That’s a good question that starts with an explanation of business property. First, think of business property as a house. The entire house and all of its rooms are what the IRS calls Section 1231 property.
Section 1231 generally defines business property as depreciable property used in trade or business that has been owned for at least 1 year. This includes things such as buildings, equipment, and land. It does not include inventory or self-created intellectual property. However, the tax code has subsets of 1231 property. Much like a house is divided into rooms, so too is the taxation of business property.
Next, think of the dining room in the house as Section 1254 property. Think of the bathroom as Section 1245 property. Think of the bedroom as Section 1250 property. And so on and so on. All these rooms are under the same roof and make up the house. But the house is not just 1 big room. It’s broken into sections: bathroom, kitchen, bedroom, garage, etc. So...all 1254 property is 1231 property but not all 1231 property is 1254 property. Once you’ve identified you are in the 1231 house, you must then look to see if you need to go into the dining room, bathroom, or bedroom.
Section 1254 property is oil and gas, geothermal, or other minerals properties. That seems very broad and nondescript. Digging further, we learn that property is defined as each separate interest owned in a mineral in each separate parcel of land. That seems very nebulous and even more nondescript. Look at it this way: It is any asset created from drilling into the Earth. This can be actually owning a well or it can be having ownership rights to profits from the minerals coming out of the Earth.
Let’s create a few examples to understand the 1254 dining room.
In the simplest of examples: Stetson Company owns a small 1-acre parcel of land that it uses to produce oil. Stetson’s 1-acre parcel is 1254 property. Any buildings or equipment on the parcel are NOT 1254 property. Instead, they are 1231 property.
A more complicated example: John invests $100,000 to become a 50% partner in a proposed oil well. John’s 50% ownership is 1254 property.
A little more complicated example: Bob owns land that he leases to Zion Exploration Company to drill for and hopefully find oil. Bob is granted a 25% net profits interest as part of the lease terms. Zion finds oil and generates $1,000,000 in profit. Bob is entitled to $250,000 of the profit. Bob’s 25% interest is 1254 property.
In general, most oil and gas investment properties will meet the definition of 1254 property.
Now that we know 1254 property is like the dining room in the 1231 property house, let’s explore (pun intended) how 1254 property is taxed when it is sold.
Note: 1254 discusses property disposition (to include sale, exchange, or involuntary conversion). We will use property sale as a generic way to describe any of these dispositions.
When you sell your 1254 property, hopefully you generate a profit. If so, congratulations! How this profit is taxed is affected by the tax theory of “recapture.” In short, recapture refers to taxing items that have provided a tax benefit in prior years.
Sally sells her ownership in the Star oil well on January 1, 2018. Sally has owned the investment for 1 year. Sally received $430,000 as the sales price. She purchased her ownership for $350,000. Sally has claimed $30,000 in intangible drilling costs (IDC), exploration, and depletion expenses on her taxes during the time she was an owner.
The $30,000 in IDC and depletion were used as a deduction against ordinary income in 2017. This will create tax at 2018 ordinary income rates on the $30,000 that was “recaptured” from the previous year. Sally was able to deduct the entire amount of IDC in the 1st year (one of the benefits of oil and gas investment). However, Sally is unable to forget about IDC after that. It still plays a part in her tax planning for future years. IDC does not create a one-time tax benefit. It’s the “gift” that keeps on giving.
There are many nuances to 1254 property. This article is intended as a “dip your toe and test the water” intro into the world of 1254. Engage a CPA with knowledge and experience in the oil and gas sector when considering an investment. And definitely when you are planning to dispose of an investment.