Thursday, May 21, 2009

1031 Energy: Comparing Oil and Gas Property Ownership to Real Estate TIC Property Ownership

Comparing Oil and Gas to TICs and associated Taxes

Like Tenant-in-Common property (TIC), oil and gas properties (O&G) produce a monthly cash flow, require little management and have intrinsic value. However, unlike conventional TICs, they are diversified both by geography and product and generally do not require investors to sign personal guarantees. Most O&G replacement properties enjoy cash flow from a combination of oil and natural gas production. Because the O&G market is worldwide, or at least regional, they also generally minimize locale-specific economic trends and operator-specific business issues.

Additionally, purchase of O&G assets can provide investors with portfolio diversification, especially if an investor has a significant portion of his or her net worth in real estate. This diversification can be prudent because there is low correlation historically between O&G property value and commercial real estate property value.

While O&G production properties are not risk free, risk of investment is comparable to real estate TIC assets. The monthly production capacity in any given O&G property tends to average out to a known rate, and income fluctuation is mostly dependent on energy prices the higher the price of energy commodities, the greater the income.

Having O&G assets in your investment portfolio may help distribute or diversify risk away from factors that may devalue other kinds of assets. Individual real estate properties often carry local/regional risk because they are often strongly tied to local economic and development trends whereas ownership of geographically diverse energy-based investments offers a degree of insulation from local trends. O&G investments are instead often subject to production risks and O&G market risk. O&G assets also can serve as a hedge against rising energy prices. Other portions of your portfolio would tend to decrease as energy prices increase (certain stocks/certain real estate). Moreover, long-term performance history of O&G properties has shown only weak (or negative) correlation to Wall Street.

Although private placements are generally limited to investors who are not buying with a view to distribution, there can be a number of situations where an investor can need or desire liquidity. Generally, energy properties are more liquid than TICs. Partial or complete divestment can often be accomplished rapidly through a variety of existing and established methods, ranging from direct transfer/sale (usually 15-30 days), to online auctions (typically lasting 30 days), to traditional auctions through specialized auction houses (typically around 60 days) or divestment/brokerage firms (usually 45-60 days). The options in the liquidity spectrum for energy assets offer turn-around that can be as little as two weeks, and put your offerings into active, highly-competitive bidding environments to optimize the sale price of your properties.

Congressional Incentives Encourage Domestic Petroleum Development

Oil and Natural gas from domestic reserves helps to make our country more energy self-sufficient by reducing our dependence on foreign imports. In light of this, Congress has provided tax incentives to stimulate domestic natural gas and oil production financed by private sources. Drilling projects offer many tax advantages and these benefits greatly enhance the economics. These incentives are not "Loop Holes" -- they were placed in the Tax Code by Congress to make participation in oil and gas ventures one of the best tax advantaged investments.

Intangible Drilling Cost Tax Deduction

The intangible expenditures of drilling (labor, chemicals, mud, grease, etc.) are usually about (65 to 80%) of the cost of a well. These expenditures are considered "Intangible Drilling Cost (IDC)", which is 100% deductible during the first year. For example, a $100,000 investment would yield up to $75,000 in tax deductions during the first year of the venture. These deductions are available in the year the money was invested, even if the well does not start drilling until March 31 of the year following the contribution of capital. (See Section 263 of the Tax Code.)

Tangible Drilling Cost Tax Deduction

The total amount of the investment allocated to the equipment “Tangible Drilling Costs (TDC)” is 100% tax deductible. In the example above, the remaining tangible costs ($25,000) may be deducted as depreciation over a seven-year period. (See Section 263 of the Tax Code.)

Active vs. Passive Income

The Tax Reform Act of 1986 introduced into the Tax Code the concepts of "Passive" income and "Active" income. The Act prohibits the offsetting of losses from Passive activities against income from Active businesses. The Tax Code specifically states that a Working Interest in an oil and gas well is not a "Passive" Activity, therefore, deductions can be offset against income from active stock trades, business income, salaries, etc. (See Section 469(c)(3) of the Tax Code).

Small Producers Tax Exemption

The 1990 Tax Act provided some special tax advantages for small companies and individuals. This tax incentive, known as the "Percentage Depletion Allowance", is specifically intended to encourage participation in oil and gas drilling. This tax benefit is not available to large oil companies, retail petroleum marketers, or refiners that process more than 50,000 barrels per day. It is also not available for entities owning more than 1,000 barrels of oil (or 6,000,000 cubic feet of gas) average daily production. The "Small Producers Exemption" allows 15% of the Gross Income (not Net Income) from an oil and gas producing property to be tax-free.

Lease Costs
Lease costs (purchase of leases, minerals, etc.), sales expenses, legal expenses, administrative accounting, and Lease Operating Costs (LOC) are also 100% tax deductible through cost depletion.

Alternative Minimum Tax
Prior to the 1992 Tax Act, working interest participants in oil and gas ventures were subject to the normal Alternative Minimum Tax to the extent that this tax exceeded their regular tax. This Tax Act specifically exempted Intangible Drilling Cost as a Tax Preference Item. "Alternative Minimum Taxable Income" generally consists of adjusted gross income, minus allowable Alternative Minimum Tax itemized deduction, plus the sum of tax preference items and adjustments. "Tax preference items" are preferences existing in the Code to greatly reduce or eliminate regular income taxation. Included within this group are deductions for excess Intangible Drilling and Development Costs and the deduction for depletion allowable for a taxable year over the adjusted basis in the Drilling Acreage and the wells thereon.

Tax Bill Gives Incentive to Marginal Wells

The US Senate and House of Representative have passed a tax incentive bill to help small oil and gas producers. This bill provides a tax credit of up to $9 per well per day for marginal wells. A typical marginal well pumps 15 barrels of crude or 90 thousand cubic feet of gas per day. There are 650,000 “marginal” or “stripper” oil and gas wells in the USA. Marginal wells provide as much as 25 percent of the nations’ crude supply (on par with Saudi Arabia ) and about 10 percent of gas stocks. In 2002 alone, 17000 oil and gas wells were permanently plugged with cement (13,600 oil wells and 3,900 gas wells). This tax bill will act as a safety net to save many of these wells, thereby reducing our reliance on the Middle East.

From Houston Chronicle, October 12, 2004

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