Blog | Personal Finance

How Commodities Can Be Your Tax Friend

Invest in oil and gas and you can avoid passive loss rules

I was earning my Masters of Professional Accounting degree at the University of Texas during the height of the 1980’s oil and gas boom. Texas oil was doing so well that the Midland, Texas office one of the Big 8 (now it’s the Big 4) accounting firms was hiring my program’s graduates sight unseen. They wanted as many newly minted accountants as they could get.

Naturally, I decided to learn something about oil and gas. I took a class called “Oil and Gas Law.” I liked that class and also took the “Real Estate Law” class. This education turned out to be particularly helpful when I graduated and took my first job at Ernst & Whinney (now Ernst & Young) in Salt Lake City, Utah.

Salt Lake City was experiencing its own little natural resources boom. It boasted the largest open-pit copper mine in the world at the time (Kennecott) and was mining a lot of silver—and nearby Eastern Utah, Wyoming, and Colorado were experiencing a boom in natural gas. There was a huge natural gas find in that part of the country, and gas prices were high enough to make a lot of farmers and ranchers very wealthy, much like the ranchers in Texas got wealthy (and continue to get wealthy) from oil.

I came to really understand the tax benefits of investing in oil and gas and other minerals. In the US, the benefits of investing in oil and gas drilling programs are enormous. Let me explain.

Oil And Gas Tax Benefits

The United States has long held an energy policy promoting oil and gas drilling operations inside the borders of the United States to help reduce dependence on foreign oil. The government has put this into action through the tax law by providing significant tax benefits for anyone who invests in domestic (U.S.-based) oil and gas drilling operations.

In the US, oil and gas is one of the truly great tax shelters. Oil and gas is the only investment that is not subject to these rules. That’s right—if you invest right, you can deduct losses from oil and gas against ordinary income, and even your investment is entirely passive.

There are four types of investment in oil and gas. The first is to buy stock in an oil and gas company. This is treated like any other stock investment and has no special rules or benefits. Second, you can buy an interest in the royalties from a producing oil and gas well. This income is portfolio income, and other than creating investment income so you can deduct investment interest expense, there are no great tax benefits from investing in a royalty interest.

The other two types of investments in oil and gas are both investments in the actual drilling operation—and they provide great tax benefits. You can either invest in exploratory operations, also called “wildcat” drilling, or you can invest in development operations. Exploratory operations can be very risky, as there is no assurance that there is oil in the ground where you are drilling. Of course, with better and better technology, this risk is always decreasing with the better operators.

This isn’t the only tax benefit for investing in oil and gas. You also get to deduct 15 percent of the well’s gross income each year. This is called depletion. It’s like depreciation, only you get it every year, even after you have deducted all of the IDC and the depreciation. Basically, it’s a gift from the government. Gross income includes all of the sales proceeds from the oil and gas, and isn’t reduced by any expenses. In order to qualify for IDC and depletion deductions, you have to own a direct interest in the drilling operations. Owning stock in the drilling company or owning a royalty interest in the oil and gas doesn’t qualify. Be sure to meet with your tax advisor about this before you invest in oil and gas. And one other thing, in order to get all of the IDC deductions to which you are entitled, you have to own your investment through a general partnership or sole proprietorship. You can’t own it through a corporation, LLC, or limited partnership. If you live outside the US, be sure to check on your country’s tax laws to find out what tax benefits they allow.

To learn more about how you can build massive wealth by permanently lowering your taxes, check out my book, Tax-Free Wealth.