When it comes to tax-advantaged investments for wealthy or sophisticated investors, one commodity continues to stand alone above all others: oil. With the U.S. government's backing, domestic energy production has created a litany of tax incentives for both investors and small producers, and oil is no exception.

Several major tax benefits are available for oil and gas investors that are found nowhere else in the tax code. Below, we'll cover the benefits of tax- advantaged oil investments and how you can use them to fire up your portfolio.

Striking Oil Tax Benefits

The main tax benefits of investing in oil include:

  • Alternative Minimum Tax: All excess intangible drilling costs have been specifically exempted as a "preference item" on the alternative minimum tax return.

Oil Tax Breaks and Energy Infrastructure Development

This list of tax breaks effectively illustrates how serious the U.S. government is about developing the domestic energy infrastructure. Perhaps most telling is the fact that there are no income or net worth limitations of any kind other than what is listed above (i.e., the small producer limit). Therefore, even the wealthiest investors could invest directly in oil and gas and receive all of the benefits listed above, as long as they limit their ownership to 1,000 barrels of oil per day. No other investment category in America can compete with the smorgasbord of tax breaks that are available to the oil and gas industry.

Investment Options in Oil and Gas

Several different avenues are available for oil and gas investors. These can be broken down into four major categories: mutual funds, partnerships, royalty interests and working interests. Each has a different risk level and separate rules for taxation.

  • Royalties: This is the compensation received by those who own the land where oil and gas wells are drilled. This income comes "off the top" of the gross revenue generated from the wells. Landowners typically receive anywhere from 12% to 20% of the gross production (obviously, owning land that contains oil and gas reserves can be extremely profitable). Furthermore, landowners assume no liability of any kind relating to the leases or wells. However, landowners also are not eligible for any of the tax benefits enjoyed by those who own working or partnership interests. All royalty income is reportable on Schedule E of Form 1040.

Net Revenue Interest (NRI) and Oil Taxation


Now assume that the price of oil is $60 a barrel, severance taxes are 7.5% and the net revenue interest (the working interest percentage received after royalties have been paid) is 80%. The wells are currently pumping out 10 barrels of oil per day, which comes to $600 per day of gross production. Multiply this by 30 days (the number usually used to compute monthly production), and the project is posting gross revenue of $18,000 per month. Then, to compute net revenue, we subtract 20% of $18,000, which brings us to $14,400.

Then the severance tax is paid, which will be 7.5% of $14,400 (Note: Landowners must pay this tax on their royalty income as well). This brings the net revenue to about $13,320 per month, or about $159,840 per year. But all operating expenses plus any additional drilling costs must be paid out of this income as well. As a result, the project owner may only receive $125,000 in income from the project per year, assuming no new wells are drilled. Of course, if new wells are drilled, they will provide a substantial tax deduction plus additional production for the project.

The Bottom Line

From a tax perspective, oil and gas investments have never looked better. Of course, they are not suitable for everyone, as drilling for oil and gas can be a risky proposition. Therefore, the SEC requires that investors for many oil and gas partnerships be accredited, which means that they meet certain income and net worth requirements. But for those who qualify, participation in an independent oil and gas project can provide strong returns on a tax-advantaged basis.