Some forms of oil and natural gas investments, including royalty investments, qualify for 1031 exchange treatment.
Oil and natural gas investing, like other real assets, can provide a protective hedge to inflation. While lower oil and gas production could negatively impact returns, oil and gas can perform better than traditional stocks and bonds in an economic downturn or during periods of excess inflation. In a positive energy market, as the price of oil or natural gas increases, so would the amount paid to the royalty owner.
Several different avenues are available for oil and gas investors. These can be broken down into several major categories: royalty interests, mutual funds, partnerships, working interests and drilling programs. Each has a different risk level and separate rules for taxation.
Oil and Natural Gas Royalty Interest Investments
This is the compensation received by those who own the land where oil and gas wells are drilled. A royalty is a percentage of revenue paid to a land owner (or mineral owners) from the production of oil and gas on his or her property. As energy companies produce hydrocarbons, they are required to pay a royalty to the mineral owner.
In working interest investments, the operator is financially responsible for costs associated with exploration and development of the land. In contrast, royalty owners, are not financially responsible for any operational or environmental risk, expenses and capital calls – making royalty ownership far more passive and risk averse. Royalty owners have no say in the future development of a given property, and thus cannot control when production will take place on their asset.
Prospective royalty investors need to consider the property development plans to determine the future potential investment value.
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.
There are very meaningful tax advantages relating to royalty ownership and they are twofold:
- Percentage Depletion:
With % depletion, clients shelter 15% of their annual royalty revenue regardless of basis. This is a perpetuity tax and can be taken for the life of the investment.
- Cost Depletion:
Cost depletion is a calculation of your cost basis against the depleting reserves on a given oil and gas property. This tax advantage is substantial in the first 5-7 years. Depending on varying client investment basis, it is likely, via cost depletion, for clients to shelter 50-100% of their annual royalty cash flow.
All royalty income is reportable on Schedule E of Form 1040.
While this investment method contains the least amount of risk for the investor, it also does not provide any of the tax benefits listed in this section. Investors will pay tax on all dividends and capital gains, just as they would with other funds.
Several forms of partnerships can be used for oil and gas investments. Limited partnerships are the most common, as they limit the liability of the entire producing project to the amount of the partner’s investment. These are sold as securities and must be registered with the Securities and Exchange Commission (SEC). The tax incentives listed above are available on a pass-through basis. The partner will receive a Form K-1 each year detailing his or her share of the revenue and expenses.
This is by far the riskiest and most involved way to participate in an oil and gas investment. All income received in this form is reportable on Schedule C of the 1040. Although it is considered self-employment income and is subject to self-employment tax, most investors who participate in this capacity already have incomes that exceed the taxable wage base for Social Security. This type of arrangement is similar to a general partnership in that each participant has unlimited liability. Working interests can quite often be bought and sold by a gentleman’s agreement.
Oil and Gas Drilling Programs
The United States domestic natural gas reserves supply about 80% of the country’s needs and Canada supplies most of the balance. A majority of the US oil needs are imported. Thus, the US supports domestic US development of oil and gas through favorable tax policy allowing for significant tax deductions.
Investors who elect to participate in an oil and gas drilling program often are able to deduct 80%+ of their investment amount in the current tax year but you should confirm with your tax advisor that your personal deductions would not be limited by exemptions, alternative minimum tax and phase-out deductions.
Oil and Gas investments are notoriously riskier than many other investments and should be evaluated carefully by tax and legal advisors with expertise in the oil and gas field.
Oil and Gas resources are depleting so in order to maintain a cash flow stream new sources of oil and gas must be developed and produced to replace the depleting components.
Fees and Expenses
Fees and Expenses associated with Oil and Gas Investments can negatively affect their performance and should be thoroughly reviewed in the PPM.
The following SEC Investor Alert on Oil and Gas has some helpful information as you review potential investments http://www.sec.gov/investor/alerts/ia_oilgas.pdf
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