Gifting to Donor Advised Funds (DAFs) and oil and gas well investments are two popular strategies for offsetting ordinary income tax. How do you know which one is right for you? This article explains what these strategies are and when they make sense.

Key Highlights and Takeaways

• Two Ordinary Income Tax Strategies: Both strategies offset ordinary income tax at least to some extent.
• DAFs are a Charitable Giving Strategy with Ancillary Tax Benefits: People often think of DAFs as a tax-saving strategy. While gifting to a DAF can reduce your tax bill, you won’t come out ahead personally by doing so. You might get back 40 or 50 cents for every dollar you put in a DAF. But that’s okay, because DAFs are vehicles for charitable giving. Assuming you’re looking to support charity in a significant way, DAFs can make a lot of sense. DAFs don’t generate any income for the donor.
• Oil and Gas Wells Offer Upfront Tax Savings Plus Significant Income: Investors in oil and gas wells receive large upfront depreciation deductions. For every dollar you invest in oil and gas wells, you’ll get back between 30 and 50 cents upfront in tax savings (depending on your tax rate and your state’s laws). On top of that, you can potentially earn significant investment returns, some of which will be excluded from income tax.

What are Donor Advised Funds (DAFs)?

A Donor Advised Fund (DAF) is a charitable giving account. When a donor contributes cash, securities, or other assets to a DAF, the donor receives an immediate tax deduction. That deduction can offset capital gains or ordinary income. The donor can then recommend grants to charities from the fund. DAFs are popular because they provide immediate tax benefits while allowing for strategic charitable giving at the donor’s leisure.

What are a DAF’s Tax Consequences?

While a DAF is a relatively tax-efficient and flexible way of supporting charity, it is not a pure tax play. If your goal is just to save taxes, giving to a DAF will not make sense. Someone in the 40% marginal tax bracket who gives $100 to a DAF will only receive $40 in tax savings. The charity will get the full $100, but the taxpayer will be out, on net, $60 (perhaps a little less if the asset was appreciated and would have generated capital gain on a sale).

Benefits of DAFs:

1. Immediate Tax Deduction: Donors receive a tax deduction in the year the contribution is made, regardless of when the funds are distributed to charities.
2. Tax-Free Growth: Contributions to a DAF can grow tax-free, allowing for potentially larger future charitable donations (though you do not receive an additional charitable deduction for this growth).
3. Flexibility in Giving: Donors have the flexibility to make grants to multiple charities over time and don’t need to decide which charities to support until at some point after the assets have been contributed to the DAF.

Drawbacks of DAFs:

1. Irrevocable Contributions: Once assets are donated to a DAF, they cannot be reclaimed by the donor.
2. Fees and Management Costs: DAFs are managed by sponsors, which may charge administrative fees.
3. Negative Financial Transaction: The assets you give away will be worth more than the tax benefits you receive in return, which is why you need to be philanthropically minded for this to make sense!

What is an Ideal Use Case?

Astrid is a married New Yorker earning $1,200,000 per year. Her annual tax bill is $550,000. She isn’t particularly focused on tax mitigation, but she’s passionate about her favorite charity: the Boys & Girls Club. Astrid wants to give six figures to charity each year, ideally in a relatively tax-efficient way. Astrid could sell $250,000 of her appreciated investments, pay $50,000 in taxes and donate the remaining $200,000, or she could directly donate $200,000 of stock to the DAF, have the DAF sell the stock tax free, and then the DAF could donate the money to the Boys & Girls Club! Using the DAF allows Astrid to avoid capital gains taxes. Of course, Astrid would have been better off personally if she had just kept the stock for herself. But given her philanthropic goals, gifting to a DAF may make sense for her.

Oil and Gas Drilling Investments

Oil and gas drilling investments are exactly what they sound like: investments in oil and gas drilling partnerships. These projects offer substantial tax benefits that can offset ordinary income tax while generating significant income for investors. Best of all, they don’t require investors to do anything other than invest to be considered active.

How Does Oil and Gas Depreciation Work?

A taxpayer is able to claim depreciation on oil and gas well investments. This means that a taxpayer who invests in oil and gas wells will be able to deduct the cost of the investment — and typically, the vast majority can be deducted in the first year. Intangible drilling costs (IDCs), which include labor, fuel, and chemicals, are 100% deductible in the first year and can comprise as much as 94% of an oil and gas well investment. Tangible drilling costs, which include project expenses not considered IDCs, are deductible over the course of several years, rather than all upfront.

For example, if you are a top marginal taxpayer in New York City, you could invest $100,000 into oil and gas drilling projects and offset $94,000 of your ordinary income in the first year, saving $50,000 on taxes that year ($94,000 * 53% marginal tax rate)! Much of the remaining $6,000 would be deductible in subsequent years.

No Material Participation Requirements

In general, U.S. law requires taxpayers to be “active” in an investment in order to use tax credits or depreciation from that investment to offset active income like a salary or income from a business. For example, depreciation from a “passive” real estate investment — one where you buy a property and rent it out without being actively involved — can only be used to reduce your passive rental income. To offset active income, you need losses from a business in which you are actively involved. Typically that means 100+ hours (in some cases 750+ hours) of activity in the business. But oil and gas investments are not subject to this requirement due to a 1913 law, so you can qualify as active without doing any work.

Benefits of Oil and Gas Investments:

Drawbacks of Oil and Gas Investments:

What is an Ideal Use Case?

John, a married New Yorker earning $1,200,000 per year, mostly from his W-2 job, historically has invested only in stock indexes. Tired of his $550,000 annual tax bill, John invests $300,000 in an oil drilling partnership. He deducts 94% of this amount as intangible drilling costs in the first year, reducing his taxable income by $282,000 that year (and another $18,000 over the next five years as a result of depreciation for tangible drilling costs). If his marginal tax rate is 51%, that will save him close to $153,000, effectively reducing his at-risk principal to just $147,000 ($300,000 – $153,000), even as John generates returns on his full $300,000 investment. You can estimate your potential returns here!

Why Choose One Strategy or the Other?

Gifting to Donor Advised Funds and investing in oil and gas wells accomplish different things. DAFs allow donors to support charity while realizing modest tax benefits. Oil and gas well investments yield higher returns, between the tax savings and the income they generate, but oil and gas makes less sense for people who are focused on charitable giving. When choosing between these two strategies, the key question is: What are you trying to accomplish? If your goal is primarily to support charity, then a DAF may make sense — though Charitable Remainder Unitrusts may be even more attractive. If your goal is simply to maximize returns, then oil and gas well investments probably make more sense.

Conclusion

Gifting to Donor Advised Funds and investing in oil and gas wells are both viable tax strategies, but they serve different objectives. Hopefully this article has given you a better idea of what each strategy entails, and whether one or the other might be a better fit.

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