Oil and Gas as a 1031 Exchange
by Keith Walters    Sun, May 20, 2007, 05:44 PM
Rodney was running late to our morning coffee meeting at Javalato’s.

 That was actually a good thing, allowed me to catch up on emails on the free wireless there. Did you ever notice how coffee in a paper cup tastes like paper. One thing I love about Javalatos is the ceramic mugs. And the baristas know enough to warm the mug up before pouring the joe.

The purpose of the meeting was, selfishly, to pick Rodney’s brain a bit about what opportunities he may know for an entrepreneurial operations guy such as myself. But, instead, we spent most of the time talking about the intriguing project Rodney is working on. The half-hour turned into an hour as we dove into this project and picked apart the oil and gas business.

Rodney Wren and his partner, Todd Garner, at Pinnacle Royalties, Ltd. are putting together an interesting way to bridge the thirst for real estate investment and its tax breaks, with the oil and gas market, by acquiring working interests to introduce to the 1031 Exchange community

If you invest in real estate you can’t turn around without someone throwing 1031 at you. But, as most active investors know, a 1031 exchange can be very limiting, particularly the 45-day period to identify replacement properties. How likely is it that you’ll find qualified properties to buy with close to the same value of what was sold that are available in the limited time frame? Typically you end up with either a) left over funds that are now taxable (known as the ‘taxable boot’), b) not enough funds and you need to borrow, or c) properties that weren’t quite what you wanted but were all that was available at the time. And, once the sellers find out you’re operating under the limitations of a 1031, it gives them some negotiating strength.

The IRS’s rulings in 2002 that 1031 exchanges can be used for fractional ownership (known as Tenants in Common) or TIC has helped to address many of the 1031 limitations by providing a larger number of investment options of a highly variable value. Additionally, it’s provided a way to step away from the day-to-day drudgery of owning real estate. No more fixing the overflowing toilet or collecting rent from a deadbeat tenant. Most 1031 TIC investment options buy a fractional interest in a piece of real estate that includes such niceties as property management. Just sit back and watch the cash flow.

Rodney, Todd and Pinnacle Royalties are expanding that 1031 TIC market into the oil and gas arena. Oil and gas working interest ownership is considered real estate from a ‘like-kind’ exchange perspective; a royalty owner has a deed to the mineral rights – which are a form of real estate. So, in essence, the funds from selling your office building downtown can, in turn, be 1031’d into an interest in a well in the Barnett Shale. And, because owners own a percentage of the total working interest under oil and gas rules, there is not a limit of 35 fractional owners – a limitation that applies to other 1031 TIC investments. On top of all this, there is potential for a higher level of liquidity in an oil and gas royalty interest. So, when that next big building comes along to buy you can be out of the oil and gas and into the building with a minimum of fuss.

It seems like the real challenge here is finding the right oil and gas properties to invest in. Unlike most oil and gas investments, Pinnacle is not looking for the gusher, that boom well that spikes early and then tails in production. Instead, Rodney is looking for boring stuff, wells that produce steady and long-term, but not necessarily high-volume. Unlike traditional real estate, which typically appreciates with time, most oil and gas royalty interest depreciates because of dwindling production (unless increasing prices offset decreasing production). A long-term, steady producer offsets that trend. Oh well, boring can be good. Sometimes.

So, a cup of coffee (and, OK, a chocolate muffin) turn into an eye-opening look at an interesting tie between oil and gas investment and real estate investment. The dynamics of business and the free market continually interest me. Dallas abounds with thought leaders like Rodney and Todd who will likely serve as change agents for the oil and gas sector as well as real estate market. Now, hopefully they’ll grow like crazy and need an operations guy like me to run it all.

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