1031 Oil and Gas Tax Exchange

Oil and Gas Investments

The most common 1031 exchange we facilitate is real estate for real estate. Did you know the definition of “real property” includes mineral / oil and gas rights?

Energy investors have been enjoying the benefits of private ownership and 1031 “like-kind” exchanges for over 60 years. Is it the top of the market? Who knows. What we do know is that many of our Oil and Gas clients are moving their profits tax free with a 1031 exchange to Real Estate. Of course, it takes a good eye to spot excellent value. That’s always the trick, but there is no doubt it is a buyer’s market and it’s great to diversify.

Reinvest capital from recent investment real estate sales

Private ownership results in Direct Assignment of Leasehold Interest; energy investors receive legal title to the percentage of the working interest purchased. As such, it provides an attractive 1031 Exchange opportunity for individuals and companies looking to reinvest capital from recent investment real estate sales. Private O&G ownership offers many benefits to the sophisticated real estate investor. It is an alternative that provides the same or better cash flow than many other forms of real estate, is not at the mercy of the broader economy and, thanks to an active auction market, provides flexible liquidity options. Furthermore, royalty ownership provides an excellent hedge against the impact of sustained high or rising energy prices on other asset classes.

Most 1031 exchangers often do not realize that many oil and gas properties are designed to meet the qualifications of like-kind replacement property for real estate 1031 Exchanges. Subsurface real estate interests are often referred to as mineral rights and include interests in oil and natural gas. The mineral rights are generally subdivided again into a royalty interest and a working interest. While the mineral owner is entitled to a royalty of any extracted minerals, the party who owns the lease rights to the minerals (the working interest owner) is a partner to the producing unit, with the Operator drilling and produces the oil and gas on the property.

The owner of an oil and gas working interest is given exclusive right to enter the land to extract oil and gas. So, in addition to sharing in production revenue (along with any royalty interest owners), the Operator will operate and control the extraction process for the other working interest owners.

Depletion vs depreciation in Oil and Gas Investments

Oil and Gas property ownership offer benefits and advantages such as monthly cash flow, tax deferral and a 15% depletion allowance. Depletion allowance is similar to depreciation deductions on rental real estate, but is a larger percentage. Because oil and gas are depleting assets, the government permits a depletion deduction to offset income received.

Depletion is similar to depreciation except that it is associated with the oil and gas in the ground. For large oil and gas companies, depletion is limited to the cost basis of the properties they own, but for small producers and individual investors there is a special form of depletion called “percentage depletion.” Federal tax law allows investors to deplete the cost of a well, or actually to amortize the value of the oil or gas in the ground, as a deduction against taxable income generated by the well. The amount of allowable deduction is now 15% of gross revenue, before operating costs, generated by the well during the year. Since the depletion allowance is based on the gross revenue rather than the net revenue, it can shelter between 20% and 30% of the annual cash flow to investors until the well is no longer producing. Also, the depletion allowance is not limited to your investment (basis) like in real estate, so the total write offs can ultimately exceed your investment.

You will recall the basic rule of 1031 Exchange that you need to trade even or up in value. This means reinvesting all of the cash that you received out of the relinquished property sale (plus more cash, if you wish). Also, if you had a mortgage balance on the relinquished property, you need to place at least that much debt on your replacement property unless you offset the mortgage requirement by putting in more cash. Oil and gas programs generally do not provide a debt replacement component so oil and gas programs are especially attractive to those 1031 exchangers who owned their relinquished property free and clear. However, oil and gas interests can also be attractive to 1031 exchangers who have already arranged to replace debt and wish to diversify their replacement property holdings with some oil and gas interests.

Current oil and gas prices and the ability to diversify out of 100% real estate are making these programs appealing today for many high-net-worth individuals, especially those attempting to complete 1031 Exchanges.

Related party exchange in the oil and gas industry

Questions from clients about 1031 exchanges into oil and gas

Dear 1031x,
My private oil and gas company holds an option to purchase certain oil and gas working interests. The right to exercise these options is assignable. I am in the midst of a 1031 exchange. I own 100% of this oil company. I would like to acquire the same working interests as part of my 1031 replacement property. If my oil company assigns its rights to exercise these options to purchase to me, and then I exercise the option, buying the working interests from a third party, will tax deferral will be maintained?


Let me explain how tax deferral under IRC section 1031 can be effected when exchanges occur involving related parties and how these exchange rules will effect a specific fact pattern.

The IRS defines related parties as parents, spouses, children, agents of the taxpayer or entities where the same individuals control at least fifty percent of both entities. With specific regard to related parties and 1031 exchanges:

Section 1031(f)(1) of the Code provides that if a taxpayer exchanges property with a related person, resulting in non-recognition of gain under the section, and within two years of such exchange the related person or the taxpayer disposes of the property received in the exchange, then the taxpayer must recognize the gain. The effective date upon which the taxpayer must recognize the gain will be the date upon which the later sale occurs.

Therefore, when related parties engage in an exchange, both parties must retain the property obtained in the exchange for two years for either of them to gain the tax deferred advantages of section 1031.

The purpose of this code section is to prevent basis shifting between related parties, for example. Dad owns the Mayfair apartment building with value of $1M and basis of $100K. Son own the Fairoaks apartment building with a value of $1M and a basis of $900K. Dad receives an offer to sell Mayfair.Instead Dad and Son 1031 exchange Mayfair and Fairoaks. Son then sells Mayfair to buyer.Unless two years had elapsed after the 1031 exchange between Dad and Son both parties would lose their 1031 tax deferral.

In a three party exchange where the exchanger sells the old property to a related party and buys the new property from an unrelated party, the old property should be held for two years in order to assure no recognition.The same rational as expressed above applies here.If the related party, now owning the old property,immediately sold the old property they would have no gain recognition.They would, as a practical matter, have accomplished the basis shifting prohibited by section 1031(f). (TAM 9748006)

In a three party exchange where the exchanger sells the old property to an unrelated party; the new property usually may NOT be purchased from a related party. The IRS treats purchase from a related person as buying from yourself and disallows tax deferral.If you think of related parties as the same tax payer then buying from a related party does look like buying from yourself. When you buy from yourself you start the exchange with two properties and finish the exchange with one property and cash, no exchange. This cashing out of real estate will disallow the tax deferral.

There are two exceptions to this rule:

  • a) The related party is also doing a 1031 exchange when he sells to you, (PLR 2004-40002), or
  • b) the gain that the related party is recognizing is larger than the one that you are deferring. (1031)(f)(2)(C).

Under exception:

  • a) no cashing out occurs, and under except
  • b) tax deferral is not occurring.

Applying these rules to your situation, I believe that your structure will satisfy the requirements of section 1031 and that tax deferral will be achieved as you are not buying from a related party.

1031x does Oil and Gas Nationwide Exchanges

We often are asked if we work in all 50 states. We do! Even properties in Alaska may be 1031 tax exchanged for another property in Alaska or somewhere else in the United States. Section 1031 is a federal tax code and as such it applies to all 50 states. With the recent energy concerns, it is also important to note that we handle 1031 Exchanges for Oil and Gas Mineral / Drilling Rights. Yes, those can be exchanged!

Why invest in the oil and gas business?

  • Investors are provided with portfolio diversification with the purchase of oil and gas assets;
  • Oil and gas assets also can serve as a boundary against rising energy prices;
  • Oil and gas tax codes allow for a 15% depletion allowance from gross revenues, for most investors, it is recommended to consult with the appropriate professional in this area;
  • Oil and gas properties are often used as replacement property for real estate and other investments to defer capital gains taxes under IRS section 1031.
  • There are no additional closing costs, points, fees to exchange from a real estate property into a oil/gas with 1031x.
  • The energy market is in worldwide focus. 1031x offers a tax deferred investment, through a 1031 exchange for real estate investors wanting to apply their real estate sales proceeds and invest in oil and gas. We believe the oil and gas industry is a solid investment opportunity that is driven by a combination of influences. The oil and gas properties we offer have a production history. While inexact, production curves in oil and gas wells are predictive of future production. With a direct leasehold ownership in oil and gas properties, the Investor will own a record title ownership in the leasehold interest associated with the oil and gas well(s). The Owner will receive a monthly revenue check (less expenses) directly from the purchaser of the oil and/or gas product.

Defer your taxes with a 1031 exchange

We can answer your questions about oil and gas exchanges.
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1031 Oil & Gas Ownership Benefits

  • Increased Monthly Cash Flow: Energy investments have historically generated annual income of 10-15%+.
  • Diversification: Oil and gas assets consist of ownership in hundreds and often thousands of producing wells, on hundreds or thousands of acres of land in multiple oil and gas regions in the United States.
  • Management Free: An experienced operator will have the organization, professionals, and systems in place to properly analyze and operate the investment.
  • Reduced Exposure to Real Estate: and gas can help reduce many 1031 exchange investors exposure to real estate.
  • Flexible Liquidity Options: Each year, hundreds of millions of dollars of oil and gas interests are bought and sold through online auctions, third party divestment companies, and private sales.
  • Investment Portfolio Hedge: Oil and gas ownership provides a hedge against the impact of sustained high or rising energy prices on other asset classes.

Questions from clients about 1031 exchanges into oil and gas

Dear 1031x,
I noticed on your web site that it’s possible to exchange working or royalty interest in oil or gas production for real estate. Can one exchange real estate (apartments, etc) for working or royalty interests in oil/gas production?


Royalty interests are also known as mineral interests. They are perpetual and transferred by deed. As such they are real estate and therefore “like kind” to other real estate. Working interests are less clear as they are more contractual in nature. Generally assets that transfer by deed are exchangeable.

If this sounds like an option you’d like to consider, please contact our office. Oil and gas investments require some research, and our staff includes a Landman who can help work with you on your 1031 exchange into oil and gas replacement properties. We look forward to hearing from you, and helping you with your future exchanges. We enjoy keeping up with our investors throughout the United States.