Significant Tax Planning Opportunities Available for Like-Kind Exchanges of Oil and Gas Properties
Why are Like-Kind Exchanges So Attractive for Oil and Gas Properties?
Generally, the types of assets that are most suitable for a like-kind exchange are those assets with a a low tax basis relative to current fair market value, either due to appreciation in the asset’s value or as a result of the taxpayer having previously taken income tax deductions that enable the tax basis of the asset to be significantly reduced.
In the oil and gas industry, there are significant income tax incentives in place that encourage investment in oil and gas properties. The two most significant items that receive favorable tax treatment in the oil and gas industry are intangible drilling costs and depletion. These two items are discussed in further detail below.
Intangible Drilling Costs
The U.S. tax code provides an exception from the capitalization rules for intangible drilling and development costs for oil and gas wells. The owner of an operating interest in a property may elect to immediately deduct such costs. The election applies only to those items that do not have a salvage value. Intangible expenditures include wages, fuel, repairs, hauling, supplies, and other items incidental to, and necessary for, the drilling of wells and the preparation of wells for the production of oil or gas. The election covers expenditures for the clearing of ground and geological work in preparation for the drilling of the well, and those expenditures incurred in the construction of derricks, tanks, pipelines, and other physical structures that are necessary for drilling and the preparation of the wells for production. These expenditures usually constitute the major part of the costs of drilling an oil or gas well prior to completion, and the election provides an incentive to develop the property. Intangible drilling and development costs usually represent approximately 60 to 80% of the costs associated with an investment in an oil and gas well.
Depletion
Oil, gas, and other minerals are wasting assets, which are physically consumed or exhausted by development of, and production from, mineral properties. In addition to the depreciation allowance for the use of physical properties, the U.S. tax code provides an annual allowance for the depletion of mineral reserves in determining the owner’s taxable income. In order for a party to be entitled to claim depletion deductions, the party must have an “economic interest” in the minerals in place and look to the mineral produced and sold for cost recovery. The taxpayer claims the greater of “cost depletion” or “percentage depletion.” Cost depletion is based on the unit cost of the reserves that are sold and permits recovery of the taxpayer’s capital investment in the reserves consumed in the production of income. Percentage depletion is based on a percentage of the income from the property, and can result in the recovery of more than the capital investment in the property (“excess percentage depletion”). Percentage depletion of oil and gas properties is permitted only within narrowly defined parameters and is not available for integrated producers who also are large retailers or refiners. Percentage depletion (sometimes referred to as “statutory depletion”) is a stipulated percentage equal to 15% of the gross income generated from the relevant oil and gas property during a given taxable year. Percentage depletion usually results in accelerated tax deductions to a taxpayer who owns a working interest in an oil and gas property since percentage depletion is based on the gross income generated from the production of an oil and gas property even though the net income from such a property (after deducting both tangible and intangible drilling costs) is usually significantly less than the gross income from oil and gas production.
Recapture Rules
Once tax is triggered on a taxpayer’s disposition of an oil and gas property, historical tax deductions claimed for intangible drilling costs, depletion deductions, and depreciation deductions on drilling equipment are generally required to be “recaptured” — meaning that some or all of the tax owed could be treated as ordinary income. Also, even if a taxpayer enters into a tax-deferred 1031 exchange with respect to a given oil and gas property, these deductions are generally required under the U.S. tax code to be recaptured if the taxpayer relinquishes property that is subject to recapture but receives replacement property that is not. Therefore, it is extremely important for a taxpayer interested in entering into a 1031 exchange on a given oil and gas property to engage experienced tax counsel in order to make sure that the exchange is carefully structured to avoid triggering the recapture rules, while still enabling the taxpayer to meet its anticipated cash flow needs and other non-tax objectives.
Conclusion
When disposing of oil and gas properties, taxes can be deferred under a properly structured Section 1031 like-kind exchange. While the alternatives for structuring a like-kind exchange are quite flexible for oil and gas properties, the formalities of a like-kind exchange must be complied with. Due to the special circumstances of any specific mineral property and due to the wide range of property interests encountered in the oil and gas industry, there are pitfalls and traps specific to these properties that must be carefully navigated. The structure of a particular like-kind exchange and the documentation required varies from being fairly routine to being very complex, depending upon the circumstances. Planning should begin early and possibly even as soon as interests in oil and gas properties are acquired in order to better facilitate for the disposition of property through a like-kind exchange. Owners of oil and gas properties can greatly benefit by deferring taxes as tax savings can be reinvested. Section 1031 could defer taxes and enable tax-deferred compounding with respect to oil and gas investments, which is extremely valuable to companies and individuals who wish to participate in oil and gas investments due both to the significant tax incentives available with respect to oil and gas assets and the superior investment return that can potentially be generated on investments in oil and gas properties over a long-term time horizon.
For further information, please contact Coby Hyman at General Tax Counsel, PLLC. Mr. Hyman can be reached by phone at (972) 740-0161 or via email at chyman@generaltaxcounsel.com.