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Balancing Real Estate Risk with Reward
Diversification is one of the keys to preserving investor dollars while enjoying the benefits of investing in real estate. The advent of Tenants in Common properties that are 1031 compliant has greatly increased the ability of investors to diversify their portfolio, eliminate management headaches and enjoy strong stable cash flows.
TIC (Tenant In Common) ownership presents an opportunity to build a portfolio from different investment categories (Office, Retail, Multi-family, etc), different geographical areas and different levels of risk. This can provide the investor with good cash flows (7% to 10%) and attractive appreciation potential while minimizing risk by spreading it out over a number of properties.
In an effort to increase cash flow and further diversify many investors are considering Oil and Gas Royalty properties. Currently these investments offer first year cash flows of 12% to 20% with healthy depletion allowances to help shelter income. Historically, court rulings have affirmed that Oil & Gas Royalties qualify as “like kind” for a 1031 exchange. It is important for 1031 exchange investors to verify that the Oil and Gas investment they are considering is 1031 compliant.
In regards to 1031 exchanges the issue for Oil and Gas typically is if a “production payment” is considered personal property (not qualified for a 1031 exchange) or not. A “royalty interest” (sometimes known as an “overriding royalty”) is generally 1031 compliant. The difference between production payments and royalty payments is the amount of time an interest is held. A production payment usually terminates when a specified amount of Oil or Gas has been produced or a stated amount of proceeds have been received. A royalty interest continues until the Oil or Gas deposit has been exhausted.
The higher return on an investment in Oil & Gas is attractive to investors because of the strong potential cash flow and tax advantages. It is important to remember that the higher return reflects higher risk. A complete discussion of the various risk aspects of Oil & Gas investments versus more conventional real estate is beyond the scope of this article but needs to be fully understood before making any investment.
It is important that investor discuss the suitability and risk of any investments with their tax and legal advisors prior to making a final investment decision.