1031 Energy: Oil and Gas Tax Benefits
* Oil and Gas property ownership offer benefits and advantages similar to TIC investments, such as monthly cash flow and tax deferral options
* Oil and Gas tax codes allow for a 15% depletion allowance from gross revenues
* Depletion allowance is similar to depreciation deductions on rental real estate, but is a larger percentage
* There are no additional closing costs, points etc. in 1031 Energy's transactions.
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. Like a TIC investment, investors hold interests in shared property estates. However, in the case of an O&G based program, most of a participants interest lies underground. Hence the term "subsurface interests."
Subsurface real estate interests are often referred to as mineral rights and include interests in oil and natural gas. For producing O&G properties 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 properties offered are operated by PetroSun, while the investor owns a working inertest through their ownership of the leasehold interest.
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.
Oil and Gas property ownership offer benefits and advantages similar to TIC investments, 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. The depletion allowance is described further in the following paragraph, but generally provides a greater "write off" than a depreciation schedule of 27.5 years on residential real estate (apartments) and 39 years on other rental real estate (office buildings, shopping centers, etc.).
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.
There are other advantages to consider when deciding on diversification outside the traditional real estate sector (or when comparing, for example, a TIC investment and an oil and gas investment). When you buy from 1031 Energy, you are actually buying directly from the owner of the producing property (and out parent company), Petrosun, Inc. There are no additional closing costs, points etc. in 1031 Energys transactions. No commission is paid and we prepare and record all of the transfer documents. There are no closing costs. The closing risk of typical TIC investments does not exist because the oil and gas interests are owned by us and ready for purchase at any time. Also, an oil and gas investment is not dependent on real estate values or rent collections, and participants benefit from a virtually unlimited product demand. Likewise, there is a ready resale market for oil and gas interests (which may not be true of TIC investments).
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. Unlike TICs for example, 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 with traditional, triple net or TIC properties, but wish to diversify their replacement property holdings with some oil and gas interests.
Participation in oil and gas programs by 1031 exchangers is growing up from less than 3% of all TIC programs to close to 12% from just the first to second quarter of 2005. Of course, anyone interested in an oil and gas program should carefully review the applicable Private Placement Memorandum (PPM) for risks and rewards before committing. 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.
For more information, please contact Dana Veitch (866) 901-9455 (or e-mail firstname.lastname@example.org, or fill out and submit the Contact Us form).
Dry Hole - All dollars invested are written off as an ordinary loss against your ordinary income in the year incurred.
Producing Well - 70-85%(approx.) of the amount of your investment constitutes what are known as intangible drilling cost, and are written off your ordinary income in the year incurred.
15%-25% of the investment constitutes tangible drilling costs (well equipment). This portion of your investments is depreciated over a seven year period using the Accelerated Cost Recovery System. In some cases, approximately 5-10% of the investment is considered syndication fees which will be amortized over a three to five year period.
Depletion Allowance An allowance granted on taxable income from oil and gas by the Federal and most State Governments. The current Federal rate is 15% of gross income. The law is rather involved and a tax specialist should be used when computing the tax free portion of income. This information is supplied to each partner prior to filing his income tax returns on April 15th of each year.
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. The "Small Producers Exemption" allows 15% of the Gross Income from an oil and gas producing property to be tax-free.
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 IRS publication 925 Passive Activity and At-Risk Rule.
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. The tax credit phases-in if the average crude price for a year is less than $18 a barrel or $2 per thousand cubic feet of gas. The maximum tax credit is $3 a barrel for the first three barrels of crude produced if prices plunge below $15 a barrel, and 50 cents per thousand cubic feet if gas prices average less than $1.67 per thousand cubic feet.
Section 1031 Tax Deferred Exchanges - Click here for more information
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