Tax Implications of Directly Owning Oil & Gas Assets

The oil and gas industry provides various ownership opportunities for accredited investors seeking tangible, royalty-generating assets, including working interests, midstream operations, and royalty interests. Working interest is percentage ownership that ties the owner to exploration and production costs, and is an asset class that can be high-risk but yield potentially high returns. Midstream operations, which include transportation, storage, and processing of oil and gas, tend to offer more stability. Lastly, purchasing mineral rights or royalties allows mineral owners to receive a share of the revenue generated from oil and gas production without directly operating the assets. Each segment carries its own risk-reward profile.

Oil and gas asset ownership can be potentially lucrative due to several factors. The high global demand for oil and gas remains crucial to energy consumption despite the growing adoption of renewable energy sources. Commodity price fluctuations, while presenting volatility, can lead to significant profitability during periods of rising oil and gas prices. Additionally, ownership of oil wells or royalties can provide long-term revenue streams over several years. However, these assets also come with inherent risks, including geopolitical instability, regulatory changes, and environmental concerns. Thorough due diligence is essential to mitigate these risks.

One of the most attractive aspects of ownership in oil and gas is the range of tax incentives available. These benefits are designed to encourage domestic energy production and reduce dependency on foreign oil. Intangible drilling costs (IDCs) represent expenses associated with drilling a well that do not result in tangible assets, such as labor, chemicals, and equipment rentals. These costs typically constitute 60-80% of the total drilling expense. Under Section 263(c), taxpayers can elect to either deduct these costs in the year they are incurred or capitalize and amortize them over 60 months. For instance, consider an investor who contributes $100,000 to a drilling project. If 70% of the investment qualifies as IDCs, the investor can deduct $70,000 from their taxable income in the first year. Assuming a 35% tax rate, this results in $24,500 in tax savings. Tangible drilling costs (TDCs), such as rigs and pipelines, are generally capitalized and depreciated over their useful life under Section 167.

Depletion deductions can also provide tax incentives for those with ownership in oil and gas. Section 611 of the IRS Code allows for a deduction in computing taxable income for the depletion of oil and gas wells. This deduction is intended to account for the reduction in the wells' productive capacity over time. Under Section 168(K), bonus depreciation is a tax incentive that allows businesses to immediately deduct a significant percentage of the purchase price of eligible assets. As of 1/1/2024, 60% of the purchase price is eligible for an immediate deduction on qualified assets.

While the tax advantages are appealing, oil and gas investments are not without risks. Commodity prices can fluctuate significantly, impacting profitability. Stricter regulations and environmental opposition can pose challenges. Drilling projects can experience delays, cost overruns, or even fail to produce oil or gas. To make informed decisions, it is crucial to understand the market by familiarizing yourself with industry trends, geopolitical factors, and technological advancements. Conducting due diligence by evaluating the financial health, track record, and management team of potential ownership opportunities is also vital. Engaging professionals, including financial advisors, tax experts, and industry consultants, can provide valuable insights and guidance. Once assets have been acquired, it’s important to regularly review the performance of your assets to ensure alignment with financial goals.

These assets are best suited for high-income earners seeking tax deductions to offset high taxable income. These opportunities also appeal to those who are willing to accept short-term risks for potentially high long-term rewards. Additionally, they can serve as a valuable asset class for those seeking diversification, performing independently of traditional stock and bond markets.

Oil and gas ownership opportunities offer a unique blend of high return potential and substantial tax benefits. For those willing to navigate the associated risks, these opportunities can play a significant role in generating income and receiving tax benefits. By understanding the intricacies of the industry and leveraging available tax incentives, you can make informed decisions that align with your financial goals. As always, consult with professionals to tailor your strategy to your specific needs and circumstances.

Eckard Enterprises is a family-owned oil and gas company that helps qualified individuals directly own royalty-generating oil and gas assets such as mineral rights, working interest, and more. To learn more about what we do and how we can help you develop your energy portfolio, visit our website or call (800) 527-8895 to speak to one of our experts.