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dispose of the property in the context of a "like-kind" exchange of property under Section 1031 of the Internal Revenue Code. While a qualifying "like-kind" exchange can be a valuable tax planning tool, the rules are complex
and subject to numerous limitations.
General.
Generally under the Internal Revenue Code, a taxpayer realizes taxable gain when the taxpayer sells, exchanges or otherwise disposes of property. The amount of the gain is generally equal to the difference between the amount
received by the taxpayer in the sale, exchange or disposition, and the adjusted basis of the property relinquished. The gain is typically recognized in the year of the disposition the property. In the case of property which has
been depreciated (such as vehicles or well equipment), or property on which intangible drilling and development costs have been deducted, gain may be recast as ordinary income under applicable recapture rules.
Under Section 1031 of the Internal Revenue Code (the "Code"), property held for productive use in a trade or business or for investment (i.e. "qualifying property") may be exchanged on a tax-deferred basis for other
qualifying property. The nonrecognition of gain or income does not apply to the extent the taxpayer receives money, is relieved of liabilities with respect to the transferred property or receives other nonqualifying property.
Such nonqualifying property is termed "boot" and is currently taxable to the recipient notwithstanding nonrecognition treatment on the part of the transaction involving to the exchange of qualifying property. The nonrecognition
of gain is, in effect, a deferral of taxes which would have otherwise been incurred under general provisions of the Code in the disposition of the property. When a transaction qualifies as a "like-kind" exchange under Code
Section 1031, the adjusted tax basis of the transferred property is carried over to the like-kind property acquired in the transaction. There is no step-up in basis for the acquired property qualifying for tax-deferred exchange
treatment as there would be had the transaction been a taxable sale or exchange. The result is that the taxes not paid in a "like-kind" exchange transaction under Code Section 1031 are deferred until the newly acquired
like-kind property is later disposed in a taxable transaction. If the acquired property is later traded for a qualifying property in another "like-kind" exchange, the tax deferral may once again occur.
Like-Kind Property Defined.
General. Property is generally considered to be of "like-kind" for purposes of Code Section 1031 if it is of the same nature or character. Most exchanges of real properties qualify as "like-kind" exchanges. An exception is that real property located outside the United States and real property located in the United States are not considered to be property of a like kind.
Personal properties are of "like-kind" if they are of the same class. For example, depreciable tangible personal properties are of a like class if they fall within the same general asset class according to Internal Revenue
Service published depreciation guidelines or the same product class according to published Standard Industrial Classification (SIC) codes. Although the published depreciation schedules and SIC codes do not cover tangible
equipment used in the oil and gas industry (other than relatively generic equipment such as autos, trucks, furniture, fixtures etc.), exchanges of substantively like kind oil and gas field or service equipment may still qualify
for tax-deferred exchange treatment under Code Section 1031.
Oil and Gas Properties. Oil and gas properties generally fall within three categories relevant to the issue of tax-deferred like kind exchanges: (1) an economic interest in an oil and gas leasehold (i.e. pure working interest or royalty interest); (2) a noneconomic interest in oil and gas leasehold (i.e. an interest in minerals, revenues or profits from an oil and gas leasehold that is carved out from the general leasehold and limited in time, scope or amount); or (3) oil and gas field or service equipment (well-head equipment, pipelines, compressors, rigs, vehicles, etc.)
An economic interest in an oil and gas lease will generally be considered "qualifying property" in the nature of real estate for purposes of Code Section 1031. An interest in an oil and gas leasehold that is not considered
an economic interest (such as a production payment deemed a loan or a mortgage under Code Section 636) will generally not be considered "qualifying property" for purposes of Code Section 1031. Oil and gas field or service
equipment may constitute "qualifying property" for purposes of Code Section 1031 based on the rules described above generally applicable to personal property.
Limitations.
Nature of Property. Only property held for productive use in a trade or business or for investment is eligible to qualify for "like-kind" exchange treatment under Section 1031 of the Code. "Like-kind" exchange treatment is not available, however, with respect to inventories (i.e. stock in trade or other property held primarily for sale).
Exclusion of Partnership Interests. Nonrecognition treatment under Section 1031 is not available for the exchange of interests in a partnership. An exception to this exclusion exists if the organization had properly excluded itself pursuant to Code Section 761 from the application of the partnership tax provisions of Subchapter K of the Code. Fractionalized working interests in an oil and gas lease covered by a joint operating agreement typically are subject to clauses in the joint operating agreement specifically excluding the parties from being considered partners for state law purposes and also for federal income tax purposes. The fractionalized working interests of the parties to the joint operating agreement would thus, absent other unique circumstances, constitute "qualifying property" for purposes of Code Section 1031.
Related Persons. Special rules apply to "like-kind" exchanges between related persons. If property received in a "like-kind" exchange between related persons is disposed of within two years after the date of the last transfer that was part of the "like-kind" exchange, the original exchange will not qualify for nonrecognition treatment. Any gain or loss that was not recognized by the taxpayer on the original exchange must be recognized as of the date that the like-kind property is disposed of by either the taxpayer or the related person.
Related persons for this purpose include family members (brother, sister, spouse, ancestor or lineal descendant); an individual and a corporation more than 50% owned by such individual; two corporations that are members of
a controlled group (at least 50% owned) of corporations; two S corporations if the same person owns more than 50% in value of the outstanding stock of each corporation; an S corporation and a C corporation if the same persons
own more than 50% in value of the outstanding stock of each corporation; a grantor and a fiduciary of any trust; any fiduciaries of trusts with the same grantor; a fiduciary of a trust and its beneficiary; any fiduciaries of
trusts and the beneficiaries of such trusts if the trusts have the same grantor; a fiduciary of a trust and a corporation if more than 50% in value of the outstanding stock is directly or indirectly owned by or for the trust or
a grantor of the trust; a corporation and a partnership if the same persons own (a) more than 50% in value of the outstanding stock of the corporation and (b) more than 50% of the capital or profits interest in the partnership.
In determining stock ownership for purposes of the above rules: (a) stock held by a corporation, partnership, estate, or trust is considered owned proportionately by its shareholders, partners, or beneficiaries; (b) an
individual is considered to own stock owned by his family, as defined above; and (c) stock held by an individual's partner is considered owned by such individual if such individual also owns stock in the corporation
Tax-Deferred "Like-Kind" Exchange Transactions Involving Oil and Gas Properties.
Working Interest for Working Interest. The exchange of the working interest in a producing oil and gas lease for that in another producing oil and gas lease is considered by the IRS to be an exchange of oil and gas leasehold rights for oil and gas leasehold rights and another exchange of well equipment for well equipment. Where the fair market value of either class of property received in the exchange exceeds the fair market value of the property of such class transferred, the excess would be considered taxable boot.
When multiple oil and gas properties are involved in a single exchange transaction, Treasury Regulations promulgated under Code Section 1031 require a separate computation for exchange purposes. An exchange is considered
one of multiple properties if the properties transferred are separable into more than one "exchange group." Also, a multiple-property exchange can occur if only one exchange group is involved, but there is more than one
property being transferred or exchanged within that group. For purposes of the Treasury Regulations, all properties transferred and received within an exchange that are of a like-kind or like class are considered to be part of
an "exchange group." Each exchange group must consist of at least one property transferred and at least one property received in the exchange. The amount of gain or loss realized with respect to a particular exchange group is
the difference between the aggregate fair market value of the properties transferred in that exchange group and the properties' aggregate adjusted basis. The amount of gain for each exchange group is recognized for tax purposes
to the extent of the lesser of : (1) the gain realized, or (2) the amount of the "exchange group deficiency." The "exchange group deficiency" is the excess of the aggregate fair market value of the properties transferred in an
exchange group over the aggregate fair market value of the properties received in that exchange group.
Real Estate for Working Interest in Oil and Gas Lease. In Rev. Rul. 68-331, 1968-1 C.B. 352, the IRS stated that the exchange of a producing oil and gas lease for a fee interest in a ranch constituted a nontaxable exchange of real estate, but only to the following extent: (a) the oil and gas leasehold interest was held for productive use in a trade or business or for investment, extended until the exhaustion of the deposit and did not include personal property, stock in trade or other property primarily held for resale; and (b) the fee interest in the ranch, exclusive of the personal residence thereon, was to be held for productive use in a trade or business or for investment, and did not constitute personal property, stock in trade or other property held primarily for sale.
Royalty for Real Estate. A royalty interest in oil, gas and other minerals which constitutes "qualifying property" may be exchanged on a tax-deferred basis under Code Section 1031 for real estate which constitutes "qualifying property."
Production Payments. Carved-out production payments which retain their status as "economic interests" under Code Section 636(a) of the Code, should be considered "qualifying property" potentially eligible for tax-deferred exchange treatment under Code Section 1031. Production payments subject to Code Section 636 which are not considered "economic interests" but instead loans or mortgages, cannot be considered "qualifying property" and thus are not eligible for tax-deferred exchange treatment under Code Section 1031.
Net Profits Payments. The United States Supreme Court has ruled that a net profit payment carved from an oil and gas leasehold interest can be akin to a royalty to the extent it represents an "economic interest" in the property. As such, the same rules that apply to royalty interests for purposes of Section 1031 should apply to net profits interests.
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Brookstone Resources, Inc. is a capital formation advisory firm providing specialized advisory services to new and emerging companies, market intermediaries and individuals primarily in the areas of oil and gas, real
estate and technology development.
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For further information contact:
Patrick R. Sughroue
at
Brookstone Resources, Inc.
3777 Sparks Drive, SE
Suite 130
Grand Rapids, MI 49546
(616) 940-3389
(616) 940-3592 fax
E-Mail: prspc@aol.com
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