Individual Tax Considerations for Investing in Oil and Gas Properties

The recent fall in demand for oil and gas resulting from the COVID-19 pandemic has put many oil and gas companies in a distressed position. While many investors are looking to make oil and gas investments in the down market, those new to investing in this industry should understand the different types of investments and the impact of related tax considerations.

Tax rules designed to encourage oil and gas production can make direct investment in oil and gas properties, rather than in marketable securities of oil and gas companies, an attractive option for many investors. There are generally two types of direct investments in oil and gas assets, a working interest and royalty interest. These ownership interests benefit from different tax incentives.

Working Interest

A working interest is an ownership interest in an oil and gas well or lease that gives the investor a right to a share of income from production after royalty income investors are paid and obliges the investor to share in the cost of developing and operating the well. A working interest investor has greater exposure to increases in operating and drilling costs, commodity price fluctuations, and unsuccessful or underperforming wells. Those considering investing in a working interest should understand the decision to capitalize or expense certain drilling costs as well as the rules for loss limitations and deductions for qualified business income and depletion.

Intangible drilling costs (IDC): Most costs associated with drilling and completing a well are intangible drilling costs (IDCs), which include labor costs, ground preparation, and similar “non-salvageable” costs associated with the development of the well. IRC Section 263(a) provides an election to deduct IDCs when incurred for domestic oil and gas wells (the deduction option is unavailable for foreign IDCs). Otherwise, taxpayers capitalize IDCs and amortize the costs over 60 months.

Given that a working interest investor is responsible for its share of IDCs, this deduction is one of the most attractive tax aspects of oil and gas investing. There are some risks, however. If the well is sold after IDCs have been deducted, the deduction could be subject to recapture at ordinary income tax rates and could be subject to capital gains treatment after recapture has been satisfied. Also, excess IDC, which is the difference between IDCs deducted and the amount that would have otherwise been amortized during the tax year, could cause an add back to alternative minimum taxable income (AMTI) as preference IDC that is not deductible for Alternative Minimum Tax (AMT) purposes. This issue is common in tax years with high IDCs or low taxable income.

Tangible drillings costs (TDC): Tangible drilling costs (TDCs) are costs for lease and well equipment that are at least partly salvageable after production has ended. These costs are primarily incurred during the drilling and development of a well, but they can also be incurred during production due to repair, replacement, or additions to certain equipment. These costs are capitalized and depreciated over seven years under the modified accelerated cost recovery system (MACRS). Currently, taxpayers have an added benefit of a 100 percent bonus depreciation of lease and well equipment under IRC Section 168(k). This bonus depreciation, however, will gradually be eliminated by 2027, with a reduction to 80 percent on qualified assets beginning after January 1, 2023. As with IDCs, a working interest investor will be responsible for its share of TDCs. If the well is sold after TDCs have been deducted, the costs are also subject to recapture at ordinary income tax rates with the potential for capital gains treatment after recapture is satisfied.

Loss limitations: There are several loss limitation rules that could affect an investor’s deductions related to oil and gas properties. IRC Section 469 generally disallows losses from passive activity. Whether a working interest investor is subject to the Section 469 loss limitation rules depends on the type of entity in which the investor holds the interest. If the investor holds the working interest in an entity that does not limit the taxpayer’s liability with respect to the interest, Section 469(c)(3) provides an exception to passive loss limitation rules. If the taxpayer holds the investment in an entity that limits liability, the investor is subject to the passive loss rules, which disallow a deduction of passive losses unless the investor has passive income to offset the losses or the investment is disposed. The investor may still be able to treat the income or loss as non-passive, but they would need to satisfy the IRS’s seven criteria for determining material participation in its passive activity rules.

Another loss limitation provision, IRC Section 461, limits overall business deductions to $250,000 for single filers and $500,000 for married filing jointly filers. Tax losses from working interest operating costs, drilling costs, and depreciation are considered business losses for purposes of Section 461 (even if they are passive losses under Section 469) and could limit the tax benefits of IDC and TDC deductions. The CARES Act repealed Section 461 for tax years 2018, 2019, and 2020, but it will come back into effect in 2021. Lastly, investors should be aware of IRC Section 465, which limits deductions to the amount at risk, meaning that an investor who has taken tax losses equal to its investment may not use any additional losses.

Qualified business income deduction: Individual investors may also deduct income from a working interest in an oil and gas asset under Section 199A, which allows taxpayers to deduct up to 20 percent of qualified business income. Losses from working interest operations and drilling are also considered qualified business losses under Section 199A that offset qualified business income either in the current year or a future year.

Depletion: Depletion is a cost recovery that accounts for the “wasting” of a well that occurs with every barrel produced, and the depletion deduction accounts for this loss. IRC Section 613A generally limits the deduction to 65 percent of a taxpayer’s taxable income for the year. While this limits the benefit for working interest investors in assets that are in the development phase, investors in a producing well can realize a significant benefit, as the depletion deduction is still available after an investor’s basis is fully recovered through depletion.

Royalty Interest

Investors may also consider an investment in a royalty interest, which is an ownership interest in a portion of the property’s production that has the first right to the revenue from a producing well. Royalty interest investors are responsible for production costs, severance taxes, shared marketing expenses, and certain other expenses, but they are not responsible for the costs associated with drilling and operating a well. They can also claim a deduction for the depletion of a well. While this makes a royalty interest less risky than a working interest, investors should understand the risks of incurring certain taxes in addition to income tax.

Depletion: While depletion is available for both working interest income and royalty income, royalties do not bear the burden of drilling and operating costs and are typically not subject to net income limitations. This difference makes the depletion deduction a greater benefit for royalty income investors. The depletion calculation can be complex but it can produce a significant benefit. For example, if royalty income that generated $100 of gross revenue has $10 in costs, an investor will have taxable income of $90. A depletion deduction of $15, however, would bring deductions to $25 and reduce the investor’s taxable income to $75.

Taxes in addition to income tax: Royalty income is portfolio income for tax purposes and is taxed at ordinary income rates. Royalty income is usually considered passive income that is subject to the 3.8 percent IRC Section 1411 net investment income tax (NIIT), which is in addition to regular income tax. The NIIT applies to taxpayers with modified adjusted gross income greater than $200,000 for single taxpayers or $250,000 for taxpayers that are married filing jointly. An investor that qualifies for non-passive treatment of working interest income, either by participation or by holding the investment in anything other than an entity that limits liability, may be subject to self-employment tax, which is also in addition to regular income tax.

Conclusion

The tax treatment of a direct investment in oil and gas assets differs significantly from investing in public company stock and partnerships. While gains from investing in oil and gas stocks are taxed at the lower capital gains tax rates, gains from direct oil and gas investments can also be subject to reduced rates that make this type of investment more attractive. To achieve these reduced rates requires investors to understand the complex tax issues involved in direct investment and take advantage of rules that can create favorable tax results.

Weaver can help oil and gas companies facing financial difficultly from the COVID-19 pandemic. Please contact us with any questions. We’re here to help.

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