The working interest owner of a portfolio of proved up leases has fully recovered its cost of the leasehold through depletion and would like to sell its holdings at a gain. The leases have increased in value because they have proven that there is oil and gas in economically viable quantities but all well locations have not been drilled.
There are two components to the gain. The first is actual appreciation of the property, relating to the increase in value from proving up the non-drilled (i.e. undeveloped) portion of the leases. The second is a result of recovering the costs the working interest owner has in the property via depletion. With proper planning, the owner will experience two different tax rates. Any gain received on the appreciation in value related to the undeveloped leasehold will be taxed at capital gains rates. However, the gain attributable to the producing leasehold as a result of recovering costs through depletion will be taxed as ordinary income.
To maximize the capital gains treatment, the selling party will try to allocate as much value as possible to the nonproducing leases in the purchase agreement and as little as possible to the proved up leases. The buyer may be more interested in allocating value to the physical equipment on the producing leases in order to accelerate cost recovery through depreciation and depletion. It can be a tricky negotiation process, but can be sweetened for the seller by one more possible option.
Mineral interests are considered real property and qualify for like-kind exchange treatment (1031s). If the nonproducing piece of the transaction is significant, the seller can shelter gains through a like-kind exchange of real property (e.g. hotels, more raw land, apartment buildings, etc.). The exchange may increase the value of the gain in the long run, depending on the property exchanged. The seller must disclose to the potential buyer that a 1031 exchange is involved and must draft the contract properly to shelter the nonproducing portion of the property. To the extent the seller receives cash as part of the deal or has too large a percentage of value allocated to producing property, the transaction may have limited tax deferral options as a 1031 exchange.
Conclusion: For the seller of proven leases with significant undeveloped acreage, there are significant tax planning opportunities depending on how the contract is written. Proper planning may result in shifting of gain from ordinary rates to long term capital gains rates. The seller may also choose to pursue a like-kind exchange of the mineral rights for another qualifying real estate investment. This option can shelter the gains while adding a tangible asset to the seller’s portfolio.
To view other scenarios and learn more about this topic, visit: Oil & Gas Update: Tax Implications of Buying and Selling Mineral Rights
The oil and gas industry has experienced booms and busts of varying lengths since the dawn of mineral exploration. The current climate for O&G suggests continued consolidation, however forecasts by industry experts anticipate the boom may be back by 2018. For any owners or buyers of mineral interests, the market may be ripe for making deals now — with a careful eye toward the tax implications of buying and selling mineral rights. No two deals are alike, and it’s important to learn the potential tax impact and the types of taxes you may be paying.
Scott Allen, CPA, joined Cornwell Jackson as a Tax Partner in 2016, bringing his expertise in the Construction and Oil and Gas industries and 25 years of experience in the accounting field. As the Partner in Charge of the Tax practice at Cornwell Jackson, Scott provides proactive tax planning and tax compliance to all Cornwell Jackson tax clients. Contact him at Scott.Allen@cornwelljackson.com or 972-202-8032.