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Owning oil and gas royalty interests: Another option in the 1031 exchange world

2013-11-26

Have you been watching the real estate market continue to rise over the past few years? Do you have a very low cost basis on some properties and would love to be able to sell and diversify a bit, but don't want to pay thirty plus percent in taxes? Well, there is another option that is little known in the 1031 world. Oil and gas royalty interests are considered like kind for a real estate exchange. Whether you don't want to deal with the headaches of tenants, or just have too large a percentage of your assets in real estate, exchanging one or more of you properties for oil and gas royalties might be a appropriate strategy.

An attractive aspect of owning fractional royalty interests is that you don't have to get into the oil business. These are partial ownership interests in fields that are already producing and are continually being drilled by the major oil companies. This can give you exposure to the sector, without the exploratory drilling, which can be highly risky. This of course also takes away the chance of huge upside potential; however it has the potential to provide income. The income that is generated is going to be based on the current price of gas and oil. Historically, rising oil prices have sometimes weakened the dollar, which sometimes leads the Fed to raise interest rates. We all know that ultimately means higher mortgage rates and lower real estate prices. This can make having oil exposure a nice hedge against your real estate portfolio. Such interests also have a degree of liquidity. There is actually a secondary market for them, where 1031 sellers can sell to other 1031 buyers or investors. This allows them in some instances to be even more liquid than other real estate; however the value will be based on the current price of gas and oil. In order to diversify further, you can purchase multiple fields spread over different states as well. It can also provide for an immediate closing to accommodate the exchange as well as provide cash flow right away that in some cases is tax advantaged. As for tax purposes it is considered in the same way as any other piece of real estate, so you still get the stepped up basis at death.

As with any investment, it is also important to consider the risks before making any decisions. Some of the main things to consider are the following. First is the fact that even though there are exchanges set up to sell the interests, there is no guarantee that if you come to a point where you would like to sell your royalty position, you might not be able to get the price you would like or even be able to sell it at all. Secondly, this is a passive investment, the operators are not obligated to drill to keep wells in production, so if prices drop and they decide to cut production, your income would decrease. It is also important to keep in mind that your monthly income is tied to commodity prices and that oil and gas prices to fluctuate, which will cause your income to fluctuate as well. This is very different from owning a piece of real estate with a lease agreement for a specific amount over a fixed time period.

If the royalty market is something you are not familiar with, the following are some interesting statistics. According to the National Association of Royalty Owners, in the U.S. there are over 8.5 million private owners of oil and gas royalty interests. An estimated $400 billion are paid annually and over 70% of the minerals in the U.S. are owned individually and leased to development companies.

So, what are some of the reasons a royalty investment might be something to consider. First of all, they can be an easy way to get direct exposure to oil and gas markets without any management responsibilities. Maybe your holdings are over weighted toward real estate, and you have some highly appreciated property to exchange. You may be like a lot of investors and have the majority of your money spread out over real estate, equities and fixed income. This can give diversification in an asset not correlated to any of those markets. Perhaps you would like the potential for monthly income that isn't tied to the fixed income markets and has the potential to increase with rising interest rates and inflation. An important fact to remember is the value of your fractional ownership, as well as the amount of monthly cash flow will rise and fall with the oil and gas markets. Should prices appreciate, this will allow the potential for the asset to be exchanged for another piece of real estate at a later date. Obviously, if prices decline, not only will your monthly income be lower, but the value of the asset will decrease as well. So, if you've ever thought it would be nice to be in the oil business, but never wanted to put on a pair of boots and work some wells, royalties might be something to look into. Before making any decisions, make sure you consult with a financial advisor and an oil and gas production expert to help you with the due diligence on any interests you are considering.

Michael Packman is CEO at PNI Capital Partners, Syosset, N.Y.

He offers access to securities through J.P. Turner & Co., LLC, a nationwide broker/dealer and member of SIPC. J.P. Turner & Co., LLC and PNI Capital Partners are not affiliated.



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Michael Packman, PNI Capital Partners



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