A like-kind exchange, also known as a 1031 Exchange because it is governed by Internal Revenue Code Section 1031, is an often overlooked tax benefit that allows a taxpayer to postpone the recognition of gain on the sale of property when the proceeds from the sale are reinvested into a qualifying similar, or like-kind, property. The deferred gain is built into the basis of the new property acquired and the deferred taxes are then paid when the new property is sold. It is important to note that a 1031 exchange does not eliminate tax, but rather defers the tax until a future date.
Like-kind exchanges can be used with several different types of properties: real property, tangible personal property, and intangible assets. Businesses in any industry can benefit from the use of a like-kind exchange. However, for purposes of this article, we are focusing on real and tangible personal property and how the like-kind exchange can be used with regard to your oil and gas properties.
How does it work?
As noted above, the concept of the like-kind exchange is quite simple. A taxpayer sells real or tangible property and then reinvests the proceeds by purchasing another property which is similar in nature or class. While the concept might be simple, navigating the complex IRS rules and regulations that surround what qualifies as a like-kind exchange is anything but simple, and failure to follow them can have unfortunate consequences.
In order to qualify as a like-kind exchange resulting in a deferral of the gain on the sale of the asset, the following rules apply:
- Replacement property must be identified in writing within 45 days of selling original property
- Replacement property must be received and the transaction completed within 180 days of the date of sale or the due date of the tax return (including extensions), whichever comes first
- The taxpayer must use a qualified intermediary and cannot take possession of the proceeds of the sale; the proceeds must be put into an escrow account. All of this is handled through the intermediary
- Receipt of cash as part of the exchange can cause all or a portion of the exchange to be taxable
The above noted items represent only the general rules that apply in order for a sale to qualify as a like-kind exchange. There are also a number of rules which may and/or may not apply depending on the specifics of your transaction. In light of the complexity of the rules governed by Section 1031, this type of transaction is usually best considered as a part of an overall strategy. When used properly, however, the like-kind exchange can result in significant tax savings.
Oil & Gas Properties
The IRS has long held that an interest in an oil and gas property, including a royalty interest, is considered real property. There are many specific Internal Revenue Service rules and rulings which pertain to these holdings, including:
- Private Letter Ruling 8135048 – Found that the exchange of overriding royalty interests for an apartment building, office building, and 50% interest in a condominium are of like-kind.
- Revenue Rule 55-526 – Holds that a royalty interest in oil and gas in place constitutes real property for federal income tax purposes.
- Revenue Rule 73-248 – States that a royalty interest is an interest in real property for federal tax purposes.
- Revenue Rule 73-2117 – Agrees that an overriding royalty interest is an interest in real property for federal tax purposes.
Real property is generally always like-kind to other real property regardless of the property’s state of improvement. Thus, for example, rental real estate is like-kind to unimproved land. Because of this, taxpayers can take advantage of the like-kind exchange to diversify their holdings. For example, a taxpayer can sell commercial real estate and use the like-kind exchange to purchase an oil and gas interest without having to recognize gain, or pay tax, on the sale of the rental property at the time of the sale.
In contrast to real property, tangible personal property refers to all of the remaining tangible assets which are not permanently fixed; in other words – all assets which are movable. Machinery and equipment, vehicles, furniture, and anything else which is not tied to a place falls into this category and can qualify for a like-kind exchange.
With respect to oil and gas properties, assets that qualify for like-kind exchanges include but are not limited to oil and gas platforms and derricks, drilling rigs, drilling machinery, pumps, drill bits, and Christmas tree assemblies.
Unlike real property in which an exchange can be made for just about any other real property, tangible personal property must be almost identical. For example, a like-kind exchange for the sale of a vehicle would involve the purchase of another vehicle. In other words, you would not be able to exchange a vehicle for a drilling platform.
Thus, there is an added layer of complexity when qualifying for a like-kind exchange of tangible personal property in that the property must be like class. The regulations under IRC Section 1031 define the general asset classes as well as the product classes. A general asset class is a broad definition of a particular type of asset, such as office furniture, fixtures and equipment; light general purpose trucks, heavy general purpose trucks; information systems; etc. Product classes are the classes set forth under the North American Industry Classification System, or NAICS. For example, NAICS Code 333911 covers oil well and oil field pumps. The exchange of any equipment which would be classified under this NAICS code would be considered like-kind under the regulations.
Although the rules may be complex, utilizing the like-kind exchange as part of your overall tax strategy can result in substantial tax savings. In addition, taxpayers can take advantage of this tax saving strategy to diversify their holdings to mitigate risk, improve cash flow, etc. However, because of the complexity of the rules and regulations of IRC Section 1031, working with a qualified tax advisor is essential.
If you would like more information regarding like-kind exchanges, especially in the oil and gas field, please contact Lori Morales.
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