The purpose of estate tax planning is to maximize the assets you pass on to future generations by minimizing gift and estate taxes. Estate-tax strategies revolve around the use of irrevocable trusts. This article discusses the most common types of irrevocable trusts that are used to minimize gift and estate […]
Investing in oil and gas wells and entering into conservation easements 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.
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.
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.
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.
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!
A conservation easement is a legal agreement between a landowner and a qualified organization, such as a land trust or a government agency, that restricts the development of the land in perpetuity, protecting wildlife habitats or preserving historic sites even if the property is later sold or passed down to future generations. Conservation easements, in short, are a way for landowners to protect property from future development, no matter who ends up in control of the land in the future.
Conservation easements are also a tax tool. When you agree to restrict the use of your land for conservation reasons, the government considers that a type of charitable donation, and you get a charitable deduction based on the lost value of the land. In practice, taxpayers often claim a value that is a multiple of the value at which the land was purchased. This deduction can be used to offset ordinary income up to 30% of the donor’s adjusted gross income (AGI), with any excess carried forward for up to five years.
Because a number of players in the space are unscrupulous, the IRS has become concerned in recent years that the tax code’s conservation easement rules are being exploited. Certain types of conservation easements are now considered “listed transactions” that must be flagged for the IRS. Sen. Ron Wyden, chair of the Senate Finance Committee, has been consistently critical of conservation easements, which he describes as “a tax shelter gold mine.”
Gabriel, a single New Jersey resident, earns $1,200,000 per year. His annual tax bill is $550,000. Gabriel happens to be an avid conservationist with an appetite for risk. Tired of paying so much tax on his salary, Gabriel purchased a $100,000 property fours years ago and this year he put a conservation easement on the land to protect it from future development. The easement is valued at $350,000 and he is allowed to deduct this entire amount from his income, reducing his taxable income by $350,000 this year. If his marginal tax rate is 50%, that will save him close to $175,000, effectively reducing his taxes this year from $550,000 to under $375,000.
Both oil and gas well investments and conservation easements can be attractive strategies. The two strategies tend to generate similar upfront tax deductions. Neither requires the taxpayer to do any work besides making the initial investment. But conservation easements are legally risky, and in general the larger the tax benefits from a conservation easement, the riskier the project. Conservation easements also don’t yield any income, unlike oil and gas wells. Which strategy makes the most sense for any particular person will depend on how that person weighs the various pluses and minuses of each strategy.
Investing in oil and gas wells and entering into conservation easements 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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