Much has been written about the new Opportunity Zone (OZ) rules that convey substantial tax breaks for development in targeted low-income areas, with most of the attention focused on traditional brick and mortar real estate businesses. There’s been little discussion about the potential benefits for oil and gas exploration and development.

Of the roughly 15 states that contain 90% or more of domestic onshore development and production, many have extremely productive formations in rural OZs. This begs the question: Can oil and gas assets and development activities constitute qualified OZ properties and business activities? It is believed the answer is yes. 

The purpose behind the legislation, included in the Tax Cuts and Jobs Act of 2017, was to encourage economic growth and investment in designated distressed communities by providing federal income tax benefits to those who invest new capital in businesses within these zones. 

It is important to note there is no requirement or threshold for jobs creation under the OZ rules. Rather, the rules are focused on the investment of capital within the OZ, with the two fundamental requirements under the OZ rules being: an investment in tangible property located in an OZ; and use of that property in an active trade or business within the designated zone.

As to the first requirement, the proposed OZ regulations have made it clear that both conveyed and leasehold interests in real property meet the definition of tangible property for purposes of the rules. This seems to clearly address situations in which a party either is an oil and gas working interest owner or actually owns a fee interest in oil and gas minerals.

Investments in the zone through traditional expenditures at the wellbore that are typically capitalized, including well-finishing, the Christmas tree, and in-field production. Gathering systems are also included.

As to the second requirement, it has been the long-held policy of the IRS that the ownership and operation of working interests is an active trade business and that working interests and related assets are active trade or business assets. If mineral interests are held in connection with this trade or business, they can also qualify as active trade or business assets. However, fee mineral interests that are not actively managed in a trade or business are considered passive assets and will not qualify under the active trade or business requirement.

Additional active trade or business requirements under the OZ rules include:

  • At least 50% of the total gross income must be derived from an active trade or business;
  • If the business assets include intangible property, a substantial portion of it must be used in the active trade or business; and
  • Any non-qualified financial property must comprise less than 5% of the property in the OZ business.

In traditional oil and gas activities, none of these rules appear to create a stumbling block to taking advantage of the tax benefits under the OZ rules.

Tangible property located within an OZ generally must be substantially improved under these rules. To meet the substantial improvement requirement, at least 100% of the value of the existing improvements must be spent on additional improvements. As clarified by a ruling from the IRS, the substantial improvement requirement does not apply to land located within the OZ.

For example, if an OZ property is purchased for 140X, and 100X is attributable to the underlying land and 40X is attributable to the existing improvements, a ruling by the IRS makes clear that the 100X attributable to the land is ignored for purposes of the substantial improvement test. So, in that example, an expenditure of 40X is required to meet the substantial improvement requirement. 

However, what happens in the case of a typical oil and gas investment in which the initial expenditure is for a leasehold interest and there are otherwise no existing improvements? In other words, what constitutes substantial improvement when there are no existing buildings, fixtures or facilities to improve, which is often the case with oil and gas leasehold interests?

Unfortunately, no clear answer is given to this question under the proposed regulations. The most conservative approach is to plan to invest at least 100% or more in drilling and development as compared to the original cost of the leasehold located in the OZ. This appears to more than address the policy goal underlying the substantial improvement requirement, i.e., encouraging capital investment within the zone. 

Also, the fact that intangible drilling costs are usually expensed for federal tax purposes should be irrelevant under the substantial improvement test because the expenditures are clearly intended to improve the property and enhance its production capability, as well as its value. Arguably, a taxpayer’s method of cost recovery for tax purposes should not make a difference in whether the expenditure qualifies as an improvement.

By analogy, in the current regime of bonus first-year depreciation, no one is questioning whether improvements or equipment that qualify for first-year expensing jeopardize their qualification as an improvement expense so long as they are located within an OZ.

Accordingly, at the most fundamental level, upstream oil and gas exploration and development within a qualified OZ should qualify for the tax benefits under OZ rules. As such, any capital gains that are rolled over into a qualified OZ fund whose purpose is to invest in oil and gas upstream exploration and production (directly or through investment in another entity carrying out upstream E&P activities) should qualify for deferral under the OZ rules.

In addition, if a qualifying investment in oil and gas properties is made before Dec. 31, 2019, and properly managed until Dec. 31, 2026, the investment should likewise qualify for the 10% and 5% step-up in tax basis benefits that apply after years five and seven, respectively, as well as the complete deferral that applies to any appreciation that occurs post-investment. It would be wise for upstream entities to consult with tax counsel in investigating the potential benefits from this new tax law.

Roger Aksamit is a tax partner at Thompson & Knight LLP who advises energy and private equity clients on mergers & acquisitions, financing, joint ventures, and all aspects of tax planning. Thompson & Knight tax counsel Katie Gerber advises clients on tax matters involved in M&As, partnerships, S-corporations and related issues.