Here’s a dirty secret of passively investing in real estate:
The tax benefits probably aren’t what you think they are.
If you’re a high-earning W-2 employee or business owner and you invested in a real estate syndication expecting it to slash your tax bill, you were probably caught off guard come tax time. Most likely, the investment barely made a dent in your overall taxes, and you were still left stroking a hefty check to the IRS.
That’s because depreciation from a passive real estate investment only offsets other passive income. Unless you qualify for “real estate professional status,” the passive depreciation losses from a syndication won’t touch your active income from a business or W-2 job.
This is true in most of the tax code – active and passive are like church and state. But there are a few exceptions.
One of the big ones? Oil and gas.
Not only do oil and gas investments typically generate strong cash flow, but they also come with significant tax breaks — ones that can actually offset your active income.
This is a space I’ve been exploring for some time and am actively working to bring oil and gas investment opportunities to investors at Big Spring Capital.
So today I want to give a crash course in oil and gas investing for passive investors. This is not meant to be exhaustive, and it isn’t tax advice (always check with your CPA for the tax implications of any investment).
Let’s dive in.
Working Interests
A common way to invest in oil and gas is to own working interests, which is a stake in the legal agreement (a lease) that grants rights to explore, drill, and produce oil or gas from a specific piece of land.
Working interest owners are directly responsible for the costs associated with drilling, operating, and maintaining the wells. But in return, they receive a proportionate share of the revenue produced by those wells — so when oil or gas is sold, they get their share of the revenue.
Operators (the companies who actually drill, operate, and maintain the wells) often partner with passive investors, similar to a real estate syndication. Operators perform the work, investors supply the funding, and both share in the profits.
Cash Flow
One of the big appeals of oil and gas investments is the cash flow potential. Once production begins and oil and/or gas is being extracted, it can provide a steady stream of income for investors.
Unlike real estate syndications, which can take years to realize significant gains, oil and gas wells can produce cash flow relatively quickly once they are up and running. And depending on the price of oil, the returns can be substantial – in some cases, it’s not uncommon to receive a full return of capital inside two years.
Wells also typically have long life spans. Once operational, a strong-performing well could produce for a decade or more. This steady income is a cash flow investor’s dream.
(Note: unlike most real estate syndications that eventually have a sale or refinance, oil and gas working interest investments don’t normally have a formal “exit” event. Oil and gas investors usually consider the cash flow to start as a return of capital, then transition to a return on capital. For example, for a $100K investment, the first $100K of cash flow would be considered a return of capital; all remaining cash flow until the well is depleted is a return on capital.)
Tax Advantages
Now, let’s talk about the tax benefits, which is where oil and gas investments really shine.
They fall into a few general buckets:
Intangible drilling costs (IDCs): non-salvageable expenses related to drilling a well, like labor, site preparation, and supplies. The IDCs are 100% deductible in the first year of the investment. This immediate write-off is the single biggest tax benefit, and can dramatically lower your overall tax liability.
Tangible drilling costs (TDCs): similar to depreciation on real estate, TDCs are depreciable costs related to physical assets and equipment used in the drilling process. TDCs can be bonus depreciated to increase the year-one tax benefit, or spread out over several years to provide additional tax relief into the life of the investment.
Depletion allowance: a tax benefit for the gradual reduction of a well’s reserves as they’re extracted and sold. The idea is that, as oil and/or gas is depleted, investors are entitled to receive a tax break reflecting a diminishing value of the asset. It directly offsets income from the investment each year, and applies for the investment’s entire life.
Sounds amazing, right?
It gets better: depending on the structure of the deal, the tax losses from oil and gas investments can offset active income. This is a game changer for high-earning employees or business owners.
It’s common for oil and gas working interest investments to create a first-year deduction upwards of 80% of the investment amount. That means a $100K investment could potentially allow for an $80K deduction of active income in year one. If you’re in the 32% tax bracket, that’s an immediate tax savings of more than $25K.
So it’s possible to get what equates to a 25% return in the first year just from the tax savings alone.
What’s the Catch?
Like any investment, oil and gas syndications aren’t without risks.
For one, oil and gas are commodities whose value is determined by a complex international system of supply and demand. While oil prices have historically risen over the long term, they can be volatile in the short term. And if a wave of volatility hits at the wrong time, it can dampen a deal’s overall returns.
Then there’s the operator. It takes experience and skill to successfully and efficiently extract any natural resource. Like a real estate syndication, you want to invest in a deal with an operator who has “been there, done that” and has a track record of success.
There are also the inherent risks of drilling. Good operators perform a ton of research on a piece of land and its reserves before drilling, but problems can still arise. Equipment could fail, the geology could be unexpectedly challenging, or the reserves could be significantly less than projected.
That said, many oil and gas syndications are structured to reduce risks by partnering with experienced operators, encompassing multiple wells, and focusing on proven areas with established production. But as always, investor due diligence is key — always make sure you understand the team behind the deal, their track record, and the specific terms of the syndication before signing docs and wiring funds.
Wrapping It Up
Oil and gas syndications offer a unique opportunity to invest in something tangible that generates cash flow and provides some of the best tax benefits you’ll find.
Taxes are likely the biggest expense you’ll have throughout your whole life, and they’re a huge drain on overall investment returns. So if you’re a high earner looking to protect and grow your wealth, these investments can be a powerful tool in your portfolio.