Using real estate to exchange for an oil and gas producing well as a tax deferred investment

Many investors are unaware they can sell real estate properties and roll all the money forward into oil or gas producing wells without paying any tax on the profits from the sale of their real estate property. The IRS considers real estate and producing oil and/or gas properties as “like-kind”.  

Tax Advantages of Oil and Gas Drilling

Congressional Incentives Encourage Domestic Petroleum Development

As oil and natural gas from domestic reserves help to reduce U.S. dependence on foreign imports, Congress has provided tax incentives to stimulate domestic natural gas and oil production financed by private sources. These incentives were placed in the U.S. Tax Code by Congress to make participation in oil and gas ventures one of the best tax advantaged investments.

Intangible Drilling Costs Tax Deduction

Intangible expenditures of drilling (labor, chemicals, mud, grease, etc.) are usually about (65 to 80%) of the cost of a well. These expenditures are considered an "Intangible Drilling Cost (IDC)"which is 100% deductible during the first year. For example, a $100,000 investment would yield approximately $75,000 in tax deductions during the first year. These deductions are available in the year the money was invested, even if the well does not begin drilling until March 31 of the year following the contribution of capital. ( U.S. Tax Code, Section 263).

Exchange Working or Royalty Interest

An exchange of your working or royalty interest for another working or royalty interest qualifies for a 1031 Exchange. You can also exchange a working or royalty interest for real estate. For example, if you sell a working interest you could replace it with another working interest, a royalty interest, or fee ownership in an office building, apartment building, etc.

But, be careful. If you sell a working interest and retain the royalty interests or surface rights, the IRS may disallow your exchange. Production payments do not qualify for a 1031 Exchange.

Sales of working interests often involve the selling of related equipment. While the IRS allows you to transfer a minimal amount of equipment tax free, transfers of substantial equipment (usually exceeding 15% of the sale price) require the equipment to be treated as a separate personal property exchange. Personal property exchange rules can vary. Please contact MEGA 1031 for specifics.

The bottom line is you don’t have to exchange your mineral interest for another interest. However, you can exchange your interest for other real estate. For example, you can sell your mineral interest and buy real estate such as raw land, an office building or a 16-unit apartment complex.

Advantages of Oil and Gas Exchange

• The average pay out is 15% to 18% per year over the life of production.
• Income is eligible for a tax-free depletion allowance of about 15%. This is not charged back upon the future sale of the 1031 exchange of the investor’s “fractional interest.”
• Congress gives individual investors tax breaks that are not available to large companies.
• Unlike real estate, oil and gas is a global commodity not solely dependant on the U.S. economy and interest rates.
• 65 to 80% first year write off; up to 100% tax-free income.
• 50%+ annual rate of return; return of capital in 6-to-12 months.
• Average wells are less risky than 10 years ago due to technology and market changes.
• Several projects have a probability of success better than 90%.
• Most projects would be economically attractive even if oil or gas prices would fall 50%.