Tax Implications for Selling Oil and Gas Properties

Once purchase price allocations have been agreed upon, it is time to calculate the gain or loss. In a traditional sale, a company usually sells either an asset outright or as a disregarded entity, which in both cases in treated the same as an asset sale for federal income tax purposes. The two main components that are sold in a traditional upstream context are wells, which are further broken out between the tangible and real property components, and leases.

Leases:

• Working interest: Generate a 1231 gain or loss and ordinary gain or loss if held for over a year or less than a year, respectively
• Royalty interest: Generate long- or short-term capital gain or loss if held for over a year or less than a year, respectively

Wells:

• Royalty interest real property: Generate a 1231 gain or loss and ordinary gain or loss if held for over a year or less than a year, respectively
• Royalty interest real property: Generate long- or short-term capital gain or loss if held for over a year or less than a year, respectively
• Real property: If a well is drilled on a lease, which the company has held less than a year, the entire gain or loss will be ordinary in character. If the lease on which the well was drilled has been held over a year, then ordinary income in an amount equal to the lesser of total 1254 recapture (inception to date IDC/ICC and non-excess depletion taken on the well) or gain realized will be recognized.
• Tangible property: If a well is drilled on a lease, which the company has held less than a year, the entire gain or loss will be ordinary in character. If the lease on which the well was drilled has been held over a year, then ordinary income in an amount equal to the lesser of total 1245 recapture (inception to date depreciation taken on the well) or gain realized will be recognized.

Some are surprised when they sell an asset held over a year and pick up ordinary income. This is based on the matching principle that the company benefited from an ordinary deduction in the form of IDC, non-excess depletion and depreciation in the past, and now must “recapture” this character of income upon sale.

Depending on the tax situation of the ultimate taxpayer it may occur that these ordinary deductions were taken at a lower tax bracket while the ordinary income from the sale is recognized at a higher tax rate. There are a few planning tools that can be made both at the entity and individual level. The entity can elect out of bonus depreciation to slow down deductions, which increases the tax basis and lowers the gain in the year of sale. At the ultimate taxpayer level, IDCs can be capitalized under section 59(e) and amortized over five years and 10 years for domestic and foreign taxpayers, respectively.

If you need assistance in navigating through the tax considerations of the oil and gas sector, Weaver can help. Contact us today to learn more.

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