Oil and gas investments are 1031 compatible.  In other words, it is possible that person(s) can exchange out of real estate and into oil and gas investments and still qualify for 1031-tax deferral treatment.  Oil and gas royalties and working-interest lease ownership may be an option for real estate investors looking to conduct a 1031 exchange.  Under certain conditions, oil and gas programs may qualify as “like-kind” property, thus providing a 1031 like kind exchange possibility for those investors looking to reinvest their proceeds from the sale of investment real estate while deferring the capital gains tax. Oil and gas investing ventures are for those investors seeking passive investments, income, and, above all, diversification.

Working or royalty interests may qualify as like kind exchange property and if structured properly qualify for 1031 treatment even if the proceeds came from “like-kind” property involving office buildings, apartment buildings, retail centers, etc. The IRS may disallow a section 1031 exchange if the seller retains the royalty interests for surface rights.  It is also important to note that production payments and substantial equipment transfers (more than 15%) do not qualify or meet 1031 exchange requirements.

What are Royalties? Generally, mineral, royalty and overriding royalty owners receive revenues from the production of oil and gas without paying the drilling or monthly operating expenses.  Oil and gas royalties investment creates a chance for investors to participate in an industry without the normal risks associated with exploration, inactive wells and unsuccessful drilling.  Royalty investments normally avoid the unpredictable aspects of new production investments. Royalty investments provide the least risk in the oil investing and gas investment options.  There is never a capital call nor is there any liability as a royalty interest holder. Royalties give access to properties with existing cash flow and documented stability and growth.  These properties are considered quality properties and incur no monthly expenses or liabilities related to development, making it easy to track their performance record and potential yield.    The risks of investing in a royalty program include:  commodity pricing swings, operators that cease to drill altogether or stop drilling for extended periods of time due to weather and or drilling supply constraints, and reserves that run dry or were miscalculated.  Also, there is not a guaranteed market for resale of royalty interests, liquidity is questionable and the secondary market for a royalty investment is uncertain. It has been reported that investors have been able to sell their interests in certain oil and gas auctions, including  on specialty websites.  Nonetheless, it is best for an investor to think in terms of holding the investment long term for income and plan to pass it on to their heirs in their estate.  Concerning the oil and gas auction market, there are uncertainties and pricing risks inherently associated with auctions.  Extensive research, knowledge of reserves, engineering and commodity pricing is helpful for successful buying and selling in the auction markets.  These are not skills usually possessed by the typical investor.  Sponsors are experienced and knowledgeable in this area and it is not recommended that investors buy or sell royalties with the intention of using the specialty website auctions.  Royalty interests are typically sold in conglomerations that are difficult to separate and trying to buy or sell individual interests may be unwieldy for the individual investor.  The institutional sponsors have acquisitions, geologists and financial experts to provide this service to the investor. What is a Working Interest? A working interest is a leasehold interest which allows the lessee the right to search for and produce oil and gas on a parcel of land and receive a portion of the proceeds of the oil and gas produced.  In a typical program, each fractional owner has the same rights as a single owner and can usually subdivide or offer for sale their ownership interest on the open market.  Why Invest in Oil and Gas? The goal of asset appreciation is to buy in the path of growth. Oil is one of our most important natural resources.  For most societies in the world, oil is the principal natural resource that fuels their economies. Why, in this great age of communication and technology, do we need to be concerned about a natural resource like oil?  Simple.   Nearly 98% of everything you have or do is in some way related to crude oil.  Heat for your home, gas for your car, 2 liter plastic bottles of pop, and petroleum jelly are just a few examples of products created from crude oil. The United States has the greatest standard of living in the world, as well as the largest economy.  Why?  Because we have always tried to maintain control over the supply as well as price of oil. As democracy and capitalism are spreading around the world, global oil consumption is at record levels.  Throughout Latin America, Russia, India, and Asia, economic growth is accelerating at a remarkable pace.  In these countries, more than two billion people, or more than 40% of the world's population, are suddenly entering the age of consumerism. Thanks to American movies, TVs and VCRs, they have seen what the rest of the world has and they want it. "Oil is the one commodity absolutely essential to this tidal wave of global growth. It's literally the blood supply of capitalism. If you are a developing country, you need all the oil you can get to drive your trucks, your cars, your planes and ships. You need oil to run your factories, machines and power plants so necessary to a modem industrial economy. 'What we're seeing is the first simultaneous, worldwide economic expansion since the late 1970s. But this time, many newly industrialized countries are joining the party and importing an unending procession of super-tankers laden with black gold.' "  --Personal Finance   Benefits of Oil & Gas Investing  POTENTIAL FOR INCREASED MONTHLY CASH FLOW: Oil and gas programs may increase cash flow and total return in a traditional investment portfolio. For the individual who is looking for higher than the average returns, and is willing to assume a commensurately higher degree of risk, oil and gas programs are a possible solution.   MANAGEMENT FREE: Professional Management.  Like Tenant-In-Common ownership, a professional operator with a proven track record is very important. A good Oil & Gas investment depends on the management, good engineering, and a thorough understanding of the production life of the wells. An experienced operator will have the organization, professionals, and systems in place to properly analyze and operate the investment.   INVESTMENT PORTOLIO HEDGE: Oil and gas ownership provides a hedge against the impact of sustained high or rising energy prices on other asset classes.  Oil and gas have a low or negative correlation to other asset classes (equities, bonds, Real Estate, etc.) creating a hedge in a diversified portfolio.    REDUCED EXPOSURE TO REAL ESTATE: Oil and gas can help reduce many 1031 exchange investors over- exposure to real estate.  Many investors are over allocated in real estate. Investing in oil and gas can help reduce exposure to real estate by investing in a global commodity that is not solely dependent on the U.S. real estate market.  FLEXIBLE LIQUIDITY OPTIONS: Investor controls exit strategy.  An investor can sell directly to another investor or liquidate the investment in the secondary market. Each year, hundreds of millions of dollars of oil and gas interests are bought and sold through online auctions, third party divestment companies, and private sales. Although there is the secondary market for these investments, a prudent investor should not buy royalty interests with the idea that it is immediately liquid. INVESTMENT SIZE FLEXIBIUTY- Oil & Gas production can be acquired on a fractional basis, typically with a smaller minimum investment than what is required in the Real Estate TIC’s, (Tenant in Common). Large producing fields can be sold to hundreds of investors; each individual investor owns a fractional interest in all of the producing wells.     REDUCED CONCENTRATION RISK: Diversification.  Oil and gas assets are typically offered nationwide, and often consist of ownership in hundreds and often thousands of producing wells, on hundreds or thousands of acres of land in multiple oil and gas regions in the United States.  One oil and gas offering can potentially include several wells or drilling sites, several states, several counties within the state and several different operators running the program all creating diversification on many different levels. Risk of oil and gas Investing:  

• Prices of oil and gas are highly volatile The values of Oil & Gas investments are based on the potential production and the price of Oil & Gas as a commodity. The income and value of the Oil and Gas interest will fluctuate depending on the then-current domestic and foreign reserves, oil and gas prices, and demand for oil and gas production.  
• Reserve estimates are not an exact science There are many uncertainties inherent in estimating quantities and valuing reserves. This makes the task of projecting future rates of production or future contemplated development difficult. 
• Difficult to Leverage Unlike real estate, Oil & Gas is very difficult to leverage. 1031 exchange investors needing to replace debt in their 1031 exchange will have a difficult time acquiring only Oil & Gas interests.  Typically, an investor selling a substantial asset, (a commercial office or apartment building) will place the debt into another Real Estate TIC, and place a portion of the equity in an oil and gas investment in order to diversify the overall investment portfolio. 
• Alternative Energy Sources Oil & Gas investments will likely decrease if new areas of exploration are discovered, alternative energy sources are developed or supply begins to exceed demand.  
• Production expenses Production expenses will most likely not directly impact the proceeds received by oil and gas Royalty owners, but they do influence the operation of the well. For example, a possible result of a dramatic increase in production expense is a reduction or cessation of well production, which could have an adverse if not devastating affect on an investors yield.  While there are generally no drilling risks for royalty owners, this investment becomes worthless if all wells stop producing.  While it is unlikely that ALL wells in a large and diverse portfolio of holdings would quit producing, one has to consider all scenarios. Oil & Gas wells do require maintenance, and an Owner of a Working Interest generally has to pay a pro rata share of the expenses associated with maintaining the wells typically out of the proceeds of the production.  

• What does the term "Peak Oil" mean?  "Peak Oil" is a worldwide concern. Chief Geologist Dr. King Hubbert discovered in 1959 that once the world oil recovery rate begins to crest beyond peak levels, the world will produce less and less oil with each successive year.   There are several websites devoted to discussing “peak oil”.   
• But can't we just cut back on our oil usage in this country and build back our oil reserves? Yes and no. Certainly if this country were to aggressively begin to conserve its use of petroleum and related products we would stave off the effects of "Peak Oil'''. But oil is a worldwide issue. First, to this date there appears to be no real conservation movement underway.  Secondly, oil is a worldwide product. The emergence of China and India is sucking up more and more oil in order for their country's business sectors to operate. Each year, it is more and more evident that the huge machine that we have built cannot sustain itself in its present form. Europe and Japan are completely oil dependent as they are on the large list of countries that are considered "net importers" (meaning they use more oil than they produce). The list of countries that are now considered "net exporters" (they use less oil than they produce) is very short.  Lastly, even if we could find a miracle "cure" for our lessening oil supplies and we could offer it to the world to eliminate our dependence on crude oil the result would be a cataclysmic worldwide depression that might change the planet forever. The oil industry is a multi-trillion dollar business of refineries and transmission lines including multiple lines of transportation. How could our planet sustain such an economic loss?  In short, the world has been consuming more oil while it is drilling and extracting less oil for a long time. These two trends cannot last long. When they collide or when a crisis occurs like a hurricane, political unrest, or a large scale war, *huge increases in the price of oil and oil related petroleum products will occur. It is these basic macro-economic trends that have caused some experts to realize that we must maintain our oil dependence while realizing that the price we may pay could be costly. 
•   What other products require oil to create?  Petroleum is used to manufacture an enormous number of products for your life. Less than 20% of all recovered oil is used for any type of fuel. Over 30% is used for the creation of food via fertilizers. Nearly the same amount is used to manufacture plastics. If you were to walk through your home and office, you would become shortly overwhelmed by the thousands of items you use everyday that would not be available to you without our access to oil. In fact, everything we now buy today represents a measurement of energy in order to create and then for us to consume. Below is a short list a few everyday items made from oil.
•  How many could you do without?  Carpets, Roofing, Epoxy paint, Oil filters, Clothing, Ink, Ipods,  computers,  Sports car bodies, Tires, Motorcycle helmets, Pillows, Heart Valves,  Crayons, Parachutes, Telephones, cell phones, Enamel, Transparent tape, Antiseptics, Vacuum, bottles, Deodorant, Pantyhose, Rubbing Alcohol, , Upholstery, Hearing Aids, Car sound insulation,  Cassettes, Shower doors, Shoes, Refrigerator linings, Electrical tape, Safety glass, Awnings,  plastic dinnerware, Rubber cement, Nylon rope,  Ice buckets, coolers, Fertilizers, Hair coloring, Toilet seats, Denture adhesive, Loudspeakers, Movie film,  Fishing boots, Candles, LP records, Solvents, Food preservatives, Floor wax, Dishwashing liquids, Unbreakable dishes, Toothbrushes,  Toothpaste, Combs, Tents, Hair curlers,  Lipstick,  Ice cube trays,  Electric blankets... and the list goes on and on.