Episode Transcript: Oil and Gas Tax Deductions Explained

Transcript Summary: In this episode, Mike Jesowshek, CPA, and Nick White from US Energy discuss how oil and gas investing may create major tax deductions for high-income business owners and qualified investors. They cover intangible drilling costs, first-year tax deductions, who may qualify, how oil and gas investments may offset W-2 income and business income, key risks to understand, timing before year-end, QBI and SALT planning opportunities, and why investors should never chase tax deductions blindly.

[00:00:00] Introduction to Oil and Gas Tax Deductions

Mike: Most business owners eventually hit a point where they’re making good money, but then tax season shows up and it feels like the IRS is taking a victory lap on their success.

When your income climbs, the usual deductions only go so far. You start asking better questions like, “What else is out there? What are wealthy investors doing differently? Are there strategies that can legally reduce taxable income while also building long-term wealth?”

Today, we’re digging into one of the most talked-about and often misunderstood tax strategies for high-income earners: oil and gas investing.

We’re joined again by Nick White from US Energy to break down how oil and gas investing works, where the tax benefits come from, who it may be a good fit for, and what investors need to understand before jumping in.

Nick, welcome back to the show. I’m excited for this conversation.

Nick: I appreciate you having me today. It’s always good to reconnect.

[00:01:00] How Oil and Gas Investing Creates Tax Benefits

Mike: For business owners who have heard that oil and gas investing can create major tax benefits, what’s the simple explanation of how this works and why it works?

Nick: The simplest way I can describe it is that the government loves to incentivize things it wants investment in.

Think about solar investments. The government incentivized solar by offering tax credits. Oil and gas is similar, but it has been around a lot longer.

The government wants to incentivize investment into energy production because we don’t want to rely only on foreign nations for our energy sources.

Back in 1914, IRS Tax Code Section 263(c) was established. Essentially, it allows clients who invest directly into oil and gas drilling funds to take large tax deductions based on intangible drilling costs.

We’ll talk more about intangible drilling costs later, but here’s the simple version. If a client makes a $100,000 investment, they may receive a very large tax deduction above the line. That means the deduction can go against different types of income, including W-2 income, 1099 income, K-1 business income, and even capital gains.

You can take that deduction in the year of investment. That’s why many high-net-worth clients and business owners use oil and gas investing as an additional tax strategy. They may already be maximizing retirement accounts and making charitable donations, but then the question becomes, “What else is out there?”

Oil and gas has been one of those asset classes for well over 100 years.

[00:02:45] Why the Investment Still Needs to Make Sense

Mike: I love that. One concept I talk about often is that many people think, “I’ll buy a piece of equipment, a vehicle, or a truck I don’t really need because I’m looking for the tax deduction.”

When people come to me like that, I like to explain that oil and gas investing can be similar in one way. You may receive a large deduction in year one by making an investment, but instead of buying something you don’t need just for a tax deduction, you may be investing in another vehicle that can potentially create cash flow.

But I’m also a big proponent of saying that tax strategy should not drive the entire investment decision. The tax benefit is great, but the underlying investment needs to be clean and sound. The tax piece should be the cherry on top.

I don’t want to invest in something that is a bad investment just because it comes with a tax benefit. A bad investment is still a bad investment.

Talk to us about the return side of your projects. How does that work, and what does that look like?

Nick: That’s such an important point. Over my 15 years in this career, I’ve seen that the deduction is often what drives people to look at oil and gas investing. But you don’t make investment decisions based only on tax planning. The underlying asset needs to make sense. The return profile needs to make sense.

[00:04:00] Oil and Gas Investment Returns and Cash Flow

Nick: There are a few variables we’ll discuss when we talk about risk, such as pricing risk and drilling risk. At US Energy, we focus on predictable and repeatable results.

We drill in proven areas of production, meaning core areas where we have strong data and where we expect to find oil. I’ve personally invested in these projects for over a decade, so I’ve seen multiple years of return profiles.

When we structure these investments, what we try to achieve is a 100% return of gross payout within roughly four to six years. In simple terms, if someone invests $100,000, they may receive a large first-year deduction, realize tax savings at the federal and state level, and then receive cash flow over time.

Based on our track record, it typically takes four to six years to get that $100,000 back through cumulative distributions. The wells themselves can cash flow for an extended period of time. For example, where we drill in the Permian Basin, the average well life is typically 10 to 12 years.

The idea is to realize the tax savings, keep more money from going to Uncle Sam, reinvest that money into your business or the markets, and then receive cash flow from the underlying oil and gas assets over time.

When we model these investments, we’re typically looking for a 1.5x to 2x return in cash flow over the life of the investment. That’s on top of the tax savings.

There will be variance depending on the market. Production variance is something we try to reduce by focusing on predictable and repeatable drilling. The bigger variance usually comes from oil and gas prices. If prices are much higher, quarterly distributions may be better. If prices are lower, distributions may be lower.

[00:06:00] What Are Intangible Drilling Costs?

Mike: That makes sense. Now let’s talk about IDCs, or intangible drilling costs. These are a big reason oil and gas investments can create a large year-one deduction.

How can someone invest $100,000 and potentially get an $80,000 to $90,000 deduction in year one? What makes up that deduction?

Nick: There are generally two types of costs when drilling a well: intangible costs and tangible costs.

Tangible costs are more like equipment costs. Intangible drilling costs are costs related to the drilling process that don’t have a depreciation schedule tied to them.

Examples of intangible drilling costs include hydraulically fracturing the wells, building roads, and paying wages. Within our offerings, intangible drilling costs are typically around 80% to 85% of the investment.

Then, with accelerated depreciation, you may also receive an additional deduction on the equipment side. When you combine intangible drilling costs with tangible deductions, clients may see roughly a 90% to 92% first-year tax deduction for the calendar year.

That’s the difference. Intangible costs are costs without a depreciation schedule that may be written off in the first year, and tangible costs are equipment-related costs that may be accelerated.

[00:07:30] Can Oil and Gas Deductions Offset W-2 Income and Business Income?

Mike: One important thing to remember is that oil and gas tax deductions can potentially offset W-2 income and business income.

When we talk about real estate, for example, if you own a long-term rental property and you don’t qualify as a real estate professional, you may create losses from that rental, but you may not be able to use those losses to offset W-2 income or business income.

That’s not the case with certain oil and gas structures, correct?

Nick: Correct. It’s not really a loophole. It’s more about how the tax code is written.

You don’t necessarily need to materially participate in the same way you would with some other vehicles to take the deduction against active income like W-2 income or business income.

With real estate, you may need to meet certain material participation rules or qualify as a real estate professional. With solar investments, clients may need to show they are spending time in the project to take the deduction against active income.

Oil and gas works differently. In the first year, you invest as a general partner, and that classifies you as materially participating. There are no hours to track. Entering as a general partner is what allows the deduction to apply against W-2 income and business income, which is where most people want the deduction to be used.

[00:09:00] Who May Be a Good Fit for Oil and Gas Investing?

Mike: When we talk about oil and gas investing, what type of investor is typically a good fit? Where is their income level? What is their risk tolerance? Are they a business owner, W-2 earner, or real estate investor?

Nick: It depends. Some clients I work with earn over $25 million per year. I also work with retirees who are dealing with required minimum distributions that may affect their Medicare benefits.

There is a wide range. Some clients make $25,000 investments, while others make investments up to $10 million. A lot of that has to do with planning around income reduction, estate planning, gifting, and other goals.

To invest, you generally need to have at least $1 million in net worth, excluding your primary home, or you need to qualify based on income levels. For a single filer, that means at least $200,000 in annual income. For joint filers, that means at least $300,000 in annual income.

To me, a common ideal client is a joint filer making $300,000 or more who is looking to reduce taxable income and potentially drop tax brackets.

Many clients have already maxed out retirement accounts and made charitable contributions, but they are still in a high tax bracket. Oil and gas investing may create deductions, reduce income, and potentially move them into lower tax brackets, which can result in more tax savings.

From an investor profile standpoint, roughly 60% of our investors are individuals, and 40% are business owners looking to reduce income at the business level.

[00:11:00] Key Risks of Oil and Gas Investing

Mike: This strategy can sound attractive because people hear “big tax deduction” and “offset W-2 income or business income.” There aren’t many vehicles that offer that flexibility while also being an investment.

But what risks should people understand before investing?

Nick: That’s very important because there are a lot of companies offering drilling fund programs. I’ve reviewed many different prospectuses and deals over the years, and I’ve seen what makes a company perform well and where investors may take on more risk.

Everything is a risk-return paradigm. If you’re taking on greater risk, the hope is that you may receive greater returns. But there are several things investors should review.

First is company structure. The energy space is heavily funded through debt. If you’re making a direct energy investment, you do not want to work with a company that carries substantial debt on the portfolio. When prices move, that debt can weigh on the corporate balance sheet and affect the overall performance of the partnership and individual investors.

At US Energy, we are privately held, carry little to no debt at the corporate level, and focus on cash flow investments.

[00:12:45] Onshore vs. Offshore and Developmental vs. Exploratory Drilling

Nick: Another important point is the type of drilling a company is doing.

There are different types of drilling, including offshore drilling and onshore drilling. Offshore drilling is generally more expensive and more risky to operate.

We focus on onshore drilling in the Permian Basin in West Texas. There are thousands of wells surrounding the locations, so you can pull data from nearby production levels and get a better understanding of what to expect.

There is also exploratory drilling, sometimes called wildcatting. This means a company is drilling in an area that has never produced before. In that case, investors may be looking for a home run, but they may also strike out.

The type of drilling we do is called developmental drilling. That means we operate in a known basin and drill in proven areas. We have drilled more than 4,000 wells in our history and have not hit a dry hole.

That does not eliminate risk, but the goal is to reduce drilling risk by focusing on where and how we operate.

[00:14:00] Diversification and Pricing Risk in Oil and Gas Investments

Nick: Another important risk factor is diversification.

If a company raises capital but only drills five or 10 wells in a fund, investors may have more concentration risk. That means those few wells need to perform well for the investor to receive the expected return profile.

At US Energy, each fund typically has exposure to more than 200 wells at the fund level, which creates more diversification.

Pricing risk is another factor. Investors need to understand the current price of oil and gas, where prices may be going, and whether they feel comfortable with the return economics.

Geopolitical events can affect oil and gas prices. So can demand from technology and AI infrastructure. As AI adoption grows, more data centers are being built, and those data centers need energy to operate. That demand may continue to influence future energy markets.

[00:16:30] How to Connect with Nick White and US Energy

Mike: If anyone is interested in being introduced to Nick and Rhett, you can email us at ask@taxsavingspodcast.com, and we can get you connected.

They have documentation and materials that can help walk through the details, including the potential tax benefits, investment structure, and risks.

[00:17:00] Timing Oil and Gas Investments Before Year-End

Mike: Let’s talk about timing. If someone wants the tax benefits before year-end, when do they realistically need to start the conversation? When does the investment need to be made to lock in the tax benefits for 2026?

Nick: The tax law is based on the year you invest. Whether you invest today or on December 31, you can receive the deduction for that calendar year.

That said, we try to build in early investor incentives so we can raise capital earlier, deploy it, and start the cash flow phase more quickly for investors.

For investors who invest before the end of the early investor period, we may cut fees by 50%. That can create a better rate of return over the life of the investment. Investors may also accrue interest from their investment date through the end of the year, which can result in a tax-free distribution in January.

The challenge is that many clients don’t know their full tax picture until later in the year. The early investor incentive gives flexibility. For example, if someone invests $25,000 or $50,000 earlier in the year, then realizes in December that they had a bigger year than expected, they may be able to add more later while still receiving the full incentive.

From a tax perspective, the deduction is tied to the year of investment. But investing earlier may provide better return economics and more flexibility.

Mike: That’s important. We don’t want people waiting until December 31 and rushing to wire funds. If you’re interested, start the process earlier. Look at November as a practical deadline so you can have a more accurate picture and avoid last-minute stress.

Nick: Exactly. Having these conversations earlier allows investors to feel more educated, more comfortable, and more confident about how the investment fits into their overall tax plan.

[00:20:30] Example of a $100,000 Oil and Gas Investment

Mike: Let’s wrap the numbers into one example. If someone invests $100,000 into a fund, what could that look like from a tax impact and cash flow perspective?

Nick: Let’s assume a client is in a 50% combined federal and state tax bracket. If they invest $100,000 and receive a $90,000 tax deduction, they multiply the deduction amount by their tax rate.

In this example, a $90,000 deduction at a 50% tax rate creates $45,000 in tax savings for the year.

Cash flow may begin in the first quarter of the following year. The investor may receive quarterly distributions, and over time, those distributions may return the original $100,000 investment within a four-to-six-year window.

That is on top of the $45,000 in tax savings.

Over the full life of the fund, which may be roughly 10 to 12 years, the investor may receive $150,000 to $200,000 back in cash flow, depending on production, pricing, and performance. That is in addition to the tax savings generated on the front end.

The idea is to create tax savings, reinvest dollars that would have gone to taxes, and receive cash flow from the underlying assets over time.

[00:22:30] Is Oil and Gas Investing Just a Tax Deferral?

Mike: A lot of people worry about the exit. Is there a capital gain event at the end? Is this just a tax deferral where the investor gets hit with taxes later?

Nick: That’s a common question. Think about buying equipment. You may depreciate it in year one, but if you eventually sell it, you may face depreciation recapture.

Oil and gas drilling funds should not be designed that way. In our structure, the investor receives the deduction in the first year, and then the wells cash flow until there is nothing left coming out of the ground.

At the end of the life of the wells, there is a final K-1 and the partnership concludes. There is no sale at the end that creates recapture of the original tax savings.

The total return is based on the tax savings on the front end and the production and cash flow from the wells over their life.

[00:23:30] QBI Planning, SALT Deductions, and Phaseout Strategy

Mike: Another area we plan around with clients is QBI planning.

If you’re a business owner with qualified business income, the QBI deduction can start to phase out once income gets to certain levels, depending on the type of business and other factors. The same can apply to the SALT deduction limit, where the benefit may phase out once income gets too high.

Oil and gas deductions may help reduce income and bring someone back into a range where they can qualify for additional tax benefits.

For example, if a client saves $45,000 from the oil and gas deduction, that may not be the only benefit. If the deduction also helps them qualify for QBI or SALT deductions they would have otherwise lost, the total tax savings could be even higher.

Nick: Exactly. I call that “phasing in the phaseouts.”

We do a lot of planning where we show investors different investment amounts and how those amounts may reduce income enough to qualify for additional deductions, such as state and local tax deductions or the 20% qualified business income deduction.

For example, I recently worked with an attorney in Louisiana who had his own practice and was making roughly $650,000 in income. After retirement account planning, he made a $110,000 investment in a drilling fund. That reduced his income below a key threshold and allowed him to phase back into the business income deduction and additional state and local tax deductions.

In that case, the total tax savings was around 65% of the amount invested. That is meaningful planning.

[00:26:00] Common Mistakes When Evaluating Oil and Gas Deals

Mike: Oil and gas can have a mixed reputation. Some people hear about it and want to avoid it because they’ve heard horror stories. Others want to jump in quickly because they hear “tax deduction.”

What are the biggest mistakes investors make when evaluating oil and gas deals?

Nick: Back in the 1980s, many oil and gas partnerships and tax mitigation vehicles had less regulation around the structure of those investments.

Some companies would raise capital and then take on 100% debt at the partnership level. That allowed investors to take a 150% or 200% deduction on the front end. But when you looked deeper, only a portion of the investor’s capital was actually going to work. It was more of a deduction play with minimal cash flow and substantial risk because of the debt load.

The industry has changed significantly. At the major syndicated level, companies are generally not using debt the same way. Investors are usually only using the deduction amounts tied to the investment, and the focus has shifted toward better rates of return and cash flow over time.

Technology has also changed. When I started in 2011, horizontal drilling was not as prominent. Companies used more vertical drilling, which meant drilling straight down into the ground.

Now, with technological advancements, wells can be drilled thousands of feet deep and then extended laterally for miles. That can improve production efficiency and potentially create more cash flow for investors.

When you combine improved partnership structures with improved drilling technology, the space has become stronger in terms of potential rates of return and tax planning.

[00:28:45] Final Thoughts on Oil and Gas Investing

Mike: If anyone is interested in getting connected with Nick or Rhett to learn more about oil and gas investing, email us at ask@taxsavingspodcast.com, and we can connect you directly.

Oil and gas investing can be a powerful tax strategy, but like anything in tax planning, the key is understanding how it works, whether it is right for you, what risks come with it, and what risks you are willing to take.

The big takeaway is simple: don’t chase deductions blindly.

Look at the full picture, including your income, risk tolerance, long-term goals, and how the strategy fits into your broader tax plan.

Nick, thank you again for joining us and helping break this down.

Nick: Of course. Thanks for having me. This was fun.

Mike: If you found this helpful, don’t forget to subscribe, like, and share it with a business owner who is tired of paying too much in taxes.

If you want help from our team of tax professionals implementing a strategy like this, along with many others, visit TaxElm.com or click the link in the description for a free discovery call.

We help business owners legally lower their tax bills every single day. Thanks for tuning in, and I’ll see you on the next one.