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1031 exchangers often
do not realize that many oil and gas programs
are designed to meet the qualifications
of “like-kind” replacement property for
real estate 1031 Exchanges. In a similar
fashion to a TIC investment, investors hold
interests in shared property estates. However,
in the case of an energy-based program,
most of a participant’s interest lies underground.
Hence the term “subsurface interests”.
Subsurface interests
are often referred to as mineral rights
and include interests in oil and natural
gas. There are two types of mineral rights
for an investor to consider. The first kind
of interest in mineral rights is called
a “royalty interest”. In this situation,
the owner of the interest does not have
the right to enter the land to extract oil
or gas on his own accord. While the
royalty interest owner is entitled to a
percentage of any extracted minerals, a
party separate from the owner of the royalty
interest is contracted to enter the land
for exploration and drilling.
The second kind of
interest in mineral rights is called a “working
interest”. The owner of an oil and
gas working interest is given exclusive
right to enter the land to extract oil and
gas. So, in addition to sharing in
production revenue (along with any royalty
interest owners), working interest owners
explore, drill and receive development and
operating benefits.
These two different
oil and gas interests (royalty interest
and working interest) offer participants
varying levels of involvement and ownership.
Both working and royalty interest
investment programs offer benefits and advantages
similar to TIC investments, such as monthly
cash flow, tax deferral and a 15% depletion
allowance. Depletion allowance is
similar to depreciation deductions on rental
real estate, but is a larger percentage
since oil and gas are depleting assets so
the government permits a depletion deduction
to offset income received. The depletion
allowance is described further in the following
paragraph, but generally provides a greater
“write off” than a depreciation schedule
of 27.5 years on residential real estate
(apartments) and 39 years on other rental
real estate (office buildings, shopping
centers, etc.).
Depletion is similar
to depreciation except that it is associated
with the oil and gas in the ground. For
large oil and gas companies, depletion is
limited to the cost basis of the properties
they own, but for small producers and individual
investors there is a special form of depletion
called “percentage depletion”. Federal
tax law allows investors to deplete the
cost of a well, or actually to amortize
the value of the oil or gas in the ground,
as a deduction against taxable income generated
by the well. The amount of allowable
deduction is now 15% of gross revenue, before
operating costs, generated by the well during
the year. Each year the rate is determined
based upon the average price of oil produced
and sold in the United States for the year
before. Under the rules, it is currently
at the lowest available rate of 15%. If
the average price of oil is less than $20.00
per barrel, the rate increases by 1% for
each whole dollar the average is below $20.00.
Since the depletion allowance is based
on the gross revenue rather than the net
revenue, it can shelter between 20% and
30% of the annual cash flow to investors
until the well is no longer producing. Also,
the depletion allowance is not limited to
your investment (basis) like in real estate,
so the total write offs can ultimately exceed
your investment.
There are other advantages
to consider when deciding on diversification
outside the traditional real estate sector
(or when comparing, for example, a TIC investment
and an oil and gas investment). In
most oil and gas programs, there are no
closing costs and the closing risk of typical
TIC investments does not exist because the
oil and gas interests are pre-packaged and
ready for purchase at any time. Also,
an oil and gas investment is not dependent
on real estate values or rent collections,
and participants benefit from a virtually
unlimited product demand. Likewise,
there is a ready resale market for oil and
gas interests (which may not be true of
TIC investments).
You will recall the
basic rule of 1031 Exchange that you need
to trade even or up in value. This
means reinvesting all of the cash that you
received out of the relinquished property
sale (plus more cash, if you wish). Also,
if you had a mortgage balance on the relinquished
property, you need to place at least that
much debt on your replacement property unless
you offset the mortgage requirement by putting
in more cash. Unlike TICs for example,
oil and gas programs generally do not provide
a debt replacement component so oil and
gas programs are especially attractive to
those 1031 exchangers who owned their relinquished
property free and clear. However,
oil and gas interests can also be attractive
to 1031 exchangers who have already arranged
to replace debt with traditional, triple
net or TIC properties, but wish to diversify
their replacement property holdings with
some oil and gas interests.
Participation in oil
and gas programs by 1031 exchangers is growing––up
from less than 3% of all TIC programs to
close to 12% from just the first to second
quarter of 2005 (OMNI Brokerage, Inc. Market
Data: 3rd QTR 2005). Of course, anyone
interested in an oil and gas program should
carefully review the applicable Private
Placement Memorandum (PPM) for risks and
rewards before committing. Current
oil and gas prices and the ability to diversify
out of 100% real estate are making these
programs appealing today for many high-net-worth
individuals, especially those attempting
to complete 1031 Exchanges.
We make available
to investors both royalty and working interest
oil and gas programs. For more information,
please contact Jeff Riddell at (941) 366-1300
(or e-mail Jeff@1031replace.com,
or fill out and submit the “Contact
Us” form).
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