Like-Kind Exchanges In The Energy Industry

Parker C. Fielder Conference

November 21-22, 2013

Todd D. KeatorThompson & Knight LLP

Dallas, Texas

Lou WellerBryan Cave LLP

San Francisco, California

K. Peter BaumgartenInternal Revenue Service

Washington, DC

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.

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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)).

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“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.

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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.

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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.”

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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).

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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.

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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.

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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.”

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Oil & Gas Interests = Real PropertyExamples 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);

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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.

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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).

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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.

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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).

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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

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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.

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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).

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Typical Forward Exchange

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Taxpayer

B Leases

(1) BQualified Intermediary

(QI)(6) H

Buyer - B

Seller - H

(2) B

(3) Cash

(5) H

(4) Cash

Direct Deed

Direct Deed

“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

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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.

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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.

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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.

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Typical Exchange Last Reverse Exchange

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Taxpayer

B Leases

Exchange Accommodation Titleholder

(EAT)

(7) H

Buyer - B

Seller - H

(6) B

(5) Cash

(3) H

(2) Cash(1) Loan Cash

(4) B

(8) Repay Loan

Direct Deed

Direct Deed

Key Issues in Oil & Gas Exchanges

1. Sale vs. Lease2. Recapture3. Tax Partnerships4. Royalty Trusts5. Unitizations and 1031(f)6. Exchange Bifurcation

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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?

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BuyerDrillCo.

10,000 Acres

75% Working Interest

75% Working Interest

$100,000,000

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).

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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?

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BuyerDrillCo.

10,000 Acres

75% Working Interest

25% Overriding Royalty

$25,000,000

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).

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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?

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BuyerDrillCo.

10,000 Acres

75% Working Interest

75% Working Interest

$100,000,000

Retained ORRI

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-by-property 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.

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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).

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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?

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BuyerDrillCo.

10,000 Acres

75% Working Interest

75% Working Interest

$75,000,000

Retained ORRI

ORRI Buyer

ORRI

$25,000,000

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).

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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 pre-existing ORRI held by Related Party (instead of DrillCo reserving the ORRI at closing). Can DrillCo use a Section 1031 exchange?

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BuyerDrillCo.

10,000 Acres

75% Working Interest

Later, convey 75% Working Interest

$100,000,000

First, assign ORRIRelated

Party

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?

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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?

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BuyerDrillCo.

3 Operating Wells

75% Working Interest

75% Working Interest

$2,000

Prior IDC = $500

Prior Depletion = $600

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).

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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.

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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).

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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.”

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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?

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BuyerDrillCo.

Texas Leases

75% Working Interest

37.5% Working Interest

$1,000,000

After the sale, the parties own the Texas Leases 50/50. They execute a JOA.

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.

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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?

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BuyerDrillCo.

Texas Leases

75% Working Interest

37.5% Working Interest

$1,000,000 + 3 well carry obligation

After the sale, the parties own the Texas Leases 50/50. They execute a JOA.

Example 3b – Authorities

• Not likely. – The arrangement does not satisfy the “complete

payout” rule. See Rev. Rul. 70-336; Rev. Rul. 71-207. 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.

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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?

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BuyerDrillCo.

Tax Partnership

Appreciated Leases

Cash

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).

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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”?

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Exchange Counterparty

DrillCo.

75% Working Interest

100,000 units in W&K Royalty Trust

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?

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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?

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Before Unitization After Unitization

A – 80 acres

A – 50%

B – 50%B – 80 acres

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).

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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.

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Before Unitization After Unitization

A – 80 acres

A – 50%

B – 50%B – 80 acres

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).

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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?

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DrillCo’s H Acreage

BuyerDe Soto

FMV $250 Million

Basis $20 Million

BIG $230 Million

Red River

FMV $250 Million

Basis $200 Million

BIG $50 Million

50,000 Acres

$500 Million

QI

*Total BIG = $280 Million

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?

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QUESTIONS???