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Oil and Gas Investments: Tax Benefits and Risks

Many W2 physicians struggle with finding tax deductions for W2 earners, as the tax code was written to heavily favor business owners and real estate investors. Therefore, when W2 only members of our physician community ask questions on our groups about how to save money in taxes, they’re often told to start investing in real estate or to get a physician side gig, as the tax advantages of real estate and the tax advantages of 1099 income are plentiful. When they go to a tax strategist, however, another option that is often suggested is the opportunity to invest in oil and gas partnerships. You may also hear about this as mineral interest depletion allowances.  While oil and gas investments can offer very significant tax savings and deductions, it’s important to understand the pros, cons, & risks. These are high on the radar of the IRS and other regulatory bodies and therefore should be approached with caution. Below, we’ll explain how these investments yield significant tax savings, things to consider as you do your due diligence and vet a potential oil and gas partnership, and what the risks associated with this space are.


Disclaimer: As always, note that we are not accountants or lawyers, and this information is for general informational purposes only. You should consult appropriate expertise before taking action based on this information, which is neither guaranteed to be up to date and accurate nor individualized to your personal situation. While we’ve attempted to convey accurate information to the best of our knowledge, always confirm any information you learn about on our platforms with a licensed professional or official resource. To learn more, visit our disclaimers and disclosures.


Brief summary of what oil and gas investments are, the tax benefits that make them attractive, and the associated risks to be cautious of


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Why are oil and gas partnerships attractive to those looking to save on taxes?


There are various ways to get involved with investing in the oil and gas industry, which we’ll explore below. The US government is very interested in these sources, and therefore has given them a tax favored status to encourage production as well as investment in this space. The biggest thing of interest often touted to W2 employed physicians, who often have very little in the way of tax deductions, is that the government considers investing in oil and gas as an active activity, not a passive activity, thus allowing it to be deducted against other sources of active income such as your income as a physician. This is similar to other popular big deductions for physicians investing in active real estate, such as real estate professional status (REPS) and the short term rental tax loophole.


Of note, not all ways of investing in oil and gas allow you to take this sort of deduction, so it’s important not to get lured in by the buzzwords ‘oil and gas partnerships’ and dig deeper about what your actual tax advantages are and whether they achieve your goals before venturing into the space.



Why isn’t everyone investing in oil and gas if they are so tax advantaged?


Before you fall too far down the rabbit hole in learning about oil and gas partnerships, you should understand that these are risky investments, both from a pure investment perspective and from a scrutiny from the IRS perspective. From an investment perspective, there is no guarantee that drilling will yield results, and therefore it’s possible that you lose some or all of your money. Because of this, the SEC requires that you are an accredited investor to participate, which prevents the investment companies from enticing investors that would be financially devastated by losses in this space, thus protecting them. Advocates of these investments for tax benefits will argue that even if the investment is unsuccessful, because the IRS allows you to write off so much of the investment against your taxable earned income in some classes of these investments, it’s still okay from a return perspective, particularly if you are in a high tax bracket.


Additionally, because of the high stakes and opportunities for corruption and bribery, as well as the large tax advantages offered to investors and partners, at any given moment, many of these companies are under scrutiny. There are many strict rules and regulations that need to be followed to the letter, and if you invest with a company that makes a mistake in any of these realms (particularly an inexperienced company or company that tends to push the boundaries of the law), you could run into audit issues or other issues. These could disallow the deductions, even years later. In a worst case scenario, having to pay back taxes from such a large deduction, fees, penalties, and interest all at once could be a huge problem. The IRS has a very large document delineating how to examine these if you’re interested in all the statements they have made about investors and partners in these investments and the role of the tax deduction as a motivating factor for investment.



What exactly are oil and gas investments?


As mentioned above, there are many different ways to invest in oil and gas related to finding and exploring potential sources, actually extracting oil and gas, and refining, transporting, and selling these commodities. There are companies involved in each of these steps. The riskiest of this are those looking to find and extract oil and gas, as they need a huge investment that to drill in an exploratory fashion, hoping to find substantial enough amounts of oil and gas to justify extraction, and then to actually extract it. There are also companies that are solely involved in transport, refining, sales, and distribution.



What are different ways to invest in these companies or processes?


There are many different ways to invest, all with unique tax considerations and risks, and varying levels of ownership. This list doesn’t cover all of them but many of the major categories employed by physicians.


Common ways physicians can get involved with oil and gas investments


Mutual funds, stocks, and ETFs


This is the least risky and the closest to what physicians are used to. It just involves owning a stake in a related portfolio. While this will give you exposure and diversification into the sector, note that it doesn’t get the larger tax benefits as you pay taxes the same way you do with any of these types of investments, including dividends and capital gains (usually long term unless you only hold them for a short period of time). There are also futures contracts that allow you to trade these commodities on a set date at a set price.



Royalties from land and mineral rights 


If you own the land where drilling is occurring, you can get a significant percentage of the gross revenue generated from this activity. You don’t have to do the drilling - this can be licensed to companies in the space. Of note, if you are only collecting royalties, you won’t get the same tax benefits as those with ownership interests in the actual working or operating capacity, and won’t have the ability to claim the deductions against your active income the same way that those with working interests can.



Working interests 


If you are actually a partner on the side of drilling and production where you’re investing in the operations necessary to drill (which are expensive and risky), you will get to share in the production income once you’ve paid those with royalty rights above. This is the riskiest proposition in oil and gas investments and also comes with liability if you are a general partner.



Limited liability partnerships


Similar to how you can invest in a real estate syndication, you can invest as a limited partner in oil and gas partnerships. Since these are sold as securities, they are registered with the SEC, and the SEC specifies that you must be an accredited investor in the vast majority, if not all, of these investments. In these situations, you are allowed to purchase ownership or shares of a company or asset in this space. You may receive a K1 which passes on the returns as well as the tax implications of the investment. 



Where do the tax benefits come from?


The tax benefits often touted by tax strategists are the ones that come from either royalties, partnerships or working interest. The ones from mutual funds, stocks, and ETFs are discussed in that section above. 


Please independently verify the information below with your own tax professional, as we are not tax professionals, and all of this information is subject to change (and does change), and there are nuances to all of it. This info is simply here as an introduction to general concepts. 


Depending on the exact investment, the other forms may benefit from a:


  • Qualified business income (QBI) deduction: The 199A deduction allows qualified individuals to deduct up to 20% of their income from their working interest. Read more about the qualified business income (QBI) deduction. If there are losses, working interest operations and drilling may qualify as qualified business losses and can offset qualified business income in the current or future tax years.


  • Drilling cost deductions. These are separated into two categories:


    • Intangible drilling costs: costs related to the drilling but not tangibly seen in the same way drilling equipment is seen, such as labor costs, supplies (mud, grease, chemicals), ground preparation, or energy (fuel). These things actually constitute between 60-80% of the total costs and are fully deductible at 100% in the year the cost is occurred. This is where you see the biggest deductions that are touted as being able to be counted against your regular income as a physician. Note: this is applicable when you have a working interest, not a royalty interest. Also please note that this deduction could be subject to recapture and capital gains once the asset is sold.


    • Tangible drilling costs: This is constituted by the cost of the lease and drilling equipment and is depreciated over the course of 7 years, leading to deductions over a 7 year schedule, although there may be an opportunity for bonus depreciation depending on the year and current tax law.


  • Depletion: Depletion is complicated but basically serves as a way to recover costs that are attributable to the “wasting” of a well as you deplete natural resources. The deduction is limited by the taxpayer’s taxable income. This deduction is important when you have an asset that is actively producing oil as it can be taken even after your cost basis has been recovered and offset royalties. It is a greater benefit for royalty income investors who don’t have to factor in drilling costs as they are not usually subject to some of the limitations imposed on working capital investors.



Loss limitations


Note that there are loss limitation rules and regulations that apply and will limit how much of a deduction you can take which are dependent on the type of investor that you are and the type of entity. These are beyond the scope of this article, which is just intended to introduce the topic, and should be discussed with an accountant familiar with these types of investments.



Conclusion


Oil and gas partnerships and investments can become quite complicated, but do have the potential to give great tax deductions, even to W2 high income individuals who typically don’t qualify for many larger tax breaks. In general, we caution against investing in things you don’t understand, so dive in further and do your research before proceeding. It’s important to discuss this with an accountant familiar with these types of investments who can help you navigate the options, the relevant tax benefits for your personal situation, and give you more insight into the audit or other related risks you may put yourself on the radar for when you invest in this asset class. 



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