Oil Investments: Two Tax-Advantaged Strategies Explained
Let’s talk about oil.
If you’re intent on reducing your tax bill but feel like you’ve already maximized your deductions, here are two strategies worth knowing about. As you already know, the U.S. government uses the tax code to guide capital where it’s needed most. One of the clearest examples of this is energy. Affordable energy is in high demand, so Washington incentivizes investment in oil and gas programs.
At Axiom Wealth Solutions, our alternative investment menu includes several ways to participate in this sector. This article focuses on two specific strategies we recently covered with clients:
Oil Drilling Funds
Oil Qualified Opportunity Zones (QOZs)
Both strategies fall within the same sector — but they address different tax situations and different types of income.
1. Oil Drilling Funds: Tax Incentives + Cash Flow
The incentives with drilling funds are straightforward:
Tax Incentives
A large percentage of your investment can be deducted from ordinary income. In fact, deductions can reach 90% of the investment amount, which is then applied toward an investor’s W2 income or business income.
Cash Flow
Another reason investors deploy capital into this sector is the potential cash flow from these drilling funds. Depending on production and commodity pricing, distributions can be meaningful.
A Simplified Example
If an accredited investor in the 37% tax bracket invested $100,000 in a drilling fund with a 90% deduction, the investor is allowed to deduct $90,000 from their income. The result would be more than $33,000 in tax savings.
The benefits go even further. With a proper investment strategy, this $33,000 in tax savings is money the investor can invest in perpetuity. For perspective, $33,000 invested at 8% annually for 20 years would grow to more than $150,000.
This is something every accredited investor can consider. This strategy can be especially effective if you are experiencing a one-off increase in income, such as a one-time bonus or a capital gain event.
2. Oil Qualified Opportunity Zones (QOZs): Capital Gains Strategy
We’re in Q4 — the time when most people determine what their tax liability will be for the year. With that in mind, here is another oil-focused strategy designed specifically for capital gains.
Background on QOZs
The Qualified Opportunity Zone (QOZ) program was created by Congress in 2017 to encourage long-term investment in specific communities.
Remember, in general, the government attempts to create a flow of capital by creating tax incentives. In this case, with QOZs, the government will allow you to not pay long- or short-term capital gains tax if you invest your gains from the original investment into a QOZ.
What is a Capital Gain?
A capital gain is generated whenever you sell an appreciated asset — such as a stock, a business, or a piece of real estate — for more than you originally paid for it.
How Oil QOZ Funds Work
Short- and Long-Term Capital Gains
If you have created capital gains this year, those gains can be reinvested into a QOZ, and at tax time you don’t pay federal tax on the capital gain.
Cash Flow
In this specific QOZ, you can then earn quarterly cash flow payments. These distributions are also designed to be tax free.
Tax-Free Growth Within the Fund
If the investment is held for 10+ years, any appreciation in value is also exempt from taxation.
Long-Term Orientation
These funds are designed for investors who can commit to a decade-long holding period and are comfortable with the illiquidity that comes with it.
Why Some Investors Consider Oil QOZs
What I like about energy QOZs, when done right, is that you are purchasing into a large fund operated by an established company that has been active both inside and outside of the QOZ space for many years. This level of scale and experience provides an additional layer of diversification in and of itself.
Gone are the days when, if you wanted to invest in oil, you needed to drill your own well and hope for the best. Through our relationships, we’re able to invest alongside the large-scale operators mentioned above — companies managing multiple wells within diversified funds and supported by long track records of success. The technology in this space has made huge advancements in the last couple of decades, and investors get to leverage this technology. Of course, there is risk with any investment, but it’s a different landscape today with current technology.
When a QOZ Could Be a Fit
A QOZ could be a fit if you’ve created capital gains — whether long-term or short-term. If you don’t want to pay the tax bill due to Uncle Sam and if you’re willing to think outside the box, then this could be a great fit.
Closing Thoughts
Oil investments come in many forms, but drilling funds and oil-focused QOZs continue to stand out for their tax-advantaged structures. While each strategy is different — one focused on deductions against active income, the other focused on deferring or eliminating capital gains — both demonstrate how the government leverages the tax code to guide capital to areas deemed important.
Best,
Mike Bargetto
Financial Advisor
Axiom Wealth Solutions
This article is for educational purposes only and is not an offer to buy or sell any investment. Always consult your own tax and financial professionals about your specific situation.