While the tax deferral benefits of a 1031 Exchange can be very significant, there is another reason to consider a tax-deferred exchange. The 1031 Exchange provides the opportunity to diversify your investment portfolio, without triggering a tax liability. Let's assume your personal net-worth is heavily weighted toward real estate, and you would like to create greater balance in your portfolio without generating taxes on the sale your property(s). One way to achieve this is through the sale of a conventional investment property into a non-conventional real estate asset such as an oil and gas interest. .

Tax Benefits Review. With 15% federal capital gains tax, plus state taxes where applicable (in Colorado the amount is 4.63%), the potential for deferring taxes is significant -- particularly if you have held the property for many years.

On the sale of a $1-million property with a $250,000 basis, the amount of taxes to be paid or deferred by a Coloradoan could be nearly $150,000.

Plus, assuming you have taken depreciation for tax purposes, you have tax exposure on the recapture of this depreciation. The depreciation recapture, which is federally taxed at 25%, may also be deferred through the 1031 Exchange. When properly structured, an oil and gas interest can meet the IRS's 'like-kind' requirement for a 1031 Replacement property

Quality, Quality, Quality. If the three keys to successful conventional real estate investing are Location, Location, Location, then the three principles of successful oil and gas investing are Quality, Quality, Quality. In considering an energy asset as a 1031 replacement property, look for quality in:

• Sponsorship. Oil and gas is a specialty; deal only with investment sponsors who have a proven track record for successfully putting together energy investments.

• Physical Reserves. Unless you are a petroleum engineer or geologist, you are going to need to rely on the opinions of others. This is another reason to deal only with quality sponsors.

• Field Operations. Look for a field operator with a proven track record a stake in the on-going success of the venture.

Investment Returns. Cash-on-cash returns on gas interests tend to higher than on a conventional real estate investment -- and they should be. An important distinction between a brick and mortar property and an oil and gas interest is that while a good real estate investment will appreciate over time, the oil and gas field deplete over time.

Having energy assets in one's portfolio is a good way to diversify away risk associated with a portfolio heavily concentrated in real estate. However, exchanging into an oil and gas interest requires expertise. A good Exchange Intermediary will help ensure your exchange meets Section 1031 of the IRS code. You will also want to have your attorney and tax accountant advising you in your decision.

Lastly, an investment real estate broker with solid expertise in tax-deferred exchanges can help you evaluate the benefits of exchanging into brick and mortar versus oil and gas, and provide your available properties to consider for acquisition.

Published: December 28, 2007

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