Navagating The Newest 1031 Exchange Alternative - Oil & Gas Royalties

All investing presents a risk versus reward challenge that investors face when ever they chose to satisfy a 1031 exchange requirement in order to defer capital gains and recaptured depreciation on their investment property. The newest entrant to compete with tenants in common (TIC) investing is energy interests in oil & gas.

There is confusion as to what a royalty interest is and what a working interest is and how they compare. Each has its place in the risk versus reward scenario but more and more investors are favoring royalties over working interests because of the lack of liability involved. The investors we work with are typically at or near retirement age, desire steady income but above all else want to preserve their hard earned wealth. Consequently, they turn to Royalty Interests over Working Interest. Albeit the reward is higher with the working interest ? it is not enough to off set the risk. We are in the business of capital preservation.

The liabilities involved are multiple in a working interest but the five greatest we have discovered are:

? Liability of a Capital Call
? Liability to Governmental Authority Having Jurisdiction, Including Environmental Liability
? Liability for Costs of Exploration, Operation & Plugging
? Liability for Property Damage and/or Personal Injury caused by Operations, Fire or Blowout
? Liability for Subsurface Damage of Hydrocarbon Reservoirs Caused by Negligent or Intentional Operations

If I were selling real estate that I had owned for 20 or 30 years, had paid down the debt and was looking for a potential retirement vehicle to satisfy a 1031 exchange - then looking at the above bullets would make me very uncomfortable to say the least! Royalties have none of the above stipulated concerns. Royalty interests can have expected lives of anywhere from months to 40 years and beyond, though only those with a long expected life are appropriate for someone considering them a 1031 exchange. Energy investors have been enjoying the benefits of private royalty ownership and ?like-kind? exchanges for over 60 years. Court Rulings dating back to the 1940?s have set the precedent and affirmed the opportunity for investors to accomplish tax deferral by exchanging between brick-and?mortar and royalty interest; both of which are forms of real estate.

Many investors are nearing retirement age. They continually seek above all capital preservation and a steady stream of income. They require both to sustain their quality of living. The royalty interest is a payment derived off of the production sold on a particular property. Typically, that is 25% of any well drilled. There are inherent risks associated with royalties. They may loose their value over time. Value is based on current production and estimates of proven reserves. Royalty investment is centered on proven oil & gas production numbers (past, present and projected) and not with the current price of oil & gas. To determine a fair sales price on your interest, a registered professional petroleum engineer performs an engineering and economic evaluation, such as analyzing historical production data, calculating production decline rates, and reviewing historical cash flows. The information is then used to forecast future well performance, calculate remaining oil and gas reserves, and predict future revenues. Another risk is the price of gas and oil may decline thus reducing the monthly income stream. Although the future forecast for energy is that demand will exceed supply. Knowing who you are buying the royalties from and their performance history is absolutely crucial. For the type of investing we are writing about here we are seeking forecasts that go out 30, 40 years or more.

The working interest puts up the capital costs, the operating expenses, takes on the liability insurance and operates the well for the next 30, 40 or more years. Royalty investors get the same share of the reserves but none of the expenses or liabilities listed above. Consider this for just a moment; it cost $11 a barrel to go out and develop reserves (to drill). Its $7 a barrel to go out and acquire it; investors are buying reserves for .65 on the dollar of the cost of finding and developing it. In our view the royalty side of the business is the only side of the business that you should be involved in when reviewing your 1031 Exchange Alternatives.

Ricardo E. Jobin is Senior Vice President of 1031 Exchange Alternatives?. Ricardo attained an MBA in 2000 from Davenport University and served as a board member for The Strategy Forum of Detroit. He is a member of TICA, the national Tenant-in-Common Association and has first hand experience in the acquisition and management of commercial real estate. Ricardo is a licensed securities agent and a registered representative of SIGMA Financial Corporation, member of NASD & SIPC. For more information call 1-800-466-2003 or visit http://www.1031ea.com.