By Chase Ravsten, Vice President of Vistia Capital
Investing in oil and gas can offer potential advantages:
Oil and gas are still a staple of energy and production here in the United States and in most of the countries across the world. Many think we must have significant land with natural resources in it to take advantage of oil and gas investment and tax advantages. Luckily there are ways to take advantage of these opportunities without going out and buying and exploring land personally. I want to highlight a few of the ways you, as a CPA, can help your clients take advantage of these opportunities by empowering you with the knowledge of the possible benefits and help you avoid potential pitfalls.
Investing in oil and gas can offer significant potential for returns, but it also involves unique risks and challenges. One potential strategy for maximizing the benefits of oil and gas investing is to take advantage of the tax incentives and deductions available to investors in this industry.
One of the most well-known tax advantage strategies for oil and gas investors is through the use of master limited partnerships (MLPs). MLPs are a type of publicly traded partnership that is designed to distribute income directly to investors, while avoiding corporate income tax. MLPs typically own assets such as pipelines or storage facilities and generate income from fees charged to other companies for using those assets.
Oil and gas can offer potential investment benefits and potential tax benefits. There are companies that allow investors to join their partnerships. Here are a few ways to invest but this is not an exhaustive list.
Ways to Invest:
General Partners: individuals can invest as a general partner (GP) and depending on the partnership, this may yield tax benefits in year 1 and or 2. Some partnerships offer intangible drilling costs (IDCs) that get passed down to the investor General Partner. Those costs, come as a tax deduction which could be around 90% of what one invests. These costs get allocated as an expense and are shown coming off one’s gross income and may even offset self-employment taxes. Partnerships are usually ten-year investments, and one’s return is based on how the partnership performs and the prices of oil and gas during that time frame. Here are some options to consider: While there are risks to being a GP, these should be weighed with the long-term investment opportunity. Other factors to consider when evaluating a potential partnership include the company’s history and where drilling is planned and the forecast for gas and oil prices. One thing to note on this, if you want to receive the IDCs you have to invest as a general partner.
Limited Partners: the main difference between investing as a GP or as a limited partner would be the potential initial tax benefits years 1 and 2 that come from the IDCs. As a limited partner you may not see the big tax benefits passed through, you could potentially receive the depletion allowances and they can use those to offset passive income or invest in opportunity zones. You can potentially see investment returns just like a general partner’s but with added benefit to offset the passive income.
LLC: when investing under an LLC type scenario are doing so potentially with qualified assets. You can use the LLC structure to use your IRA or even a Roth to invest. One can use the IRA to invest and then in future years convert to a Roth IRA. This structure does not typically get any tax deductions. Also, any returns are paid to the LLC (IRA or Roth)
Reasons to invest:
1. Potential for high returns: Oil and gas investments have the potential to generate high returns, particularly in the exploration and development stages where significant discoveries can lead to substantial profits.
2. Portfolio diversification: Oil and gas investments can offer diversification benefits for investors, particularly those looking to add exposure to commodities and natural resources to their portfolios.
3. Hedge against inflation: Oil and gas investments may offer a hedge against inflation, as the prices of these commodities typically rise when inflation is high.
4. Tax benefits: Certain oil and gas investments, such as MLPs and private equity funds, may offer tax advantages, such as the ability to pass through tax deductions and losses to individual investors.
5. Growing global demand for energy: As global demand for energy continues to rise, particularly in developing economies, the demand for oil and gas is expected to remain strong in the long term, potentially leading to increased profits for investors.
Some potential tax benefits of investing in oil and gas:
1. Intangible Drilling Costs (IDCs): These are the costs incurred in the drilling process that cannot be easily quantified or physically seen. IDCs include expenses such as labor, drilling mud, and chemicals. These costs can be fully deducted in the first year of the investment, reducing your taxable income.
2. Depletion Allowance: This is a tax deduction for the decrease in the value of an oil or gas deposit as it is produced. It allows investors to recover the cost of their investment over time. A depletion allowance is available to both working interest owners and royalty owners.
3. Bonus Depreciation: Bonus depreciation allows investors to deduct a percentage of the total investment cost in the first year of the investment. In 2021, the bonus depreciation rate was 100%, meaning that investors could deduct the entire investment cost in the first year.
4. Passive Loss Deduction: Oil and gas investments are often structured as limited partnerships or LLCs, which allow investors to offset passive losses from the investment against other passive income. This can result in significant tax savings.
5. Tax Credits: The federal government offers various tax credits for investments in alternative energy, including oil and gas. For example, the Enhanced Oil Recovery Credit provides a credit for the cost of enhanced oil recovery methods.
It is important to note that tax laws can change, and it is advisable to consult a tax professional before making any investment decisions.
One of the key tax advantages of MLPs is the ability to pass through tax deductions and losses to individual investors. This means that investors can deduct their share of the partnership’s operating expenses, depreciation, and other deductions from their taxable income, potentially reducing their overall tax liability. Additionally, MLPs often pay out a high percentage of their income as distributions to investors, which may be taxed at a lower rate than ordinary income.
Another tax advantage strategy for oil and gas investors is to invest in private equity funds that specialize in the oil and gas industry. Private equity funds are investment vehicles that pool capital from investors to invest in a variety of assets, including oil and gas projects. One of the main benefits of investing in private equity funds is the ability to take advantage of tax-deferred or tax-free growth. For example, investors in private equity funds may be able to defer taxes on their capital gains until they sell their shares in the fund.
Private equity funds may also offer other tax advantages, such as the ability to take advantage of deductions for intangible drilling costs (IDCs). IDCs are costs associated with drilling and completing oil and gas wells, such as labor, supplies, and equipment rental. These costs are typically deductible in the year they are incurred, which can help reduce the tax liability for investors in private equity funds.
Investors in oil and gas projects may also be able to take advantage of tax credits and incentives offered by state and federal governments. For example, the federal government offers tax credits for certain types of renewable energy projects, such as wind and solar power. Additionally, some states offer tax incentives for investments in oil and gas exploration and production, such as tax credits for drilling new wells or for the production of oil and gas from certain types of formations.
Overall, tax advantage strategies can play a significant role in maximizing the benefits of investing in oil and gas. Investors should work closely with qualified tax professionals to identify and take advantage of the various tax incentives and deductions available to them. By doing so, investors can potentially reduce their overall tax liability and maximize their returns from this dynamic and challenging industry. It’s important to note that investing in oil and gas can also carry significant risks, such as exploration and production risks, commodity price volatility, and geopolitical risks. Investors should carefully consider these risks before making any investment decisions and seek professional advice as needed.
This article is neither an offer to sell nor a solicitation of an offer to buy the securities. An oil and gas private placement memorandum makes such an offer to “accredited investors” only, which will be furnished to prospective investors upon their request. This summary must be preceded or accompanied by and read in conjunction with such confidential private placement memorandum in order to fully understand all of the implications and risks of the offering of securities to which it relates.