Reg. § 1.1254-1 Treatment of gain from disposition of natural resource recapture property.
(a) In general Upon any disposition of section property or any disposition after December 31, 1975 of oil, gas, or geothermal property, gain is treated as ordinary income in an amount equal to the lesser of the amount of the section costs (as defined in of this section) with respect to the property, or the amount, if any, by which the amount realized on the sale, exchange, or involuntary conversion, or the fair market value of the property on any other disposition, exceeds the adjusted basis of the property. However, any amount treated as ordinary income under the preceding sentence is not included in the taxpayer's gross income from the property for purposes of section . Generally, the lesser of the amounts described in this is treated as ordinary income even though, in the absence of section , no gain would be recognized upon the disposition under any other provision of the Internal Revenue Code. For the definition of the term section costs, see of this section. For the definition of the terms section property, oil, gas, or geothermal property, and natural resource recapture property, see of this section. For rules relating to the disposition of natural resource recapture property, see , , and of this section. For exceptions and limitations to the application of section , see .
(b) Definitions
(1) Section 1254 costs
(i) Property placed in service after December 31, 1986 With respect to any property placed in service by the taxpayer after December 31, 1986, the term section costs means—
(A) The aggregate amount of expenditures that have been deducted by the taxpayer or any person under section , , or with respect to such property and that, but for the deduction, would have been included in the adjusted basis of the property or in the adjusted basis of certain depreciable property associated with the property; and
(B) The deductions for depletion under section that reduced the adjusted basis of the property.
(ii) Property placed in service before January 1, 1987 With respect to any property placed in service by the taxpayer before January 1, 1987, the term section costs means—
(A) The aggregate amount of costs paid or incurred after December 31, 1975, with respect to such property, that have been deducted as intangible drilling and development costs under section by the taxpayer or any other person (except that section costs do not include costs incurred with respect to geothermal wells commenced before October 1, 1978) and that, but for the deduction, would be reflected in the adjusted basis of the property or in the adjusted basis of certain depreciable property associated with the property; reduced by
(B) The amount (if any) by which the deduction for depletion allowed under section that was computed either under section or sections and , with respect to the property, would have been increased if the costs (paid or incurred after December 31, 1975) had been charged to capital account rather than deducted.
(iii) Deductions under section 59 and section 291 Amounts capitalized pursuant to an election under section or pursuant to section are treated as section costs in the year in which an amortization deduction is claimed under section or section .
(iv) Suspended deductions If a deduction of a section cost has been suspended as of the date of disposition of section property, the deduction is not treated as a section cost if it is included in basis for determining gain or loss on the disposition. On the other hand, if the deduction will eventually be claimed, it is a section cost as of the date of disposition. For example, a deduction suspended pursuant to the 65 percent of taxable income limitation of section may either be included in basis upon disposition of the property or may be deducted in a year after the year of disposition. See . If it is included in the basis then it is not a section cost, but if it is deductible in a later year it is a section cost as of the date of the disposition.
(v) Previously recaptured amounts If an amount has been previously treated as ordinary income pursuant to section , it is not a section cost.
(vi) Nonproductive wells The aggregate amount of section costs paid or incurred on any property includes the amount of intangible drilling and development costs incurred on nonproductive wells, but only to the extent that the taxpayer recognizes income on the foreclosure of a nonrecourse debt the proceeds from which were used to finance the section costs with respect to the property. For this purpose, the term nonproductive well means a well that does not produce oil or gas in commercial quantities, including a well that is drilled for the purpose of ascertaining the existence, location, or extent of an oil or gas reservoir (e.g., a delineation well). The term nonproductive well does not include an injection well (other than an injection well drilled as part of a project that does not result in production in commercial quantities).
(vii) Calculation of amount described in paragraph (b)(1)(ii)(B) of this section (hypothetical depletion offset)
(A) In general In calculating the amount described in of this section, the taxpayer shall apply the following rules. The taxpayer may use the 65-percent-of-taxable-income limitation of section . If the taxpayer uses that limitation, the taxpayer is not required to recalculate the effect of such limitation with respect to any property not disposed of. That is, the taxpayer may assume that the hypothetical capitalization of intangible drilling and development costs with respect to any property disposed of does not affect the allowable depletion with respect to property retained by the taxpayer. Any intangible drilling and development costs that, if they had not been treated as expenses under section , would have properly been capitalized under (relating to items recoverable through depreciation under section or cost recovery under section ) are treated as costs described in (relating to items recoverable through depletion). The increase in depletion attributable to the capitalization of intangible drilling and development costs is computed by subtracting the amount of cost or percentage depletion actually claimed from the amount of cost or percentage depletion that would have been allowable if intangible drilling and development costs had been capitalized. If the remainder is zero or less than zero, the entire amount of intangible drilling and development costs attributable to the property is recapturable.
(B) Example The following example illustrates the principles of paragraph (b)(1)(vii)(A).
Example: Hypothetical depletion offset. In 1976, A purchased undeveloped property for $10,000. During 1977, A incurred $200,000 of productive well intangible drilling and development costs with respect to the property. A deducted the intangible drilling and development costs as expenses under section . Estimated reserves of 150,000 barrels of recoverable oil were discovered in 1977 and production began in 1978. In 1978, A produced and sold 30,000 barrels of oil at $8 per barrel, resulting in $240,000 of gross income. A had no other oil or gas production in 1978. A claimed a percentage depletion deduction of $52,800 (i.e., 22% of $240,000 gross income from the property). If A had capitalized the intangible drilling and development costs, assume that $200,000 of the costs would have been allocated to the depletable property and none to depreciable property. A's cost depletion deduction if the intangible drilling and development costs had been capitalized would have been $42,000 (i.e., (($200,000 intangible drilling and development costs + $10,000 acquisition costs) × 30,000 barrels of production)/ 150,000 barrels of estimated recoverable reserves). Since this amount is less than A's depletion deduction of $52,800 (percentage depletion), no reduction is made to the amount of intangible drilling and development costs ($200,000). On January 1, 1979, A sold the oil property to B for $360,000 and calculated section recapture without reference to the 65-percent-of-taxable-income limitation. A's gain on the sale is the entire $360,000, because A's basis in the property at the beginning of 1979 is zero (i.e., $10,000 cost less $52,800 depletion deduction for 1978). Since the section costs ($200,000) are less than A's gain on the sale, $200,000 is treated as ordinary income under section . The remaining amount of A's gain ($160,000) is not subject to section .
(2) Natural resource recapture property
(i) In general The term natural resource recapture property means section property or oil, gas, or geothermal property as those terms are defined in this section.
(ii) Section 1254 property The term section property means any property (within the meaning of section ) that is placed in service by the taxpayer after December 31, 1986, if any expenditures described in of this section (relating to costs under section , , or ) are properly chargeable to such property, or if the adjusted basis of such property includes adjustments for deductions for depletion under section .
(iii) Oil, gas, or geothermal property The term oil, gas, or geothermal property means any property (within the meaning of section ) that was placed in service by the taxpayer before January 1, 1987, if any expenditures described in of this section are properly chargeable to such property.
(iv) Property to which section 1254 costs are properly chargeable
(A) An expenditure is properly chargeable to property if—
(1) The property is an operating mineral interest with respect to which the expenditure has been deducted;
(2) The property is a nonoperating mineral interest (e.g., a net profits interest or an overriding royalty interest) burdening an operating mineral interest if the nonoperating mineral interest is carved out of an operating mineral interest described in of this section;
(3) The property is a nonoperating mineral interest retained by a lessor or sublessor if such lessor or sublessor held, prior to the lease or sublease, an operating mineral interest described in of this section; or
(4) The property is an operating or a nonoperating mineral interest held by a taxpayer if a party related to the taxpayer (within the meaning of section or section ) held an operating mineral interest (described in of this section) in the same tract or parcel of land that terminated (in whole or in part) without being disposed of (e.g., a working interest which terminated after a specified period of time or a given amount of production), but only if there exists between the related parties an arrangement or plan to avoid recapture under section . In such a case, the taxpayer's section costs with respect to the property include those of the related party.
(B) Example The following example illustrates the provisions of of this section:
Example: Arrangement or plan to avoid recapture. C, an individual, owns 100% of the stock of both X Co. and Y Co. On January 1, 1998, X Co. enters into a standard oil and gas lease. X Co. immediately assigns to Y Co. 1% of the working interest for one year, and 99% of the working interest thereafter. In 1998, X Co. and Y Co. expend $300 in intangible drilling and development costs developing the tract, of which $297 are deducted by X Co. under section . On January 1, 1999, Y Co. sells its 99% share of the working interest to an unrelated person. Based on all the facts and circumstances, the arrangement between X Co. and Y Co. is part of a plan or arrangement to avoid recapture under section . Therefore, Y Co. must include in its section costs the $297 of intangible drilling and development costs deducted by X Co.
(v) Property the basis of which includes adjustments for depletion deductions The adjusted basis of property includes adjustments for depletion under section if—
(A) The basis of the property has been reduced by reason of depletion deductions; or
(B) The property has been carved out of or is a portion of property the basis of which has been reduced by reason of depletion deductions.
(vi) Property held by a transferee Property held by a transferee is natural resource recapture property if the property was natural resource recapture property in the hands of the transferor and the transferee's basis in the property is determined with reference to the transferor's basis in the property (e.g., a gift) or is determined under section .
(vii) Property held by a transferor Property held by a transferor of natural resource recapture property is natural resource recapture property if the transferor's basis in the property received is determined with reference to the transferor's basis in the property transferred by the transferor (e.g., a like kind exchange). For purposes of this , property described in this is treated as placed in service at the time the property transferred by the transferor was placed in service by the transferor.
(3) Disposition
(i) General rule The term disposition has the same meaning as in section , relating to gain from dispositions of certain depreciable property.
(ii) Exceptions The term disposition does not include—
(A) Any transaction that is merely a financing device, such as a mortgage or a production payment that is treated as a loan under section and the regulations thereunder;
(B) Any abandonment (except that an abandonment is a disposition to the extent the taxpayer recognizes income on the foreclosure of a nonrecourse debt);
(C) Any creation of a lease or sublease of natural resource recapture property;
(D) Any termination or election of the status of an S corporation;
(E) Any unitization or pooling arrangement;
(F) Any expiration or reversion of an operating mineral interest that expires or reverts by its own terms, in whole or in part; or
(G) Any conversion of an overriding royalty interest that, at the option of the grantor or successor in interest, converts to an operating mineral interest after a certain amount of production.
(iii) Special rule for carrying arrangements In a carrying arrangement, liability for section costs attributable to the entire operating mineral interest held by the carrying party prior to reversion or conversion remains attributable to the reduced operating mineral interest retained by the carrying party after a portion of the operating mineral interest has reverted to the carried party or after the conversion of an overriding royalty interest that, at the option of the grantor or successor in interest, converts to an operating mineral interest after a certain amount of production.
(c) Disposition of a portion of natural resource recapture property
(1) Disposition of a portion (other than an undivided interest) of natural resource recapture property
(i) Natural resource recapture property subject to the general rules of § 1.1254-1 For purposes of section and of this section, except as provided in and of this section, in the case of the disposition of a portion (that is not an undivided interest) of natural resource recapture property, the entire amount of the section costs with respect to the natural resource recapture property is treated as allocable to that portion of the property to the extent of the amount of gain to which section applies. If the amount of the gain to which section applies is less than the amount of the section costs with respect to the natural resource recapture property, the balance of the section costs remaining after allocation to the portion of the property that was disposed of remains subject to recapture by the taxpayer under section upon disposition of the remaining portion of the property. For example, assume that A owns an 80-acre tract of land with respect to which A has deducted intangible drilling and development costs under section . If A sells the north 40 acres, the entire amount of the section costs with respect to the 80-acre tract is treated as allocable to the 40-acre portion sold (to the extent of the amount of gain to which section applies).
(ii) Natural resource recapture property subject to the exceptions and limitations of § 1.1254-2 For purposes of section and of this section, except as provided in of this section, in the case of the disposition of a portion (that is not an undivided interest) of natural resource recapture property to which section does not apply by reason of the application of (certain nonrecognition transactions), the following rule for allocation of costs applies. An amount of the section costs that bears the same ratio to the entire amount of such costs with respect to the entire natural resource recapture property as the value of the property transferred bears to the value of the entire natural resource recapture property is treated as allocable to the portion of the natural resource recapture property transferred. The balance of the section costs remaining after allocation to that portion of the transferred property remains subject to recapture by the taxpayer under section upon disposition of the remaining portion of the property. For example, assume that A owns an 80-acre tract of land with respect to which A has deducted intangible drilling and development costs under section . If A gives away the north 40 acres, and if 60 percent of the value of the 80-acre tract were attributable to the north 40 acres given away, 60 percent of the section costs with respect to the 80-acre tract is allocable to the north 40 acres given away.
(2) Disposition of an undivided interest
(i) Natural resource recapture property subject to the general rules of § 1.1254-1 For purposes of section , except as provided in and of this section, in the case of the disposition of an undivided interest in natural resource recapture property (or a portion thereof), a proportionate part of the section costs with respect to the natural resource recapture property is treated as allocable to the transferred undivided interest to the extent of the amount of gain to which section applies. For example, assume that A owns an 80-acre tract of land with respect to which A has deducted intangible drilling and development costs under section . If A sells an undivided 40 percent interest in the 80-acre tract, 40 percent of the section costs with respect to the 80-acre tract is allocable to the transferred 40 percent interest in the 80-acre tract. However, if the amount of gain recognized on the sale of the 40 percent undivided interest were equal to only 35 percent of the amount of section costs attributable to the 80-acre tract, only 35 percent of the section costs would be treated as attributable to the undivided 40 percent interest. See of this section for an alternative allocation rule.
(ii) Natural resource recapture property subject to the exceptions and limitations of § 1.1254-2 For purposes of section and of this section, except as provided in of this section, in the case of a disposition of an undivided interest in natural resource recapture property (or a portion thereof) to which section (a)(1) does not apply by reason of , a proportionate part of the section costs with respect to the natural resource recapture property is treated as allocable to the transferred undivided interest. See of this section for an alternative allocation rule.
(3) Alternative allocation rule
(i) In general The rules for the allocation of costs set forth in section and and of this section do not apply with respect to section costs that the taxpayer establishes to the satisfaction of the Commissioner do not relate to the transferred property. Except as provided in and of this section, a taxpayer may satisfy this requirement only by receiving a private letter ruling from the Internal Revenue Service that the section costs do not relate to the transferred property.
(ii) Portion of property Upon the transfer of a portion of a natural resource recapture property (other than an undivided interest) with respect to which section costs have been incurred, a taxpayer may treat section costs as not relating to the transferred portion if the transferred portion does not include any part of any deposit with respect to which the costs were incurred.
(iii) Undivided interest Upon the transfer of an undivided interest in a natural resource recapture property with respect to which section costs have been incurred, a taxpayer may treat costs as not relating to the transferred interest if the undivided interest is an undivided interest in a portion of the natural resource recapture property, and the portion would be eligible for the alternative allocation rule under of this section.
(iv) Substantiation If a taxpayer treats section costs incurred with respect to a natural resource recapture property as not relating to a transferred interest in a portion of the property, the taxpayer must indicate on his or her tax return that the costs do not relate to the transferred portion and maintain the records and supporting evidence that substantiate this position.
(d) Installment method Gain from a disposition to which section applies is reported on the installment method if that method otherwise applies under section or of the Internal Revenue Code and the regulations thereunder. The portion of each installment payment as reported that represents income (other than interest) is treated as gain to which section applies until all of the gain (to which section applies) has been reported, and the remaining portion (if any) of the income is then treated as gain to which section does not apply. For treatment of amounts as interest on certain deferred payments, see sections , , and the regulations thereunder.
[T.D. 8586, 60 FR 2502, Jan. 10, 1995]