredited investors who are not buying with the intent of divesting, there may be certain situations where liquidity is needed. There is an active secondary market for established oil and gas investments. This gives the buyer the opportunity following the 1031 Exchange to sell their investments to other 1031 Exchange buyers.

Auctions that specialize in oil and gas investments can assist in the sale of these assets. Partial or complete sales can often occur rapidly through a number of established methods, ranging from direct sale/transfer (typically 15-30 days), to online auctions (usually lasting 30 days), to traditional auctions via specialized auction houses (usually around 60 days) or brokerage firms (typically 45-60 days). Traditional banks will also allow owners to leverage significant portions of the oil and gas “fractional interest” acquired in a 1031 Exchange. The number of options in the liquidity spectrum for energy assets offer rapid turn-around that can be as little as three weeks.

The IRS requires a neutral third party, also known as a facilitator, accommodator or qualified intermediary (QI) to facilitate any 1031 Exchange. US Oil Properties has several strategic partners who can assist you in this endeavor.