TAX BENEFITS OF SECTION 1031 EXCHANGES

Tax-Deferred Real Estate Exchanges for Oil & Gas Properties


What is a 1031 Exchange?

Typically, when real estate is sold, tax is due on the capital gain from the sale of the property. This taxable gain results from property appreciation over time and/or from depreciation deductions previously taken for tax purposes.

The Internal Revenue Code's Section 1031 contains the major exception to the tax liability on capital gains. A 1031 Exchange allows deferral of the tax that is normally due on capital gains from a business or investment real estate sale.

If proceeds from a sale of current real estate will be used to buy more business or investment property, a 1031 Exchange can help investors avoid taxation and maximize their available funds.


Tax Free or Tax Deferred?

Is a 1031 Exchange tax-free or simply tax-deferred? In reality, the result can be either.

• When the replacement property is later sold outright, taxes are simply deferred until capital gains are realized on the eventual sale.
  
  
• When the replacement property is either held until death or exchanged until death, the step-up in basis absorbs the deferred taxes, making the previous exchange effectively tax-free.
  
  

Due to the future value of present dollars, if taxes are deferred for a fairly long period (such as fifteen years or more), the transaction is effectively tax-free.


Planning for Profits

Real estate is usually defined as land and anything permanently attached to the land. A 1031 Exchange of real estate for interest in oil and gas exploration and production properties can provide significant tax advantages, including deferred capital gains taxes, depletion allowances, tangible and intangible drilling cost deductions.

In addition to tax benefits, today’s global energy industry offers the promise of rapid, impressive returns on capital. Market history has shown an ever-increasing demand for oil and natural gas products worldwide. Limited supply and increasing demand form an economic equation for higher prices—and higher profits for those who own the supply. When petroleum prices increase, oil and natural gas investments become even more profitable.

The advantages of diversification are well known, and drilling partnership programs offer a unique opportunity to participate in exploration and production projects on high-quality oil and gas properties. Many investors’ portfolios include oil and gas exploration partnerships because these programs offer the potential for exceptional returns on investment as well as appealing tax benefits.


How a 1031 Exchange Benefits Investors

In addition to tax considerations, a 1031 Exchange provide a way to increase cash flow from investments. For instance, a non-productive bare land investment could be transferred to a high cash-flow commercial property. Conversely, an investor could use a 1031 Exchange to increase sell a property, buy bare land, and construct a building on it. The 1031 Exchange also provides a means of consolidating multiple properties into a single property, thereby reducing management costs. On the other hand, an investor could convert a large property into several smaller ones to achieve diversification or manage the realization of gains over an extended time period.


Important Details About 1031 Exchanges

• Both the old property and the new property must be (1) held for investment, or (2) used in your trade or business.
  
  
• To realize zero taxable gain, all cash proceeds from the sale of the old property must be invested in purchasing a property of equal or greater value.
  
  
• In general, real estate other than a person’s primary residence can be sold and replaced with property other than his or her primary residence. This means that an investor can sell real estate and buy a mineral interest or vice-versa.
  
  
• A list of potential properties for purchase must be    prepared within 45 days from the date of closing on the old property.
  
  
• Closing on the purchase of one or more of the properties from the 45-day list must occur within 180 days from the date of closing on the old property.
  
  
• Whoever is on the title of the old property must take title to the new property.
  
  
• The investor cannot touch the money. By law, the funds must be held by a qualified intermediary. The proceeds cannot be left in escrow until the second property is acquired; nor can a friend, employee, broker, CPA or attorney hold the money on a temporary basis.