Legal Briefs

Oil and Gas Exchanges

Section 1031 transactions involving energy assets can be tricky.

No doubt some participants in the thriving oil and gas business are looking — or probably should be looking — to move some wealth out of the highly cyclical energy field. An obvious tactic for diversification into real estate is using a Section 1031 like-kind exchange. The Internal Revenue Service considers many oil and gas assets, or OGA, as real property and therefore like-kind with commercial real estate. But exchanging OGA for real estate can be trickier than the typical real estate-for-real estate exchange.

Exchanging real property for OGA does not present the transferor with any special tax or legal issues not present in a typical real estate for real estate exchange. The problem is a practical one: Because the party exchanging the OGA faces difficulties related to exchanging OGA, it is sometimes hard to find owners of OGA willing to participate in a like-kind exchange for real estate.

Here is a brief overview of issues surrounding the exchange of OGA for commercial real estate.

Sale or Exchange?

A like-kind exchange must, of course, be an exchange. That’s obvious, but it is easy to violate this basic rule in a transaction involving OGA.

Oftensellers and transferors of OGA want to retain an interest in the properties sold or transferred, commonly through an overriding royalty interest, or ORRI. An ORRI is a royalty interest carved out of the working interest. For example, XYZ Energy Co. has an oil and gas lease from Mr. Landowner, and the lease reserves a 3/16 royalty to Mr. Landowner. XYZ Energy Co. pays 100 percent of the costs of the wells on the lease but gets 13/16 of the revenue, or 81.25 percent. Mr. Landowner bears no costs and gets 3/16 of the revenue, or 18.75 percent.

Now XYZ sells its leasehold to Giant Oil Co. and delivers to Giant Oil Co. 80 percent net revenue. XYZ then retains an ORRI of 1.25 percent. But retention of the ORRI changes the nature of the transaction. It is no longer a sale; it’s a sublease. And whatever value XYZ receives from Giant Oil is treated as a lease bonus and taxed as ordinary income.

The same result happens in an attempted 1031 exchange if the transferor retains an interest, such as an ORRI. No exchange happens, so there can be no like-kind exchange. In a transaction other than a like-kind exchange, it is sometimes possible that the present value of the ORRI is great enough to justify accepting the immediate recognition of ordinary income. But in an attempted like-kind exchange, the lease/sublease treatment is disastrous.

Recapture

Internal Revenue Code Section 1254 requires an OGA seller to recapture as ordinary income certain items previously written off. This also applies to like-kind exchanges, as the provisions of Section 1254 take precedence over the provisions of Section 1031. So if one exchanges OGA for like-kind property not classified OGA, the party transferring the OGA must recognize ordinary income to the extent of intangible drilling costs, development and exploration costs, and depletion taken. The taxable gain to the transferor may not be greater than the gain recognized without reference to Section 1254 plus the fair market value of the like-kind, non-OGA property received in the exchange.

Personal Property

Normally an owner of a working interest will also own personal property — usually equipment related to producing, transporting, and treating the oil, gas, and other products. In an exchange involving working interests, therefore, one must segregate and separately value such personal property. This is an issue even in OGA-for-OGA exchanges but is particularly problematic when OGA are exchanged for real estate assets, as the types of personal property involved are unlikely to be considered like-kind (or, more accurately for personal property, like class or like product).

Partnerships

Partnership interests, which are never like-kind under Section 1031, are sometimes lurking in the background when OGA are involved. Unlike in real estate transactions where partnerships are usually apparent, in the oil and gas business, it’s not uncommon for parties to create a tax partnership to allow for special allocations even if they do not create a statutory or common-law partnership. If the OGA being exchanged are subject to a tax partnership, the exchange will fail.

There are other kinds of OGA — production payments (IRC Section 636), net profits interests, back-ins, and more — and there are numerous issues besides those mentioned here. The fundamental point is that some OGA lend themselves to like-kind exchanges for real estate better than others.

One tactic to pursue: Given the problems created by Section 1254 recapture, use OGA that are non-producing mineral interests and/or non-producing leasehold interests — that is, OGA against which no deductions have been taken that would trigger the Section 1254 recapture. The practical problem with using non-producing OGA, however, is that they are normally more difficult to value than producing properties. And, of course, anyone structuring a like-kind exchange involving OGA for real estate must have a solid understanding of OGA, because a misstep can lead to immediate recognition of ordinary income and an angry client.

Brian J. Stanley, CCIM, JD, is vice president and general counsel for The Hefner Co. Inc. in Oklahoma City. Contact him at bstanley@hefnerco.com.

Recommended

Changing Climate, Changing Laws

Spring 2020

Legislation is responding to new wildfire risk requirements faced in commercial real estate development.

Read More

Environmentally Unfriendly

Nov.Dec.19

Michigan aims to tackle complications associated with vapor intrusion and emerging chemicals.

Read More

Valuing Retail Properties

Sept.Oct.19

Assessments can differ, so understand what considerations go into calculating the value of retail properties. A store owned and operated by Lowe’s in Georgia was valued by the local tax assessor at $10.4 million. Not satisfied, Lowe’s counsel hired its own appraiser, who valued the property at $3.9 mill

Read More

Paint the Town – But Get a Waiver First

July.Aug.19

One case highlights the many considerations real estate professionals need make when a property includes street art. What happens when the paint on the outside of a building suddenly becomes a property interest? It's a good question - one addressed in a shocking landmark case involving a New York property kno

Read More