Like-Kind Exchanges
In The Energy Industry
Parker C. Fielder Conference
November 21-22, 2013
Todd D. Keator
Thompson & Knight LLP
Dallas, Texas
K. Peter Baumgarten
Internal Revenue Service
Washington, DC
Lou Weller
Bryan Cave LLP
San Francisco, California
Background
• General Rule – Gain or loss recognized upon a
sale or exchange of property. § 1001.
• Current LTCG tax rate either 20.0% or 23.8%.
• Exception – Since 1924, no gain or loss
recognized if disposition structured as a “1031
exchange” for “like kind” property.
• Purpose – Congress did not want to impose a
tax on theoretical gain where taxpayer
continued his investment in like kind property.
2
Exceptions
• Key exclusions: no stock, partnership
interests, certificates of trust, or “dealer”
property.
– Oil and gas tax partnerships must elect out of
subchapter K prior to a 1031 exchange.
– No buying and “flipping” inventory.
• Special rules for related parties (1031(f)).
3
“Boot”
• Boot: taxpayer allowed to receive cash “boot”
in the exchange, but boot is taxable to the
extent of gain realized.
• Liability relief also considered boot, but may
be offset by liabilities assumed in the
exchange or cash paid in the exchange.
• Boot always recognized first without any basis
offset.
4
Basis
• Basis: generally, basis in relinquished
property rolls over into replacement property,
with certain adjustments.
• MACRS – the default MACRS Treatment for
replacement property is to “step into the
shoes” of the relinquished property. Treas.
Reg. 1.168(i)-6.
5
Key Elements of § 1031
• § 1031(a) provides: “No gain or loss shall be
recognized on the exchange of property held for
productive use in a trade or business or for investment
if such property is exchanged solely for property of like
kind which is to be held either for productive use in a
trade or business or for investment.”
• 3 prongs of the general rule:
– There must be an “exchange.”
– The exchanged properties must be “held for” productive
use in trade or business or investment (“held for” test).
– The exchanged properties must be of “like kind.”
6
Meaning of “Exchange”
• Reciprocal transfer of property.
• Sale and immediate reinvestment of cash does not
qualify – can’t touch the cash.
• No requirement that exchange be simultaneous;
forward and reverse exchanges are allowed (and
normal).
• Special rules govern “exchanges of multiple
properties.” Treas. Reg. 1.1031(j)-1.
• Cannot start a 1031 exchange with a lease (but oil &
gas leases are different). Pembroke v. Helvering, 23
B.T.A. 1176 (1931) (99-year lease).
7
The “Held For” Requirement
• Both “relinquished property” and
“replacement property” must be held for
productive use in a trade or business or for
investment.
• Intent determined at time of the exchange.
• Oil and gas properties generally qualify, unless
held as dealer property. See, e.g., H.E. Gerke v.
Comm’r, TC Memo 1954-30; FSA 1999-819.
8
Satisfying the “Held For” Requirement
• Test is intent at the time of the exchange; prior
bad intent may be converted to good.
• No bright line tests for holding period of
relinquished or replacement property.
• Same taxpayer must start and complete the
1031 exchange; disregarded entities are
disregarded.
– Ex.) TP owns royalties and exchanges them for working
interests. For liability reasons, TP causes a new, 100%-owned
LLC to take title to the working interests. 1031 exchange still
valid because the LLC is a DRE.
9
Meaning of “Like Kind”
• Broadly defined:
– “The words ‘like kind’ have reference to the nature or
character of the property and not to its grade or
quality. . . . The fact that any real estate involved is
improved or unimproved is not material, for that fact
relates only to the grade or quality of the property
and not to its kind or class.”
• Any real property usually qualifies.
• By statute, foreign and domestic properties are
never of “like kind.”
10
Oil & Gas Interests = Real Property
Examples of “Like Kind”
• Mineral properties for undivided interest in
hotel (Comm’r v. Crichton, 122 F.2d 181 (5th
Cir. 1941));
• Undivided interest in unimproved real estate
for interest in overriding oil and gas royalties
(General Counsel Memorandum 34651);
• Working interests in two leases (Revenue
Ruling 68-186);
11
Examples, cont’d
• Interest in a producing lease of an oil deposit in
place for a fee interest in an improved ranch
(Revenue Ruling 68-331);
• Overriding oil and gas royalties for unimproved
real estate (Revenue Ruling 72-117).
• Note that the above examples are unlimited
“economic interests” in oil and gas in place. See
Palmer v. Bender, 287 U.S. 551 (1933); Rev. Rul.
68-226.
12
Potential Exceptions
• Production payments are treated as loans and
are not “like kind” to other real property.
• Recapture items may not be deferred (e.g.,
depletion recapture cannot roll over into a fee
interest in real property).
13
Potential Exceptions, cont’d
• Personal property and equipment not like kind to real
property, but might be like kind to other personal
property and equipment acquired in the exchange.
• Personal property generally must be within same 6-digit
NAICS code to qualify. Examples:
– 333132 (derricks, drilling equipment, drilling rigs);
– 333911 (oil-field pumps);
– 3336611 (floating oil and gas drilling platforms);
– Pipelines not listed in any of these categories.
14
Pipelines and Distribution Systems
• State law determines whether property is real
or personal.
• Fixtures generally regarded as real property
under most state law.
• Installed pipeline generally (but not always a
fixture).
15
Pipelines, cont’d
• TX v. OK– In Texas, pipelines are real property if they are
buried.
– In Oklahoma, pipelines are personal property.
• Can a pipeline in TX be “like kind” to a pipeline
in OK?
• IRS has tried to alleviate some of the tension
for 1031 exchanges in ILM 20123807
16
Typical Exchange Structures
• “Forward” Exchanges are products of IRC
1031(a)(3) and generally use a “Qualified
Intermediary” (and sometimes a “qualified
trust” or “qualified escrow”).
• “Reverse” Exchanges have no Code authority
and rely on safe harbor Rev Proc 2000-37,
generally using an “Exchange Accommodation
Titleholder.”
• 45-day “identification” and 180-day closing
required.
17
Forward Exchange
• Taxpayer owns Barnett (“B”) Leases and desires to
acquire Haynesville (“H”) Leases from Seller. However,
Seller wants to sell H Leases for cash. A different Buyer,
however, desires to purchase B Leases for cash. Taxpayer
engages QI to facilitate the transaction.
• At closing, Taxpayer “transfers” B Leases to QI, and QI
sells B Leases to Buyer for cash. Next, QI uses the cash
to purchase H Leases from Seller, and then QI “transfers”
the H Leases to taxpayer to complete taxpayer’s 1031
exchange.
• QI normally doesn’t take title to anything. Transfers
typically occur via “direct deeding” per Reg authority.
• QI respected as the “exchange” counterparty (not agent).
18
Typical Forward Exchange
Direct Deed
Seller - H
(5) H
(1) B
Taxpayer
(6) H
(4) Cash
Qualified
Intermediary
(QI)
(3) Cash
(2) B
B Leases
Direct Deed
Buyer - B
19
“Identification” of Replacement
Property
• Identification for each “single exchange” is
limited to
– 3 properties (without regard to the FMV) OR
– Any number of properties so long as aggregate
FMV does not exceed 200% of FMV of the
relinquished property.
– There is also safety valve 95% rule
20
Identification of Oil & Gas
• Identification of Oil and Gas properties in
1031 exchanges raises several questions:
– Do non-contiguous properties under a single lease
represent multiple properties for 3 prop/200%
Rule?
– How specific do you need to be in identifying oil
and gas properties?
• For oil & gas, each individual lease or royalty
must be identified; thus, 200% rule usually
applies.
21
Reverse Exchange Safe Harbor
• The IRS issued a safe harbor Rev Proc 2000-37 pursuant to
which taxpayers may safely engage in reverse 1031 exchanges.
• To summarize, the taxpayer engages an “Exchange
Accommodation Titleholder” (EAT, similar to a QI) to “park”
either the replacement property or the relinquished property
in a “Qualified Exchange Accommodation Arrangement”
(“QEAA”).
• Basic requirements: taxpayer and the EAT must enter into a
written QEAA Agreement; if the replacement property is
parked, taxpayer must properly identify the relinquished
property in the same manner as described for forward
exchanges; taxpayer must complete the entire transaction
within 180 days; EAT must report itself as tax owner of the
property it holds during the QEAA period.
22
Reverse Exchange Safe Harbor
• Where EAT parks replacement property, known as Exchange Last
QEAA, since exchange occurs at end when relinquished property
is sold. This is most common structure.
• Where EAT parks relinquished property, known as Exchange First
QEAA, since exchange occurs at beginning when replacement
property acquired, EAT acquires and immediately trades for
taxpayer relinquished property, holding it until sale.
• Benefits: taxpayer can safely loan money to the EAT to acquire
the replacement property (whether or not it is to be parked), or
taxpayer can guaranty loans to the EAT for such purpose.
Taxpayer can lease the parked property from the EAT pending
completion of the exchange for no rent. Taxpayer can also
manage the parked property during such period.
23
Typical Exchange Last
Reverse Exchange
Direct Deed
Seller - H
(3) H
(1) Loan Cash
(4) B
Taxpayer
(7) H
(8) Repay Loan
Exchange
Accommodation
Titleholder
(2) Cash
(EAT)
(5) Cash
(6) B
B Leases
Direct Deed
Buyer - B
24
Key Issues in Oil & Gas Exchanges
1.
2.
3.
4.
5.
6.
Sale vs. Lease
Recapture
Tax Partnerships
Royalty Trusts
Unitizations and 1031(f)
Exchange Bifurcation
25
Sale vs. Lease
1a. “DrillCo” owns a 75% working interest in approximately
10,000 acres (comprised of hundreds of individual leases).
DrillCo has negotiated to sell the entire working interest to a
purchaser (“Buyer”) for $100,000,000. Can Section 1031 apply
to DrillCo’s transaction?
75% Working Interest
DrillCo.
Buyer
$100,000,000
75%
Working
Interest
10,000 Acres
27
Example 1a – Authorities
• The answer is yes.
– See GCM 39572; Rev. Rul. 88-78; GCM 34033; Rev.
Rul. 72-117; Comm’r v. Crichton, 122 F.2d 181
(5th Cir. 1941); GCM 34651; Rev. Rul. 68-186; Rev.
Rul. 68-331; Rev. Rul. 72-117.
– The answer would be the same upon an exchange
of a lesser fraction of the working interest (e.g.,
65% of the 75%). See Berry Oil Co. v. U.S., 25 F.
Supp. 96 (Ct. Cl. 1938); Ratliff v. Comm’r, 36 B.T.A.
762 (1937).
28
1b. Continue assuming that DrillCo owns the 75% working
interest, but now DrillCo instead agrees to sell only a 25%
overriding royalty in the leases to the Buyer for $25,000,000.
Can Section 1031 apply?
25% Overriding Royalty
DrillCo.
Buyer
$25,000,000
75%
Working
Interest
10,000 Acres
29
Example 1b – Authorities
• Probably so.
– See PLR 8237017 (exchange of working interests
for overriding royalty interests in the same
properties qualified as a Section 1031 exchange);
G.C.M. 38907 (carved out net profits interest is
not an assignment of income); G.C.M. 39181 (sale
of carved out royalties).
• Any issue with the “held for” test?
– Probably not. See Fleming v. Comm’r, 241 F.2d 78
(5th Cir. 1957), rev’d sub nom. Comm’r v. P.G. Lake,
356 U.S. 260 (1958).
30
1c. Assume DrillCo negotiates a better deal to sell the 75%
working interest to Buyer for (A) $100,000,000 and (B) retention
of an overriding royalty (an “ORRI”) equal to 25% less all
landowner royalties on the leases. Thus, on leases burdened by
a 20% landowner royalty, the ORRI will be 5%, but on leases
burdened by a 25% landowner royalty, there will be no ORRI. Is
the transaction eligible for a 1031 exchange?
75% Working Interest
DrillCo.
Buyer
$100,000,000
Retained
ORRI
75%
Working
Interest
10,000 Acres
31
Example 1c – Authorities
• The answer is determined on a lease-by-lease basis. See
Cullen v. Comm’r, 118 F.2d 651 (5th Cir. 1941) (whether a
sale or lease occurs must be determined on a property-byproperty basis).
• The answer is no for any leases upon which DrillCo
retains an ORRI.
– See Crooks v. Comm’r, 92 T.C. 816 (1989) (retention of a royalty
in the “sale” of mineral interests converts the transaction into a
lease for federal income tax purposes; Section 1031 is not
available); Rev. Rul. 69-352.
• The answer is yes for leases upon which DrillCo does
not retain an ORRI.
32
Example 1c, Continued
• Can DrillCo change the business deal and fix the
problem?
• Probably so. Some possibilities are:
– Don’t retain an ORRI and instead ask for more cash or
other consideration.
– Sell a smaller working interest for the same cash payment.
– Re-define the retained “ORRI” so that it is not a “royalty”
for federal income tax purposes (e.g., use a term shorter
than the expected life of the burdened properties). What
impact does this have on the Buyer? See Cullen and PLR
9437006 (re. retained production payments).
– Beware retained production payment on “wildcat” acreage! See
Watnick v. Comm’r, 90 T.C. 326 (1988).
33
1d. Now assume instead that Drillco sells the 75% working
interest to Buyer for $75,000,000 plus reservation of the ORRI,
and at closing, Drillco also sells the ORRI to a third party for
$25,000,000 as part of an integrated plan. Can Drillco use the
$100,000,000 total consideration in a Section 1031 exchange?
ORRI
ORRI
Buyer $25,000,000
75% Working Interest
DrillCo.
Buyer
$75,000,000
Retained
ORRI
75%
Working
Interest
10,000 Acres
34
Example 1d – Authority
• Because DrillCo has disposed of its entire
interest in the leases in one transaction, the
answer should be yes, but is not clear.
– See FSA 1999-819 (sales of working interests to
third parties, coupled with reservation of ORRIs
and contemporaneous conveyance of ORRIs to
trust for benefit of seller’s children, respected as
sales of the working interests for federal income
tax purposes).
35
1e. Assume that DrillCo wants to preserve the ORRI as part of
the deal with a potential buyer. Thus, prior to entering into
discussions with Buyer, DrillCo carves off the ORRI and assigns it
to a separate, related entity (“Related Party”) for a business
reason. Later, DrillCo negotiates the same deal with Buyer,
except that DrillCo’s sale to Buyer now is “subject to” the preexisting ORRI held by Related Party (instead of DrillCo reserving
the ORRI at closing). Can DrillCo use a Section 1031 exchange?
Related
Party
Later, convey
75% Working Interest
First, assign
ORRI
DrillCo.
Buyer
$100,000,000
75%
Working
Interest
10,000 Acres
36
Example 1e – Authorities
• The answer clearly is yes under the form of the transaction
because DrillCo has sold a working interest and has not
“retained” an ORRI as part of the transaction with Buyer.
– Instead, the ORRI is a pre-existing interest owned by a separate
taxpayer (Related Party).
– Cf. Badger Oil Co. v. Comm’r, 118 F.2d 791 (5th Cir. 1941).
• Can IRS attack the transaction on substance over form or
step transaction grounds.
– Provided DrillCo has a bona fide business purpose and the
assignment has economic substance, DrillCo’s Section 1031
exchange should be valid. See FSA 1999-819.
• What business purposes might suffice?
37
Example 1e - Continued
• What if Drillco is a partnership, and Drillco
carves off and distributes the ORRI to its
partners the day before closing, to be held by
the partners in proportion to their % interests?
• In form, the answer looks the same at 1(d).
• In substance, this transaction seems more
vulnerable on economic substance or step
transaction grounds.
Recapture
2a. Assume DrillCo owns a working interest upon which DrillCo
has 3 operating wells. Drillco previously has taken IDC
deductions of $500 and depletion deductions of $600. At a time
when Drillco’s adjusted basis in the working interest is $0, Drillco
sells the working interest to Buyer for $2,000. What result?
75% Working Interest
DrillCo.
Buyer
$2,000
75%
Working
Interest
3 Operating
Wells
Prior IDC = $500
Prior Depletion = $600
40
Example 2a – Authorities
• Drillco recognizes gain of $2,000. IRC § 1001.
$1,100 of such gain is recaptured as ordinary
income. IRC § 1254.
– i.e., must recognize recapture in an amount equal
to the lesser of prior deductions ($1100) or gain
from the sale ($2000).
41
2b. Recall that DrillCo contemplates selling working interests
subject to $500 of IDC recapture and $600 of depletion
recapture. Now assume that Drillco is investigating a possible
Section 1031 exchange of the working interest for the following
property interests (each valued at $2,000) and asks you what
recapture it might face in the exchange:
• Other producing working interests?
– Drillco recognizes no gain pursuant to the Section 1031
exchange and is not required to recognize any recapture.
Treas. Reg. § 1.1254-2(d). Instead, the recapture of $1,100
rolls over and remains preserved in the replacement
properties. Treas. Reg. § 1.1254-3(d).
– Reason: No recapture required if “Sec. 1254 property” is
exchanged solely for other “Sec. 1254 property.”
– Exception: Must still recapture to the extent of boot and like
kind property that is not Sec. 1254 property received in the
exchange.
42
Example 2b, Continued
• Royalties worth $1,800 and $200 cash boot?
- Drillco must recapture $200, to the extent of the cash boot.
• A ranch in Montana?
– Because the ranch is “like kind,” Drillco recognizes no gain from the
exchange but must recapture all $1,100 of prior deductions because
the ranch is not “section 1254 property.” Treas. Reg. §§ 1.1254-2(d),
1.1254-1(b)(2).
• Other working interests with producing wells ($1,500) and a ranch
in Montana ($500)?
– Again, Drillco recognizes no gain pursuant to the Section 1031
exchange but must recapture $500 of prior deductions because the
ranch is not “section 1254 property.” Treas. Reg. §§ 1.1254-2(d),
1.1254-1(b)(2).
43
Example 2b, Continued
• Undeveloped leases in a recently-discovered shale
play?
– The answer depends on whether undeveloped leases
constitute “section 1254 property.” See Treas. Reg. §
1.1254-2(b)(2)(iv)(A) (defining property as Sec. 1254
property in part if the property “is an operating mineral
interest with respect to which the expenditure [IDC] has
been deducted.”
– Note the past-tense language – may mean recapture is
required on exchange of producing for nonproducing.
– Contrast § 1245 and § 1250 recapture which define
“section 1245 property” and “section 1250 property” as
property “which is or has been property of a character
subject to the allowance for depreciation.”
44
Tax Partnerships
3a. DrillCo owns a 75% working interest in Texas leases. DrillCo
sells half of the leases to Buyer for $1,000,000. DrillCo and
Buyer execute a joint operating agreement appointing DrillCo
operator. The first well is a gusher. Investor then seeks to
purchase DrillCo’s 37.5% working interest for $10,000,000. Can
DrillCo structure the deal as a 1031 exchange?
37.5% Working Interest
DrillCo.
Buyer
$1,000,000
75%
Working
Interest
After the sale, the
parties own the Texas
Leases 50/50. They
execute a JOA.
Texas Leases
46
Example 3a – Authorities
• Yes, unless the WI is subject to a tax partnership.
– By default, the working interest jointly owned and
operated by Drillco and Buyer creates a tax partnership.
See Bentex Oil Corp. v. Comm’r, 20 T.C. 565 (1953); I.T.
2749, XIII-1 C.B. 99 (1934).
• Notwithstanding the tax partnership, Drillco and
Buyer may jointly elect out of subch. K, and then
Drillco may proceed with a 1031 exchange. §761(a).
• Election out effective as of first day of taxable year for
which the election is filed.
47
3b. Now assume that the consideration paid by Buyer for half of
Drillco’s working interest is (A) $1,000,000 plus (B) Buyer’s
obligation to pay 100% of the cost of the first 3 wells to be drilled
on the property. Buyer and Drillco will divide all revenues 50/50.
As a practical matter, will Buyer consent to Drillco’s request to
elect out of Subchapter K?
37.5% Working Interest
DrillCo.
Buyer
$1,000,000 + 3 well
carry obligation
75%
Working
Interest
After the sale, the
parties own the Texas
Leases 50/50. They
execute a JOA.
Texas Leases
48
Example 3b – Authorities
• Not likely.
– The arrangement does not satisfy the “complete
payout” rule. See Rev. Rul. 70-336; Rev. Rul. 71207. Thus, Buyer needs the tax partnership in
place in order to deduct 100% of the IDCs funded
by Buyer on the first 3 wells.
– As a practical matter, Drillco probably cannot
obtain Buyer’s consent to elect out, meaning
Drillco cannot dispose of the 37.5% working
interest in a Section 1031 exchange.
49
3c. Now assume that DrillCo contributes appreciated leases to a
tax partnership and Buyer contributes cash to develop the
properties. Later, the tax partnership acquires additional leases
within an AMI. Three years later, after Buyer has deducted all of
its IDCs, DrillCo locates a purchaser for its share of the leases and
requests and election out of subchapter K. Issues?
Buyer
DrillCo.
Cash
Appreciated
Leases
Tax Partnership
50
Example 3c – Authorities
• DrillCo may recognize gain due to the
distribution of the AMI properties. See IRC
Sec. 737.
• See also IRC Sec. 704(c)(1)(B).
51
Royalty Trusts
4. DrillCo desires to exchange a 75% working interest (valued at
$5,000,000) for 100,000 units in the W&K Royalty Trust (valued
at $5,000,000). The W&K Royalty Trust (a) is publicly traded on
the NYSE, (b) is a “grantor trust” for federal tax purposes, and (c)
owns thousands of interests classified as oil and gas royalties for
federal tax purposes. Are the properties “like kind”?
75% Working Interest
DrillCo.
100,000 units in
W&K Royalty Trust
Exchange
Counterparty
53
Example 4 – Authorities
• Prohibited trust interest?
– See Rev. Rul. 2004-86 addressing a non-public Delaware
Statutory Trust.
– See also CCA 201343021 (grantor trusts are “DREs”).
• Prohibited security?
– See G.C.M. 35242 (whisky warehouse receipts were not
“securities” for purposes of Section 1031); Plow Realty Co. of
Texas v. Comm’r, 4 T.C. 600 (1945) (mineral deeds were not
securities under [former] Section 543 even though they were
securities under the securities laws).
• Eligible real property?
• Identification?
• IRS opinion?
54
Unitizations and
Related Parties
5a. A and B each own 80 acres of contiguous mineral property,
each with a FMV of $100 and basis of $0. State implements a
unitization program and forces A and B to combine their 80 acre
tracts into one 160-acre unit. A and B each receive a 50%
interest in the 160-acre unit. Is this a 1031 exchange?
Before Unitization
A – 80
acres
B – 80
acres
After Unitization
A – 50%
B – 50%
56
Example 5a – Authorities
• Unitization qualifies as a 1031 exchange.
– See Rev. Rul. 68-186 (unitization of oil and gas
interests was a 1031 exchange); GCM 33536
(same).
57
5b. Same question as 5a, but now assume that A and B are
father and son, and that one year later A sells his 50% interest in
the unit for $200.
Before Unitization
A – 80
acres
B – 80
acres
After Unitization
A – 50%
B – 50%
58
Example 5b – Authorities
• The original 1031 exchange may no longer be
valid. See IRC 1031(f)(1).
• Does the “no tax avoidance purpose”
exception apply? See IRC 1031(f)(2)(C).
59
Exchange Bifurcation
6. DrillCo owns 50,000 acres in the H Shale. Half of the acreage
is located in De Soto Parish, and the other half in Red River
Parish. DrillCo accepts an offer to sell everything to Buyer for
$500 million. DrillCo desires to acquire new leases in the Eagle
Ford Shale for at least $250 million, and possibly up to $500
million. Therefore, DrillCo structures the sale of the H acreage as
a 1031 exchange. DrillCo asks if it can split the transaction into 2
separate exchanges ($250M each). Why? Is this possible?
DrillCo’s H Acreage
De Soto
Red River
FMV $250
Million
FMV $250
Million
Basis $20
Million
Basis $200
Million
BIG $230
Million
BIG $50
Million
Buyer
50,000 Acres
$500 Million
QI
*Total BIG = $280 Million
61
Example 6 – Authorities
• Can the transaction be bifurcated into two
exchanges? Maybe.
– See Sayre v. U.S., 163 F. Supp. 495 (D. W.Va. 1958);
Serdar v. U.S., TC Memo 1986-504.
• Factors: Separate PSAs? Separate negotiation?
PSAs cross-conditioned? Division of assets along
natural lines? Different closing dates? Different
buyers?
• Do separate QIs solve the problem? Is a business
purpose required?
62
QUESTIONS???