Tax Benefits of Investing in Energy Programs
In addition to providing potential income and appreciation, investing in petrochemical production can offer a range of potential tax benefits to investors. The federal government designed these advantages specifically to encourage development of energy resources in the United States and reduce dependence on imported oil and gas. As with real estate tax benefits, oil/gas deductions are not “loopholes”, but long-standing policies to support a national economic health and security.
Drilling programs usually are structured as limited partnerships, with tax benefits from the project passed through to investors. Unlike partnership units, direct mineral rights are deemed real property interests under U.S. law, with economic rights subject to a recorded deed. Of course, an investor’s tax treatment, potential income and financial risk ultimately depend on the type of interest and the specific wells.
Working Interests and Royalty Interests
The two most common types of oil and gas interests are working interests and royalty interests. The working interest owners (via a partnership or LLC) generally bear the costs of developing and operating a project, fully participate in the revenues of the wells, and typically constitute a trade or business. A royalty interest holder participates in production revenue without an obligation to pay the costs of developing and operating the well(s) on the subject property.
At the risk of oversimplification, a taxpayer can invest merely in the sub-surface mineral rights (real property) with lower risk, less upside potential and moderate tax benefits, or invest in the well operation, with higher risk, more upside potential and significant tax benefits. In reality, there is a complex spectrum of mineral-rights interests, and some investment programs may include a cross-section of royalty and working interests, among other contractual arrangements.
Some mineral-interest owners may also be entitled to lease income, separate from the income based on production. This income can be offset by expense deductions relating to the lease agreement. Working-interest income should be reported on Schedule C, along with directly-related expenses. Royalty income and depletion deductions (see below) should be reported on Schedule E. Note that working-interest income generally is subject to self-employment tax, while royalties are subject to NIIT (3.8% surtax). Depending on the interest, losses may be offset against other income.i
Intangible Drilling Costs
Intangible drilling costs (IDCs) are costs necessary to prepare wells for production, but have no salvageable value. IDCs include wages, fuel, chemicals, hauling, supplies, ground clearing, survey work and repairs. Approximately 60-85% of total drilling costs are intangible. IRS regulations allow well owners (investors) to deduct 100% of IDCs against their income in the first year.ii
Tangible Drilling Costs
Tangible drilling costs (TDCs) are the components of a well that have salvageable value. TDCs include certain heavy equipment, casings, pump jacks and wellheads. IRS regulations allow well owners (investors) to deduct 100% of IDCs against their income over the course of seven years.iii
For owners of oil/gas interests, the IRS may allow an annual depletion deduction against current income. This deduction, known as “percentage depletion”, is limited to the lesser of 15 percent of the taxable income from the property, or 65 percent of taxable income from all sources. Your tax professional can help determine if you are eligible to take advantage of this type of tax break.iv
Can percentage depletion exceed the cost of a well? Yes. Congress purposefully created this tax benefit to promote development of American minerals and remains a key factor in keeping America’s marginal wells producing.
1031 Exchange Eligibility
An investment in direct mineral rights (on which royalty payments are based) constitutes “like kind” real estate for purposes of completing a capital-gains tax-deferred exchange under IRC §1031. Taxpayers may acquire fractional, deeded interests in a “basket” of mineral rights across several properties in multiple jurisdictions. The program sponsor then handles the revenue collection, accounting and reporting for all of the royalties in the basket. In addition to deferring recognition of gain, investors in 1031-eligible mineral rights programs typically can claim their share of depletion allowance from active and future wells across the various underlying properties. Unlike standard depreciation, if a royalty is sold at a loss, there is no depletion recapture.v
As with all investment programs that include tax benefits, be sure to consult with your tax professional.
Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor.
This is for educational purposes only, does not constitute as investment advice, and is not legal or tax advice. Please consult the appropriate professional regarding your individual circumstance.
This material is not to be interpreted as tax or legal advice. IRC Section 1031, IRC Section 1033 and IRC Section 721 are complex tax concepts; therefore, you should consult your legal or tax professional regarding the specifics of your particular situation.
Oil and gas mineral royalty Interests are illiquid investments, are speculative and involves a high degree of risk; investors should be able to bear the complete loss of their investment. In addition, the oil and gas market is affected by many factors, such as general economic conditions, oil and natural gas pricing, financing markets, supply and demand, and other factors that are beyond an Offeror’s control. All these factors could restrict an investor’s ability to sell their mineral/royalty interests. loss.
Securities offered through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Advisory services offered through Concorde Asset Management, LLC (CAM), an SEC-registered investment adviser. 1031 Capital Solutions is independent of CIS and CAM.