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.