Oil Investment Yields Income, Tax Break

Alex Coppola for the Wall St Journal writes: The doctor was a partner in a private medical practice that had enjoyed a good year. He was expecting a $50,000 bonus, but wasn't happy about having to pay taxes on that money.

He brought his concerns to his adviser, Clint Gharib, founder of the Gharib Group in Atlanta. "This was a client in the top tax bracket," explains Mr. Gharib, whose firm manages about $200 million for 300 family and corporate clients. "Between state and federal taxes, as much as $20,000 of that bonus was going straight to the government."

The doctor had maxed out his 401(k) contributions for the year and earned too much to qualify for a tax-deductible IRA contribution. He wanted a vehicle that would significantly offset the tax hit, while giving him the opportunity to make a return on his money.

Mr. Gharib had already used alternative investments in the client's portfolio, so he thought of another non-traditional strategy that could help the man achieve both of his goals: investing in oil wells.

Mr. Gharib has used oil and gas investments in his clients' portfolios since 2008 and believed that such an investment could be a good fit for this client. He also knew that the strategy was uncommon, so he started by explaining exactly how the investment would work.

To invest in a land-based oil drilling project, the client could buy into an oil partnership. For a minimum investment--usually about $20,000--he would become a partner and receive a percentage of profits generated by those wells.

But in the first year of his investment, the client would also receive a deduction against his taxable income for money the partnership spent on intangible drilling costs, or IDC. These costs, which include expenses like labor and insurance, typically constitute about 85% of a project's initial investment.

The client was intrigued, but before they went any further Mr. Gharib laid out the risks involved--primarily, that he could lose his principal if the wells didn't produce oil. "There are plenty of horror stories about investors losing money because they didn't do their homework on the general partner who organized the partnership," says Mr. Gharib.

However, Mr. Gharib had spent three years researching a particular general partner and had placed other clients into well investments with the company. The general partner had decades of experience, a good track record, and was starting a new drilling project. Together, Mr. Gharib and his client reviewed the new project's private placement memorandum, a document that includes a detailed budget outlining expected intangible drilling costs as well as estimates for the wells' production.

Mr. Gharib also shared the information with the client's accountant, who worked with the oil partnership's accounting firm to review the procedures the client would need to follow to claim the IDC tax credit. With the client ready to invest, Mr. Gharib then gave the client's $50,000 to the partnership.

In the first year, the partnership spent 88% of the money on IDC, which meant the client received a $44,000 deduction against his income taxes in 2011. By the second year, he had received about $7,692 in income from the wells' yield, and can expect additional income for as long as the wells are still productive--typically 10-20 years, says Mr. Gharib.

As successful as this strategy was for this client, Mr. Gharib notes that it isn't for everyone. Investors typically need at least $250,000 in net worth to qualify for an oil partnership. And because there's no secondary market for the partnerships, they must also be comfortable holding illiquid assets.

"If you're looking for an investment you can sell in three years, this isn't it," warns Mr. Gharib. "But for clients with the right assets and the right appetite, it can be a very useful and rewarding opportunity."