This is a real estate newsletter. Why are we talking about oil and gas?
Unlike investing in Nvidia, which recently had the LARGEST MARKET CAP LOSS IN HISTORY only to gain back 44% the next day, investing in real estate allows you to somewhat control your destiny in a more hands-on way. Oil and gas investments are similar to real estate in that they are a tangible item connected to land, and continue to be essential to human existence.
The reason we investors like real estate investments is because they allow some control over the investment – but also because of the tax advantages. Oil and gas are similar in many aspects, including their driving control of inflation and the tax shelters they provide to investors.
As AI continues its rise to influence our society, an unusual connection between the tech and energy sectors has started to come together. AI has significantly increased our need for electricity to power the data centers which are critical to AI’s function. All the energy will come from existing sources at the onset – primarily oil and gas.
As seen in the chart below, our need for electricity has grown substantially, and the combined oil and natural gas industries fuel over half of the needed energy.

So, how can investors engage with the energy sector?
1. Direct Investment in Oil and Gas Projects
Direct Participation Programs are investment strategies that allow accredited investors to invest directly in oil and gas ventures. Unlike indirect investments, such as stocks or mutual funds, DPPs provide a direct stake in energy projects. This direct involvement offers a unique blend of potential rewards and risks. While they require significant capital and involve higher risk, they also offer substantial tax benefits.
Tax Benefits of Direct Investments:
- Intangible Drilling Costs (IDCs): These are costs incurred for non-recoverable expenses such as labor, chemicals, and other items necessary for drilling a well. Investors can deduct up to 100% of IDCs in the first year, even if the well does not produce any oil or gas.
- Tangible Drilling Costs (TDCs): These cover the costs of equipment and other physical assets used in drilling. Unlike IDCs, TDCs are depreciated over several years.
- Depletion Allowance: Once the well starts producing, investors can claim a depletion allowance of up to 15% of gross income from the property. This deduction accounts for the reduction in reserves over time.
- Active vs. Passive Income: The Tax Reform Act of 1986 added the concepts of “Passive” and “Active” income to the Tax Code. It prohibits offsetting losses from Passive activities against Active business income. However, the new Tax Code clarifies that Working Interest in an oil and gas well is not a “Passive” activity. Therefore, deductions can offset income from active stock trades, business income, salaries, etc.
DPPs are tailored for accredited and qualified investors who meet specific financial and experience thresholds. They are best suited for those who can handle the potential risks involved in these investments.
2. Investing in Master Limited Partnerships (MLPs)
Master Limited Partnerships (MLPs) are publicly listed limited partnerships that trade on a national securities exchange. Most MLPs have general partners and many limited partners (the investors). The general partners manage the MLP’s day-to-day operations, while the limited partners purchase shares in the MLP and provide capital in return for cash distributions from the entity’s operations.
MLPs primarily focus on natural resource-related activities, including oil, gas, coal, timber, and certain ways of transporting commodities.
Tax Benefits of MLPs:
- Tax-Deferred Distributions: MLPs distribute a significant portion of their income to investors, and a substantial portion of these distributions is treated as a return of capital rather than taxable income. This means investors can defer taxes until they sell their shares, when taxes are paid on the difference between your basis and the selling price.
- Pass-Through Taxation: MLPs do not pay corporate taxes, as income “passes through” to individual investors, avoiding double taxation.
MLPs offer investors more liquidity than direct investments, which can make them an attractive option.
3. Royalty Interests and Mineral Rights
Purchasing royalty interests or mineral rights allows investors to earn a percentage of revenue generated from oil and gas production. This type of investment involves less risk compared to direct participation, since there are no operational responsibilities.
Tax Benefits of Royalty Interests:
- Depletion Deduction: Similar to direct investments, investors in royalty interests can claim a depletion deduction of up to 15% of gross income.
- 1031 Exchanges: Real estate investors can use a 1031 exchange to defer taxes when selling a property and reinvesting the proceeds into qualifying oil and gas real estate, such as mineral rights or long-term land leases. Mineral rights can be a completely passive investment, ideal for a 1031 seller who no longer wants the hassle of real estate but wants to continue to defer their capital gain taxes.
4. Oil and Gas EFTs and Mutual Funds
For investors seeking a less hands-on approach, exchange-traded funds (EFTs) and mutual funds focused on oil and gas companies provide diversified exposure to the sector. While these investments do not offer the direct tax benefits of IDCs or depletion allowances, they provide a simpler way to invest in the industry.
Risks and Considerations
While the tax advantages of oil and gas investments are significant, they come with inherent risks, including price volatility, regulatory changes, and environmental concerns. Investors should consult with tax professionals and financial advisors to ensure these investments align with their financial goals and risk tolerance.
Make sure you carefully select who you invest with in this sector, and look for operators that make money – not just ones with flashy tax benefits. Don’t let the tax tail wag the dog!
Conclusion
The oil and gas industry offers a variety of ways for investors to participate, from direct drilling projects to publicly traded MLPs and EFTs. Each investment type comes with unique tax advantages, such as deductions for drilling costs, depletion allowances, and tax-deferred income.
Many real estate investors we work with choose to expand their investments into unique sectors. While we are not engaged in this industry, we are always pleased to provide knowledge and resources to our clients to further their financial independence. Contact us to discuss your real estate strategy today.
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Sources
https://www.schwab.com/stocks/understand-stocks/mlps
https://www.investopedia.com/articles/personal-finance/062515/mlps-how-they-are-taxed.asp