There are other types of property that can be fractionalized besides traditional real estate that still work in the context of a 1031 exchange. With a renewed focus on energy, many investors would like to capitalize on all the activity in that sector of the market. With the right vehicle, it is possible to move from traditional real estate into oil, gas or other mineral interests. Many investors are surprised to find that certain types of these interests qualify for 1031 exchange treatment and are considered “like-kind” with real property. So, if an investor is selling their rental real estate (also known as their “relinquished property”) in an exchange, they may be able to buy qualified fractional interests in oil or gas as their replacement property.
Most oil, gas and mineral interests are divided into these categories:
1. Leases (an “Operating” interest):
A working lease interest is a mineral lease that gives the tenant the right to explore, drill and share in production. The costs that are associated with these activities can carry some significant, positive tax write-offs known as depletion allowances and intangible drilling costs (IDC). Operating interests such as these may also include equipment and personal property. Though returns may be highest in this type of venture, they also bear the most risk. This type of lease is considered real property for 1031 purposes.
2. Production Payments: A production payment interest is the purchase of a fractional portion of potential future production. This type of interest is for a specific duration. When the pre-specified production quota has been met, the right to receive compensation terminates. While it may be possible to exchange a production payment interest for another production payment interest of similar duration, these interests are not “like-kind” with real estate.
3. Royalties (a “Non- Operating” Interest): This type of interest gives the owner the right to receive a certain share of the mineral production for the life of the property. Because this is not a working interest, investors do not get the benefit of IDC or depletion. While some royalty interests do not qualify for exchanges, there are others that are structured to qualify as like-kind property with real estate. It is important to check with your tax advisor to get their blessing on the structure of any royalty offering before acquiring it.
In conclusion, if you are doing a 1031 exchange and like the idea of owning a energy related investment, you may want to consider one of these types of interests in oil, gas or mineral rights. Some of the advantages include the aggressive tax write-offs you could receive for depletion and intangible drilling costs (IDC). Some of the drawbacks include the risk of missing projected production levels, lowering your return. Also, when selling this type of interest on the secondary market you may have to take a reasonable discount from the acquisition price—it may still bear considering if the current annual returns are high enough to justify a lower residual value. Finally, just because a promoter is offering this type of an investment as a 1031 product, independent review needs to be done to be sure it meets the proper requirements. As with any investment, it is wise to see qualified tax advice before proceeding.
