Like-Kind Exchanges In The Energy Industry. Todd D. Keator Thompson & Knight LLP

Like-Kind Exchanges In The Energy Industry Todd D. Keator Thompson & Knight LLP 214-969-1797 Todd.Keator@tklaw.com February 2, 2015 Introduction Background Operation of 1031 Forward Exchanges Reverse Exchange Hot Issues for Oil & Gas Sale vs. Lease Recapture Tax Partnerships Royalty Trusts Unitizations and 1031(f) Exchange Bifurcation 2 1

Why Do a 1031 Exchange? Taxable Sale 1031 Exchange Price: $1,000,000 Price: $1,000,000 Basis: $200,000 Basis: $200,000 Recognized Gain: $800,000 Recognized Gain: $0 Tax: $190,400 (at 23.8%)* Tax: $0 Cash to Reinvest: $809,600 Cash to Reinvest: $1,000,000 Basis of New Asset: $809,600 Basis of New Asset: $200,000 *Note: Effective 1/1/13, the long-term capital gain rate is 20%. In addition, a new 3.8% tax on net investment income applies to net gain from the sale of property (other than property held in an active trade or business). 3 Background General Rule Upon a sale or exchange of property, a taxpayer must recognize gain or loss. Exception - 1031 was enacted in 1924 as an exception. 1031(a)(1): 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. Purpose Congress did not want to impose a tax on theoretical gain where taxpayer continued his investment in like kind property. 4 2

Exceptions, Boot and Basis Key exceptions: no stock, partnership interests or dealer property. Oil and gas tax partnerships must elect out of subchapter K prior to a 1031 exchange. No buying and flipping of inventory. Boot: taxpayer allowed to receive some cash, but cash is taxable to the extent of gain realized. Liability relief is considered boot, but is offset by liabilities assumed in the exchange or cash paid in the exchange. Basis generally, basis in relinquished property rolls over into replacement property, with certain adjustments. Special rules for related parties (1031(f)). 5 Boot Examples Sale (Relinquished) Property Buy (Replacement) Property Price: $1,000,000 FMV: $700,000 Basis: $200,000 Cash ( Boot ): $300,000 Potential Gain: $800,000 Basis: $200,000 Recognize lesser of Gain or Boot: Preserved Gain: $500,000 = $300,000 Gain Recognized *1031 saves $500,000 gain Sale (Relinquished) Property Buy (Replacement) Property Price: $1,000,000 FMV: $700,000 Basis: $800,000 Cash ( Boot ): $300,000 Potential Gain: $200,000 Basis: $700,000 Recognize lesser of Gain or Boot: Preserved Gain: $0 = $200,000 Gain Recognized *1031 N/A here 6 3

General Rule 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 meet the held for requirement. The exchanged properties must be of like kind. 7 Meaning of Exchange Requires a 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. Leases do not qualify (but oil & gas leases are OK). 8 4

The Held For Requirement Both the relinquished property and the replacement property must be held for productive use in a trade or business or for investment. Intent determined at time of the exchange. Generally covers all property used in a trade or business and all property held for investment, but excludes dealer property (e.g. home lots) and personal use property (e.g. vacation homes, unless safe harbor met). Oil and gas properties generally qualify, unless held as dealer property. 9 Satisfying the Held For Requirement No bright line tests for holding period of relinquished or replacement property. Same taxpayer must start and complete the exchange Disregarded entities are allowed. 10 5

Example Taxpayer owns 1,000 net mineral acres in the Barnett Shale, and exchanges them for 100% of the membership interest in an LLC that owns 800 net mineral acres in the Haynesville Shale. 1031 can apply to this exchange. Same result if Taxpayer caused a pre-existing, 100% owned LLC to acquire the Haynesville leases. 11 Example Taxpayer and Partner are 50/50 partners in LLC 1, which owns leases in the Barnett Shale. Taxpayer and Partner are also 50/50 partners in LLC 2, which owns oil & gas interests across the U.S. Taxpayer and Partner cause LLC 1 to sell the Barnett leases and structure the transaction as a 1031 exchange. Taxpayer and Partner then cause LLC 2 to acquire leases in the Haynesville Shale to complete their exchange. 1031 does not apply because the same taxpayer requirement is not satisfied. (LLC 1 is the Taxpayer). 12 6

Drop & Swap a held for issue Potential solution to exclusion of exchanges of partnership interests. Prior to exchange, partnership drops undivided interests in property to exchange partners. Afterwards, exchange partners swap pursuant to 1031. Issue: Did exchange partners satisfy the held for requirement with respect to the relinquished property? The Tax Court and 9th Circuit have ruled in favor of TPs on this issue, but the IRS continues to challenge these transactions. See Form 1065, Schedule B, Line 14: At any time during the tax year, did the partnership distribute to any partner a tenancy-incommon or other undivided interest in partnership property? 13 Drop & Swap - Example A and B are 50/50 members in LLC. 10 years ago A and B each contributed $1,000,000 each to LLC, and LLC bought leases in the Haynesville Shale for $2,000,000. LLC now has an offer to sell the Haynesville leases to a buyer for $20,000,000. A would like to reinvest his $10,000,000 share in like kind leases in the Eagleford Shale, while B desires to cash out and move to the Caribbean. Can they each accomplish their goals? Potential Solution: Drop & Swap whereby LLC distributes 50% undivided interests in the Haynesville Leases to A and B, and then at closing A and B each sell their 50% interests to buyer. A uses his $10,000,000 in a 1031 exchange, and B keeps his $10,000,000 in cash. Other alternative structures may also be available in this situation. 14 7

Meaning of Like Kind Broadly defined by Treasury Regulations: 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. Examples: a 25,000 acre farm for the Empire State Building; a 35-year lease of real property for a fee interest in real property; perpetual water rights for a perpetual easement. Foreign and domestic properties are not of like kind. 15 Oil & Gas Interests Examples of Like Kind Mineral properties for undivided interest in hotel; Undivided interest in unimproved real estate for interest in overriding oil and gas royalties; Working interests in two leases; Interest in a producing lease of an oil deposit in place for a fee interest in an improved ranch; Overriding oil and gas royalties for unimproved real estate. 16 8

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). 17 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. But See ILM 201238027 18 9

Typical Exchange Structures Forward Exchanges, generally using a Qualified Intermediary (QI) (and sometimes a qualified trust or qualified escrow ); Reverse Exchanges, generally using an Exchange Accommodation Titleholder. 19 Forward Exchanges A non-simultaneous exchange whereby Taxpayer disposes of relinquished property first, and acquires replacement property at a subsequent date. May be a 2-party exchange, but generally is a 4-party exchange involving (1) Taxpayer, (2) QI, (3) Buyer of Taxpayer s relinquished property, and (4) Seller of Taxpayer s replacement property. 20 10

Forward Exchanges Key Requirements: Taxpayer can t touch the cash the cash must sit with the QI (QI is not an agent for tax purposes!). Note that QI becomes the exchange counterparty. Taxpayer must identify replacement property within 45 days of closing. Limited to 3 properties or 200% of FMV. Taxpayer must acquire the identified replacement property within 180 days of closing (or by due date for next tax return). 21 Identification Rules Identification Period begins on date Taxpayer transfers relinquished property and ends at midnight on 45th day. Identification must be in writing, delivered to a third party (the QI), and must unambiguously describe the replacement property (legal description, street address, or distinguishable name). For oil & gas, each individual lease must be identified (means 200% rule usually applies) Permitted to identify up to 3 alternate replacement properties regardless of value ( 3-property rule ), or any number of replacement properties provided the aggregate value does not exceed 200% of the value of the relinquished property ( 200% rule ). 22 11

Forward Exchange Example Taxpayer owns Barnett Leases and desires to acquire Haynesville Leases from Seller. However, Seller wants to sell Haynesville Leases for cash, not Barnett Leases. Buyer, however, desires to acquire Barnett Leases, and is willing to pay cash. Taxpayer engages QI to facilitate the transaction as follows: Day 1: Taxpayer transfers Barnett Leases to QI, and QI sells Barnett Leases to Buyer for cash. Day 2: QI uses the cash to purchase Haynesville Leases from Seller. Day 3: QI transfers Haynesville Leases to taxpayer to complete taxpayer s 1031 exchange. 23 Typical Forward Exchange (3) Haynesville Leases* Seller - Haynesville Leases Taxpayer (1) Barnett Leases (4) Haynesville Leases Qualified Intermediary (3) Cash *Note that title will move directly. (2) Cash 24 Barnett Leases (2) Barnett Leases* Buyer - Barnett Leases 12

Use of a QI The QI safe harbor is the most widely-used safe harbor because the buyer of the relinquished property does not have to participate in the taxpayer s 1031 exchange. It simplifies the transaction. If the taxpayer and QI adhere to the safe harbor rules, the QI is not treated as the taxpayer s agent. Thus, the taxpayer is not in constructive receipt of cash held by the QI pending acquisition of the replacement property, and the taxpayer s receipt of replacement property from the QI is treated as an exchange. 25 Practical Requirements Must select a QI. Be careful, some are thieves and terrible credit risks! QI security is at a premium (see LandAmerica bankruptcy Taxpayers recovered 70/25%). Consider combining QI safe harbor with qualified escrow or trust. Need an Exchange Agreement (executed prior to closing; requires 2-3 days lead-in time); EA must limit the taxpayer s rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash held by the QI before the end of the exchange period. PSA with buyer must be assignable to QI; typically handled via Exchange Cooperation Clause. Then must assign rights under PSA to the QI. Must deliver written notice of assignment to all parties (including the buyer). QI will provide the documents; attorney should review. Where to deposit 1031 cash? Whose bank? What interest rate? 26 13

Sample 1031 Cooperation Clause 1031 Exchange. Buyer hereby acknowledges that Seller may elect to structure the disposition of the Properties as a like kind exchange under Section 1031 of the Internal Revenue Code (an Exchange ), which Exchange will not delay the Closing or cause additional liability or expense to Buyer. In connection with an Exchange, Seller s rights under this Agreement may be assigned to a qualified intermediary (as defined by Treasury Regulation 1.1031(k)-1(g)(4)) of Seller s choice for the purpose of completing the Exchange. Buyer agrees to cooperate with Seller and the qualified intermediary (including by executing documents) in a manner necessary to timely complete the Exchange. The purchase and sale of the Properties shall not be contingent or otherwise subject to the consummation of the Exchange. 27 Reverse Exchange Safe Harbor The IRS has issued a safe harbor pursuant to which taxpayers may safely engage in reverse 1031 exchanges. To summarize, the taxpayer engages an Exchange Accommodation Titleholder (similar to a QI) to park the replacement property. Basic requirements: taxpayer and the EAT must enter into a Qualified Exchange Accommodation Agreement; taxpayer must properly identify the relinquished property in the same manner as described for forward exchanges (i.e., 45 day limit); and taxpayer must complete the entire transaction within 180 days. Benefits: taxpayer can safely loan money to the EAT to acquire the replacement property to be parked, or taxpayer can guaranty loans to the EAT for such purpose. Taxpayer can lease the replacement property from the EAT pending completion of the exchange for no rent. Taxpayer can manage the replacement property during such period. Depletion during parking period? 28 14

Typical Reverse Exchange Taxpayer (1) Loan Cash (3) Barnett (5) Haynesville (6) Repay Loan (2) Haynesville Leases Exchange Accommodation Titleholder (2) Cash Seller - Haynesville Leases (4) Cash 29 Barnett Leases (4) Barnett Leases Buyer - Barnett Leases Recap Reasons to do a 1031 Exchange 1031 Requirements: Reciprocal Exchange (forward or reverse) Can t touch the cash! Must be like kind Must be held for trade or business or investment Boot is taxable first to the extent of gain realized. 30 15

Key Issues in Oil & Gas Exchanges 1. Sale vs. Lease (exchange) 2. Recapture (like kind/boot) 3. Tax Partnerships (like kind/held for) 4. Royalty Trusts (like kind) 5. Unitizations and 1031(f) (exchange) 6. Exchange Bifurcation (exchange) 31 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? DrillCo. 75% Working Interest $100,000,000 Buyer 75% Working Interest 10,000 Acres 32 16

33 Example 1a - Authorities The answer is yes. See GCM 39572 ( [b]ecause this standard has been liberally construed, the replacement of one real property interest held for productive use in trade or business or for investment by another that is similarly held generally would be deemed to fall within the definition of a like kind exchange. ); Rev. Rul. 68-226 ( the interest of a lessee in oil and gas in place...isaninterestin realproperty for Federal income tax purposes.... ); Rev. Rul. 88-78 ( the disposition of oil rights is the disposition of an interest in real property. ); Rev. Rul. 73-428 ( A royalty interest in oil and gas in place is a fee interest in mineral rights and real property for Federal income tax purposes. ); GCM 34033 (An overriding royalty and... working interest are both considered interests in real property for purposes of the Federal income tax. ); Rev. Rul. 72-117 ( [O]verriding oil and gas royalties are interests in real property. ). See also Comm r v. Crichton, 122 F.2d 181 (5th Cir. 1941) (exchange of undivided interest in hotel for mineral properties); GCM 34651 (exchange of undivided interest in unimproved real estate for interest in overriding oil and gas royalties); Rev. Rul. 68-186 (exchange of working interests in two leases); Rev. Rul. 68-331 (exchange of interest in a producing lease of an oil deposit in place for a fee interest in an improved ranch); Rev. Rul. 72-117 (exchange of overriding royalties for unimproved real estate). What result upon a disposition of a lesser fraction of the working interest (e.g., 50% 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). 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? DrillCo. 25% Overriding Royalty $25,000,000 Buyer 75% Working Interest 10,000 Acres 34 17

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). In this situation, the overriding royalty is derived from the interest of the lessee and, thus, may be viewed as an exchange of a portion of the working interest (which clearly meets the held for requirement) with the stipulation that the assigned portion be free of development and operation costs. 35 1c. Now 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 other landowner royalties on the leases. Thus, for example, on leases burdened by a 20% landowner royalty, DrillCo s retained ORRI will be 5%. Can the $100,000,000 be used to acquire like kind replacement property in a Section 1031 exchange? DrillCo. 75% Working Interest $100,000,000 Buyer Retained ORRI 75% Working Interest 10,000 Acres 36 18

37 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 properties upon which DrillCo does not retain an ORRI. Also affects ordinary income vs. LTCG on sale. This is a huge, huge issue today! 38 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. 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). 19

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 Buyer ORRI $25,000,000 DrillCo. 75% Working Interest $75,000,000 Buyer Retained ORRI 75% Working Interest 10,000 Acres 39 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). 40 20

1e. Assume that DrillCo wants to preserve the ORRI as part of the deal with Buyer. Thus, prior to entering into discussions with Buyer, DrillCo separates the ORRI from the working interest 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). Can DrillCo use a Section 1031 exchange? Related Party First: ORRI DrillCo. Later: 75% Working Interest $100,000,000 Buyer 75% Working Interest 10,000 Acres 41 42 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. Cf. Badger Oil Co. v. Comm r, 118 F.2d 791 (5 th Cir. 1941). Instead, the ORRI is a pre-existing interest owned by a separate taxpayer (Related Party). Query whether the transaction may be attacked 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? Can Drillco do this 1-day before closing? 21

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? DrillCo. 75% Working Interest $2,000 Buyer 75% Working Interest 3 Operating Wells Prior IDC = $500 Prior Depletion = $600 43 Example 2a - Authorities Drillco recognizes gain of $2,000. IRC 1001. $1,100 of such gain is recaptured as ordinary income (39.6%). IRC 1254. $900 balance is long-term capital gain (23.8%). 44 22

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: 45 Other working interests with producing wells? 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 other like kind property received that is not Sec. 1254 property. 46 Example 2b, Continued Royalties burdening operating working interests (worth $1800) and cash of $200? Must recapture $200 (i.e., to the extent of cash boot). A ranch in Montana? Drillco recognizes no gain pursuant to the Section 1031 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). In other words, depletion recapture cannot roll over and remain preserved in real estate. 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). 23

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 [i.e., IDC] has been deducted. ) (emphasis added). The past-tense language implies that only operating interests that previously have generated some IDC deductions qualify. BNA Portfolio 605 at A-35 advises recapture: Accordingly, a like-kind exchange of developed property (a 1254 property) for undeveloped property, or an interest in developed property for an interest in undeveloped property will trigger 1254 recapture. 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.... These definitions would cover new items of depreciable property that, although not previously subject to depreciation, will be subject to depreciation in the hands of the taxpayer once placed in service. In other words, there is some risk that Taxpayer must recapture prior depletion and IDC upon a 1031 exchange of developed minerals for undeveloped minerals. 47 3a. DrillCo owns a 75% working interest in Texas leases. DrillCo sells an undivided 50% interest in 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? 75% Working Interest DrillCo. Texas Leases 37.5% Working Interest $1,000,000 Buyer After the sale, the parties own the Texas Leases 50/50. They execute a JOA. 48 24

Example 3a - Authorities The answer is yes, unless the 37.5% working interest is subject to a tax partnership. IRC 1031(a)(2)(D). Here, by default, the working interest jointly owned and operated by Drillco and Buyer creates a tax partnership between Drillco and Buyer. See Bentex Oil Corp. v. Comm r, 20 T.C. 565 (1953) (joint operating agreement creates a partnership for federal income tax purposes); I.T. 2749, XIII-1 C.B. 99 (1934) (same). 1031 N/A to partnerships (including tax partnerships!) Notwithstanding the tax partnership, Drillco and Buyer may jointly elect out of subchapter K, in which case Drillco may proceed with a Section 1031 exchange. See IRC 761(a), IRC 1031(a)(flush language). 49 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 ( cash and carry ). 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? 75% Working Interest DrillCo. Texas Leases 37.5% Working Interest $1,000,000 + 3 well carry obligation Buyer After the sale, the parties own the Texas Leases 50/50. They execute a JOA. 50 25

Example 3b - Authorities Not likely. Here, parties do not satisfy the complete payout rule (which is typical). See Rev. Rul. 70-336; Rev. Rul. 71-207. Thus, Buyer needs the tax partnership to remain in place in order to deduct 100% of the IDCs funded by Buyer on the first 3 wells. Thus, 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. 51 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? DrillCo. Buyer Appreciated Leases Cash Tax Partnership 52 26

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). 53 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 only interests classified as oil and gas royalties for federal tax purposes. Are the properties like kind? DrillCo. 75% Working Interest 100,000 units in W&K Royalty Trust Exchange Counterparty 54 27

Example 4 - Authorities Prohibited interest in a trust? See Rev. Rul. 2004-86 (look through interests in grantor trusts to underlying assets). However, facts were limited to non-public DST. 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 predecessor to Section 543 even though they were considered securities under the securities laws). Eligible real property? See authorities cited in first example regarding royalty interests. IRS opinion? 55 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 After Unitization A 80 acres B 80 acres A 50% B 50% 56 28

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 After Unitization A 80 acres B 80 acres A 50% B 50% 58 29

Example 5b - Authorities The original 1031 exchange may no longer be valid. See 1031(f)(1). Does the no tax avoidance purpose exception apply? See 1031(f)(2)(C). 59 6. DrillCo owns 50,000 acres in the Haynesville 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 Haynesville 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 Haynesville Acreage De Soto FMV $250 Million Red River FMV $250 Million 50,000 Acres Buyer Basis $20 Million Basis $200 Million $500 Million BIG $230 Million BIG $50 Million QI *Total BIG = $280 Million 60 30

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? 61 31