Generally when ever someone sells or trades any type of property a gain or loss for tax purposes results. The gain or loss is the difference between the amount realized (cash or value of property received) and the adjusted basis (cost of the property given up minus any depreciation or depletion).

In the early years after the passage of the income tax in 1913 there were many discussions concerning the timing or "recognition" of income for tax purposes. If a farmer trades one horse for another horse, then should he be required to put it on his tax return? What if the farmer trades a horse for a tractor? After much debate in 1921, Congress in it's infinite wisdom decided that an exchange of like kind property should not be an occasion to pay tax. For tax purposes, the "basis" of the old property is merely transferred to the new property.

Over the years, the rules for a tax free exchange have slowly evolved, but two primary concerns have prevailed: 1) what form of transaction qualifies for tax free treatment and 2) what is like- kind property? In the early days an exchange was merely a trade between two parties. Currently the two party transaction probably only makes up less than 1% of all tax-free exchanges. The most flexible and popular exchange involves a delayed exchange with an accommodator or intermediary for the purpose of selling property to one person and acquiring replacement property from yet another at a later date. Sometimes the transaction is simple and at other times quite complex depending on the goals and present circumstances of the parties involved. The form of the transaction and it's documentation is critical and determines if it is taxable or not. Since tax law can be quite complex, this is not a transaction to be designed and documented at home on the kitchen table or by the inexperienced as a self-help activity. The intermediary usually provides the required documents but the parties oil and gas tax advisors can usually provide valuable guidance as needed in the transaction and review the documents.

The definition of what is "like kind" property is generally easier when dealing with real estate. Real estate is usually land and anything permanently attached to the land. With few exceptions any form of real estate is considered like-kind to any other form of real estate. In Texas, Oil and gas beneath the surface is considered a part of the realty¹Ibut when it is removed it becomes personalty^2. In other words, you can exchange a working or royalty interest for another working or royalty interest or even a ranch, hotel or office building. A production payment is considered to be real estate under Texas law but is treated as a form of indebtedness for tax purposes and consequently may not be considered like-kind. An exchange of a working interest while retaining a royalty interest or surface rights is usually treated as a lease rather than a disposition and will not qualify for a tax-free exchange.³ If a production payment were retained, the transaction would probably qualify for tax-free treatment. Equipment furniture and other personal property can only be exchanged tax free for very similar types of equipment or furniture. Most exchanges of working interests involve some degree of both equipment (usually 5-10%) and real estate. For example, if you sold in a tax-free exchange a mineral interest for say $900,000 and related equipment for $100,000 in order to be tax-free you would need to receive a mineral interest with a value of $900,000 or greater and well equipment with a value of $100,000 or more. Also to be tax free in this example, you must not receive any thing that is not like-kind property such as cash, notes of indebtedness, net relief of indebtedness or say as an airplane. IDC recapture under IRC 1254, in an exchange, is limited to recognized gain plus the fair market value of  replacement property that is not natural resource recovery property⁴.