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 can provide huge tax advantages for individuals because the government wants to encourage domestic energy production. There are two main tax benefits to investing – a working interest or a mineral interest. Individuals primarily invest in the space by becoming Limited Partners, or investors, in oil & gas funds.
A working interest means you have rights to drill and extract oil/gas from a property. You also have to pay operating costs. But here’s the best part – the IRS doesn’t consider this a passive activity even if you are just an investor, LP, in an oil & gas well fund! According to Treasury Regulation 1.469-1T(e)(4)(i), a working interest in an oil/gas property is not treated as a passive activity, no matter how involved you are. This is a big deal. Since it’s non-passive income, you can deduct any losses from your wages or other active income under IRS Section 469. So if you invest $100k but have $80k in drilling costs, you can deduct that $80k from your salary, capital gains or business income on your taxes that year! It gets even better. IRS Regulation 1.612-4(a) says you can deduct most “intangible drilling costs” like labor, repairs, supplies, etc in the first year. These typically make up ~90% of your investment and are 100% deductible the first year. The remaining “tangible costs” like equipment and pipes get deducted over 7 years. But still a huge upfront deduction!
A mineral interest, which gives you rights to the oil/gas under a property. With mineral interests, the key benefit is the depletion deduction under IRS Section 611. This lets you deduct 15% of your gross income from oil/gas production as tax-free income! However, to claim the depletion deduction, you need to qualify as a “small producer” under IRS Section 613A, which limits how much you can produce each year and fortunately most savvy oil & gas well drillers raising money from individuals have structured themselves to meet these requirements.
Let’s look at an example to see how these deductions can save you money: Jill has a job where she earns $300,000 per year. She also invests $200,000 to acquire a working interest in an oil well. In the first year, she has $180,000 in intangible drilling costs and $20,000 in tangible costs.Thanks to the working interest rule, Jill can deduct her $180,000 in intangible costs fully that year. She can also deduct 1/7th of her $20,000 tangible costs, which is $2,857.So in total, Jill gets to deduct $182,857 ($180,000 + $2,857) directly against her $300,000 salary income. This reduces her taxable income from $300,000 down to just $117,143! Assuming a 40% tax rate, Jill would have owed $100,000 in taxes on her full salary. But after her oil investment deductions, she now only owes $46,857 in taxes – a savings of over 50,000 in just the first year! And this doesn’t even include the future deductions she can take on the remaining tangible costs over the next 6 years.
So in summary, working interests let you deduct drilling costs as active income, while mineral interests provide a 15% depletion allowance – both thanks to special IRS rules designed to incentivize domestic oil and gas investments!
