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One of the most unique aspects of the 1031 Exchange process is the ability to rebalance or diversify the real estate sector of an investment portfolio by relinquishing a property or properties for a “fractional interest” in an oil and gas production as a “like kind” property. A “fractional interest’ is considered similar to a “tenant-in-common” ownership structure in real estate by the Internal Revenue service for purposes of a 1031 Exchange. In today’s economic environment, with residential and commercial real estate continuing to decline in value, ownership of a “fractional interest” in oil and gas production is a very attractive 1031 Exchange as the price of a barrel of oil has more than doubled in 2009.
Why a 1031 Exchange Oil and Gas Production

What makes this ideal as an investment to balance out a portfolio is that rising oil prices depress real estate values in the United States for a variety of factors. As most of the oil used in the United States is imported, billions more dollars go overseas to pay for oil when the price increases. This, by virtue of supply and demand, weakens the value of the dollar. When the value of the dollar is weak, interest rates must rise to attract foreign investment in Treasury bonds and other dollar denominated securities. When interest rates rise, mortgage rates rise, making it more costly and more difficult to afford real estate.

Other factors from higher oil prices harm real estate values. When gas prices are higher, communities that require commutes become less attractive, falling in value. Many of the products used in building homes and communities, such as asphalt and chemicals, are petroleum-based and become more expensive, making houses more costly and thus less affordable.

1031 Exchange Oil and Gas Production “Fractional Interest”

A “fractional interest” in an oil and gas production offers a steady income stream without tenant concerns. The purchase of a "fractional interest" in a qualified working interest can provide the 1031 Exchange buyer the stability of an immediate closing with a predictable cash flow stream. When oil and gas prices rise, the buyer in the 1031 Exchange can also participate in the future production price gains with payment based on the rising commodity prices over the long term. Each fractional owner of an offering has the same rights as a single owner and can subdivide or offer for sale their ownership interest at any time on the open market, providing liquidity when needed after the 1031 Exchange is completed.

1031 Exchange Oil and Gas Production Investment Diversity

For the 1031 Exchange this presents a simple and economical vehicle to add diversification to a real estate portfolio by acquiring highly liquid individual fractional ownership in one or several qualified oil and gas production working interests. Further diversity emanates from doing the 1031 Exchange in several different real estate markets with predictable oil and gas production in place and no management responsibilities. By investing in “fractional interests” a 1031 Exchange buyer can participate in the income and capital appreciation of the energy sector without being exposed to the risky and difficult business of drilling and exploration.

1031 Exchange Oil and Gas Production Liquidity

Many times, a “fractional interest” in oil and production can yield greater liquidity than other real estate investments for the buyer after the 1031 Exchange. There is an active secondary market for established oil and gas production. This allows the buyer after the 1031 Exchange to sell directly to other 1031 Exchange buyers or investors. Auctions specializing in oil and gas production based on projected production and the commodity prices also sell these assets. Traditional lenders will allow qualified borrowers to leverage substantial portions of the oil and gas “fractional interest” acquired through a 1031 Exchange.

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

As there are so many unique factors involved in a 1031 Exchange for a “fractional interest” in oil and gas production, many times the issue arises of whether this type 1031 Exchange is tax-free or merely tax-deferred. The result can be either. If the 1031 Exchange replacement oil and gas “fractional interest” is later sold outright then the tax benefits are merely deferred. If the oil and gas “fractional interest’ acquired through the 1031 Exchange is either held until death or exchanged until death the deferred tax evaporates with the step-up in basis and the 1031 Exchange is rendered effectively tax-free. Due to the steady, predictable income stream and the professional management with the potential for capital gains when the price of oil rises, many choose to hold oil and gas “fractional interests” for extended periods after the initial 1031 Exchange. When this transpires, for investing purposes and tax consequences, the 1031 Exchange can become almost tax-free if held for an extended period due to the effect of inflation on the dollar, greatly reducing its purchasing power.

Questions about 1031 Exchanges for Oil and Gas Production
  1. How many oil and gas 1031 exchanges has the ES Group transacted? Three this month, and over 50 in the last two years.
  2. Have all the oil and gas 1031 exchanges transacted by the ES Group been allowed by the Internal Revenue Service? Yes.
  3. I am tired of tenants but still need an income stream from my properties. Should I consider a 1031 Exchange for oil and gas properties? Yes, it is a long-term income stream with depletion allowances of 15% in perpetuity. Yes, these properties can provide a steady income stream. You would want to focus on those properties that have a proven history of generating income.
  4. How do I select which oil and gas production “fractional interests” to buy in a 1031 Exchange? There are qualified third party reports attesting to the investment quality of each. You should also consult with other financial advisors who know your investment needs and are experts in oil and gas production assets.
  5. Will I have to buy oil and gas properties in Texas and Oklahoma in the 1031 Exchange? No, there are oil and gas property fractional interests that can be bought in a 1031 Exchange around the country. As an example, the Marcellus Shale field, which runs from upstate New York to West Virginia, is estimated to contain 489 trillion cubic feet of recoverable gas. The United States uses about 23 trillion cubic feet yearly. A new technology, hydraulic fracturing, has now made the recovery of this natural gas cost effective. Many large energy companies are now leasing land in this region.
 
Featured Exchange Counsel
  George Barlow, Esq.
Senior Exchange Counsel
260 Casa Blanca Avenue
Fort Worth, TX 76107
Direct 214.675.1031
Toll Free 800.770.5479
Fax 703.663.9889
gbarlow@1031esgroup.com
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