EP 147 - How Oil & Gas Investors Reduce Taxes With Depletion

We break down depletion allowance, the oil and gas version of depreciation, and show how it can reduce taxes on production income without reducing your actual cash distributions. We also explain why many high-income investors use depletion to improve after-tax yield while keeping an eye on the rules and the real-world limits.
• depletion allowance defined as a deduction tied to shrinking natural resources
• why depletion can increase after-tax cash flow through paper losses
• cost depletion basics using units produced and remaining reserves
• percentage depletion explained as a revenue-based formula
• why percentage depletion can continue beyond original investment
• key limitations in loss years plus rolling unused depletion forward
• working interest versus royalty interest as different investing paths
• what investors see on a K-1 and where it lands on the 1040
• IDC versus depletion, upfront deduction versus ongoing deduction
• example math showing why the effective tax benefit can exceed 15% of cash received
• combining depletion with broader tax planning like real estate losses, charitable planning, cost segregation, Roth timing, and state planning
If you’re interested, you can go to https://www.prosperlcpa.com/apply to learn more. 

Transcript

Depletion Allowance And Why It Matters

SPEAKER_00 0:00

So most people know that real estate investors get depreciation, but very few people realize that oil and gas investors can potentially deduct part of their income as well every single year through something called depletion allowance. And in some cases, investors can receive cash flow that is partially or largely tax-free because of this. So today I'm going to explain to you what is depletion allowance, how it works, how it's calculated, and why many high-income investors are attracted to oil and gas opportunities because of this. And if at any time you're wondering how this apply to me and my situation, I will personally send you a video illustrating how this could apply if you send us a little bit of information. So if you're interested, go to prosperalcpa.com. That's prosper with an L CPA.com slash apply. If you're interested in seeing how this may apply to you, and also how we can help you out in other ways. Now

Depletion As Oil And Gas Depreciation

SPEAKER_00 1:35

let's get started with the conversation here on what is this depletion thing? What is the depletion allowance? Well, the simplest way I can explain this is depletion allowance is the oil and gas version of depreciation. Instead of wearing out of a building over time, we are accounting for the wearing out of the natural resources and oil wells, mineral reserves, and the natural gases are lit because they're literally being depleted as the resources are extracted from the ground. The IRS allows investors to deduct a part of that declining resource value from the taxable income. Or another way I could explain this here is if you own an apartment building, you get a depreciation deduction because the building ages. If you own an oil and gas, well, the oil underground is disappearing every time the barrels are pumped out of it. Depletion allowance is the tax deduction tied to the disappearing of that oil and gas

Paper Losses And After-Tax Cash Flow

SPEAKER_00 2:46

resource. And let's talk about why this matters and why investors love it. Because this can reduce taxes on oil and gas income. And it's a paper loss. Money's not leaving your pocket to incur this deduction. It increases the after-tax cash flow from your investments, creating partially tax-free income streams. It can improve your overall return of invent on investment. And in many cases, investors receive distributions but only pay taxes on a part of the income. So imagine two investors can receive the exact same amount of cash flow, but the oil and gas vest investor may keep more of his taxes because of the depletion deductions.

Cost Depletion Versus Percentage Depletion

SPEAKER_00 3:32

Now there's two types of depletion here. There's a cost depletion, and this is based on how much of that you invested and how much of the oil and gas remains and how much was extracted during the current year. So essentially, imagine this: you invested $100,000 and you expect the well to produce 100,000 barrels total. So if you extracted 10,000 barrels every year, then you've already removed 10% of your basis and you get a $10,000 deduction. Now that's the less common. What we more often will see, and this is going to be oftentimes more powerful, is and simpler, luckily, is the percentage depletion.

Why Percentage Depletion Gets Powerful

SPEAKER_00 4:19

And this is a formula uh that is used instead of the actual cost. So the IRS allows us a percentage deduction based on the revenue for these projects. Now the deduction is typically going to be 15% of that revenue. So simple math here. If you brought in $100,000 of revenue, let's say you bring in a certain amount of money from this oil and gas, and the revenue amount, that top line amount, is $100,000. That would create a $15,000 deduction. But it's actually a little better, or you'll see why this is even more valuable as we further explain how the numbers together come together. Um, now the the percentage of depletion is so powerful and oftentimes more powerful because there's no limit on how much of that deduction you can take. Uh now, with the earlier method where we're talking about the units, you know, if we put $100,000 in, the most we'll ever deduct for depletion is $100,000. But in this instance, you can continue to bring in more revenue. And if you bring in more revenue than you expected, there's an un you can continue to take that depletion allowance, even if you have more gas or more oil and gas than you anticipated. So there's no limit on how far you can take this deduction every year. As long as you're bringing revenue, you're getting that depletion deduction. So if you determine that you actually have more oil and gas than anticipated, you can continue to take that write-off. Now, and again, this is why it's so powerful because your deduction can exceed your original investment into this project when you started. This is unique because, unlike that, unlike with real estate, with real estate, you've predetermined what the depreciation could be. If you bought a building for $500,000, you're never going to take a depreciation deduction that exceeds $500,000. Once basis is fully depreciated with real estate, the depreciation stops. That's not the case with oil and gas. And that depletion allowance deduction can continue over time. Now, while this can be very exciting, that we have this deduction, this paper loss, and even if we're not spending money, we get the write-off.

Limits, Loss Years, And Carryforwards

SPEAKER_00 6:49

There are some things you want to consider. There are some limitations. Now, if you operate at a loss, you're not going to be able to use the depletion the depletion allowance that year. So let's say you brought in some revenue, but you ultimately created a loss because of depreciation or other expenses. If you're showing a zero dollar income statement, that depletion allowance will not create a loss. Or if you're operating at a loss because of intangible drilling cost deductions, the depletion allowance will not further that loss. It will not create additional reduction against your other sources of income. However, it's still very powerful because you're still going to use, you're not going to lose those depletion allowance deductions. So let's say we incurred $30,000 depletion allowance deductions, but we are operating at a loss on the wells. Well, you can't use it that year, but once the revenue starts to come in, you have an additional $30,000 of depletion allowance that is going to roll forward, and you're going to have even more deductions against your income in the future. Now you got to make sure you're doing this right and you understand uh the entity structure, you're working with the right people, and you also understand alternative minimum tax if it's ever applicable to your situation. And

Royalty Interest And How K-1s Show It

SPEAKER_00 8:07

one of the things I also like about depletion, and we don't really talk about this much, but there are other ways to invest in oil and gas besides investing in working interest. And while working interest is usually the sexiest thing and the most exciting thing because it'll create tax losses to offset your other income, there are ways to invest in royalty interest where you can create passive income and it may be a little more stable and reliable for some of you guys. And you will also be able to create the depletion deduction with other forms of oil and gas investing. Um, another thing you can think about is I want you to understand how this looks on your return. You're typically going to get issued a K1, and that's gonna show you your share of that partnership income. And that is gonna show up on your schedule, epage two of your 1040. And you can rely on the prepare of that partnership return to calculate that depletion allowance and have it roll into your tax return. So you may see the gross production revenue and then the depletion deduction and the IDC as all separate items along the way.

Depletion Versus Intangible Drilling Costs

SPEAKER_00 9:18

Now, let's talk about how this depletion deduction differs from the IDC, and they're both very important and beneficial and why people love oil and gas. The IDC or intangible drilling cost deduction, which you may have heard me talk about, is a front-end deduction. Typically in year one, we see people deducting anywhere from 75 to 90 percent of their investment in year one, but that's a one-time deduction from the IDCs, and it also creates a large upfront savings that can offset your other income and it's tied to that initial cost. Now, the depletion is an ongoing deduction year after year after year. As long as you're bringing in revenue, the revenue is generally going to create a depletion allowance deduction. So the way you can see this is you have your IDC, it's like getting a tax deduction when you build the well, and then depletion is like you're continuing to receive the tax benefits while the well produces income. Now, what does this kind of look like for you,

A Simple Example Of Real Tax Savings

SPEAKER_00 10:26

right? So how much are you actually gonna save here? So remember that the uh the the depletion deduction is based on a percentage of revenue, not profits. So if we are expecting a 15% of revenue as a deduction, that means that we're remember we're not gonna report just the revenue, we also have our other deductions here. So imagine this. Let's say we have a revenue of a hundred thousand dollars, right? For our investment into the oil and gas. Now, let's say there's expenses of twenty thousand dollars, and then the money that's coming into our bank account is eighty thousand dollars, right? Now, if our depletion allowance deduction isn't gonna be fifteen percent of the eighty thousand dollars, it's gonna be fifteen percent of that hundred thousand dollars. So, what I'm trying to tell you the reason why this is so important is we're actually gonna see a deduction that's more than fifteen percent of the money that hits our account. If we were to divide fifteen by eighty thousand, it's like we're getting we're getting in that example here, it's not like we're not paying taxes on fifteen percent of our income. In this situation, it's as though we're not paying taxes on 20% of our income. But what it could be even better. And I've read some private placement memorandums of some other oil and gas providers, and what they have projected is you oftentimes are gonna pay taxes on around 65% of the income that you receive from your investment because you have your revenue and that determines your depletion deduction all the way at the top, and then you have all these other deductions that reduce your taxes as well to arrive at the net income that is reportable on your return. So you're actually going to see a deduction that's more than 15% of the money that hits your account. And this is really powerful because it can allow you to sort of smoothen out the taxable income brackets and it offsets the production revenue. And think about this: you get that initial savings with the IDC deduction, and then when the money comes in, we're offsetting the profits. So even though the money is profitable and taxable in the future, we're still moving the income into lower brackets with this depletion allowance deduction. And this is gonna improve your after-tax yield over year after year after year. Now,

Pairing Strategies And Next Steps

SPEAKER_00 13:17

you can pair this with other strategies, and I really encourage you guys if you're interested in the stuff with IDC deductions and depletion allowance and potential profits. It goes really well when you're also considering other strategies for building your wealth, investing, and reducing your taxes. You can pair it really well with real estate losses, charitable planning, cost segregation, and accelerating depreciation for real estate, maybe do some Roth conversion timing and some state planning as well, state tax planning as well. So investors should understand all these different variables when they're doing holistic wealth building and tax reduction strategies. Oil and gas investing isn't just about chasing returns, because for many investors, it's also about improving the after tax outcome. And depletion allowance is one of the biggest reasons why. But like every advanced tax strategy, you still need to understand the rules, the risks, and how it fits into your overall financial game plan here. So I really hope this gave you additional insight into what this all means with this depletion allowance and how powerful oil and gas investing can be on the tax side. And also there's great profitability that we haven't talked about. And this has to be profitable to make sense. And if you find this interesting and you're wondering how this fit into my overall picture and tax reduction strategies, I'd be more than happy to send you a personalized video illustrating what is available and also what other potential tax advanced tax reduction strategies can help you out. So if you're interested, you can go to prosperocpa.com slash apply to learn more. That's prosperous with an LCPA.com slash apply. Really hope you enjoyed this conversation today and found it helpful and gave you additional insight into why and how oil and gas is such a powerful vehicle that is uh very popular with high income earners in the affluent. And stay tuned, I got more great stuff coming your way.