Oil and Gas Tax Advantages for 1031 Exchange Investors
How cost depletion and percentage depletion actually work, year-by-year, for an investor carrying eroded basis from a prior 1031 exchange.
Key Takeaways for 1031 Exchange Investors
- Cost depletion recovers your adjusted basis based on annual production. Percentage depletion shelters 15% of gross royalty income with no basis cap and no expiration.
- Each year, oil and gas investors take whichever deduction is greater. Percentage depletion eventually overtakes cost depletion permanently.
- For 1031 investors with eroded basis, percentage depletion may be especially favorable because it is based on gross income, not your carried-over basis.
- Tax benefits do not eliminate investment risk. Oil and gas investments are illiquid, subject to commodity price volatility, and may result in loss of principal. Consult a qualified tax advisor.
Why Oil and Gas Tax Benefits Matter for 1031 Investors
In our introduction to oil and gas for 1031 investors, we covered how mineral rights qualify for 1031 exchanges, how royalties work, and why some investors are looking at this asset class alongside traditional DST investments.
But how do the tax benefits for oil and gas actually work, and what makes them potentially compelling for 1031 exchange investors? This article takes a deep dive into the math with real examples by looking at the two depletion tools every oil and gas investor should understand, because the one that may benefit an investor more will depend largely on your adjusted basis from your exchange.
Cost Depletion: Recovering Your Basis in an Oil and Gas Investment
Cost depletion may allow an investor to deduct a portion of their adjusted cost basis each year based on how much oil and gas is produced from the mineral acreage. The more the wells produce in a given year relative to total estimated reserves, the larger the deduction.
How Cost Depletion Is Calculated
Step 1: What percentage of estimated reserves were produced this year?
100,000 barrels produced / 1,000,000 total reserves = 10% depletion factor
Step 2: Apply to your basis
10% x $400,000 basis = $40,000 deduction
The $400,000 adjusted basis and 10% depletion factor are hypothetical examples for illustration only. The actual depletion factor varies each year based on production volumes and updated reserve estimates.
Percentage Depletion: The Oil and Gas Tax Deduction That Goes Beyond Basis
Percentage depletion works differently. Under IRC Section 613A, oil and gas mineral rights owners can potentially deduct 15% of gross royalty income each year, and unlike cost depletion or real estate depreciation, it may continue even after the investor's basis reaches zero, subject to certain IRS limitations.1 In real estate, once you've fully depreciated an asset, the deduction stops. With oil and gas, as long as the property produces income, 15% of that gross income may be sheltered from tax.
How Percentage Depletion Differs from Real Estate Depreciation
| Real Estate Depreciation | Oil and Gas Percentage Depletion | |
|---|---|---|
| Shelters income from taxes | Yes | Yes |
| Tied to cost basis | Yes | No, based on gross income |
| Expires or recaptures on sale | Yes, recapture at sale | No recapture, no expiration |
| Works with eroded basis from prior 1031 exchanges | Limited benefit | 15% of gross income sheltered regardless of basis |
Does Percentage Depletion Continue After Your Basis Reaches Zero?
Yes. This is the part that has no equivalent in real estate. Once your adjusted basis is fully depleted, percentage depletion continues at 15% of gross royalty income for as long as the property produces. For 1031 exchange investors who carried over a low basis from years of depreciation on their prior property, this means the oil and gas tax deduction may outlast anything they could get from another real estate investment. However, individual tax circumstances vary, and investors should consult a qualified tax advisor.
Current Oil & Gas Programs
Available through Anchor1031 for accredited investors
Inwood Minerals LLC
Inwood Minerals represents a diversified portfolio of royalty assets historically delivering both income and growth to accredited investors. The portfolio expands across 75,766 gross acres, 11 countie
Montego Energy Partners, LLC
RGP Income Fund II, LP
RGP Income Fund II, LP, a Delaware limited partnership, has been formed as an oil and gas income and development partnership for the principal purpose of building a portfolio of oil and gas reserves a
Renaissance Growth Partners, LLC
Waveland Resource Partners VIII, L.P..
Waveland Energy Partners specializes in energy-focused investments. Waveland's Total Return Income & Growth Strategy focuses on acquiring minority interests in drill-ready, proven reserves in the Unit
Waveland Energy Partners, LLC
How Cost Depletion and Percentage Depletion Work Together for 1031 Investors
How much you can deduct through cost depletion depends on your adjusted cost basis in the oil and gas interest. For a 1031 investor, the basis is generally whatever carries forward from the relinquished property after years of depreciation, which may be significantly lower than the equity being invested.
Each year, your CPA runs both cost depletion and percentage depletion and applies whichever is higher.
1031 Exchange Example: $1,000,000 Equity with $250,000 Adjusted Basis
Take a hypothetical investor who sells a property with $1,000,000 in equity but only $250,000 in adjusted basis. They 1031 exchange into an oil and gas interest. Their cost depletion is generally calculated off the $250,000 basis, not the $1,000,000 investment. But their royalty income is based on the full $1,000,000 at work.
| Year | Remaining Basis | Royalty Income | Cost Depl. (10%) | % Depl. (15%) | Best Choice | Deduction |
|---|---|---|---|---|---|---|
| 1 | $250,000 | $80,000 | $25,000 | $12,000 | Cost | $25,000 |
| 2 | $225,000 | $80,000 | $22,500 | $12,000 | Cost | $22,500 |
| 3 | $202,500 | $80,000 | $20,250 | $12,000 | Cost | $20,250 |
| 4 | $182,250 | $80,000 | $18,225 | $12,000 | Cost | $18,225 |
| 5 | $164,025 | $80,000 | $16,403 | $12,000 | Cost | $16,403 |
| 6 | $147,623 | $80,000 | $14,762 | $12,000 | Cost | $14,762 |
| 7 | $132,860 | $80,000 | $13,286 | $12,000 | Cost | $13,286 |
| 8 (crossover) | $119,574 | $80,000 | $11,957 | $12,000 | % Depl | $12,000 |
| 9 | $107,574 | $80,000 | $10,757 | $12,000 | % Depl | $12,000 |
| 10 | $95,574 | $80,000 | $9,557 | $12,000 | % Depl | $12,000 |
| 11+ | $0 | $80,000 | $0 | $12,000 | % Depl | $12,000/yr |
Hypothetical illustration only. Assumes a $1,000,000 1031 exchange with $250,000 adjusted basis, hypothetical annual royalty income, and a hypothetical 10% annual depletion factor. All figures are for illustrative purposes only and do not represent actual or projected returns. Actual results depend on individual basis, production levels, commodity prices, and tax circumstances. Consult your own tax advisor.
Notice the crossover at Year 8. Cost depletion drops below percentage depletion, and from that point forward, 15% of gross royalty income may be sheltered from tax each year, regardless of what happened to the investor's basis. This is the part that has no equivalent in real estate.
Cash Investor Example: Full Basis Advantage
What if you're a cash investor, or a 1031 investor who still has a relatively high basis? The math may be even more favorable in the early years, because cost depletion starts from a higher number.
| Year | Adjusted Basis | Royalty Income | Depletion Factor | Cost Depletion | Depl. as % of Income | Taxable Income |
|---|---|---|---|---|---|---|
| 2025 | $400,000 | $32,000 | 10% | $40,000 | 125% | ($8,000) |
| 2026 | $360,000 | $32,000 | 10% | $36,000 | 113% | ($4,000) |
| 2027 | $324,000 | $32,000 | 10% | $32,400 | 101% | ($400) |
| 2028 | $291,600 | $32,000 | 10% | $29,160 | 91% | $2,840 |
| 2029 | $262,400 | $32,000 | 10% | $26,244 | 82% | $5,756 |
| 2030 | $236,196 | $32,000 | 10% | $23,620 | 74% | $8,380 |
| 2031 | $212,576 | $32,000 | 10% | $21,258 | 66% | $10,743 |
Hypothetical illustration only. Assumes a $400,000 investment with 100% of that amount as adjusted cost basis and a hypothetical 10% annual depletion factor. Actual results depend on the investor's individual basis, production levels, commodity prices, and tax circumstances. Consult your own tax advisor.
Notice how in the first three years, cost depletion actually exceeds the royalty income, potentially creating a loss that could offset other portfolio income (see Portfolio Income section below). With full basis, cost depletion remains the dominant tool for much longer before percentage depletion eventually takes over.
The fiscal value of percentage depletion across the industry is significant: one budget analysis estimated that the percentage depletion allowance saves independent producers approximately $13.9 billion per decade in federal taxes.2
One Important Tax Nuance for Real Estate Investors: Portfolio Income
One important nuance for real estate investors: royalty income from oil and gas mineral rights is classified as portfolio income under IRC Section 469, not passive income.3 That means it cannot be used to offset passive losses from rental properties, DSTs, or other real estate investments. It's treated more like interest or dividend income for passive activity purposes. This catches some investors off guard, so it's worth flagging for your CPA early.
Can Oil and Gas Income Offset My DST Passive Losses?
No. Because royalty income is portfolio income, it lives in a separate tax bucket from your DST investments or rental properties. If offsetting passive income from existing real estate holdings is a priority, there are other oil and gas structures designed specifically for that, including some that may potentially offset not just passive income but active W-2 income as well through intangible drilling cost deductions.
Risks to Understand Before You Invest in Oil and Gas
Tax benefits can be significant, but they do not eliminate investment risk. A few things to keep in mind.
Wells are depleting assets.
Production from any individual well declines over time. Mineral rights owners bear no drilling or operating costs, and in prolific basins like the Permian, there may be strong economic incentive for operators to continue developing new wells. However, the timing of new development is driven by operator economics and cannot be guaranteed.
Commodity prices are volatile.
Royalty income is directly tied to oil and gas prices, and WTI crude has ranged from roughly $32 to over $100 per barrel in the last six years. Distributions are never guaranteed and may be reduced or suspended.
Legislative risk.
Prior administrations have proposed eliminating these provisions. However, percentage depletion has been in the tax code for over a century, survived the 1986 Tax Reform Act, and was reinforced by the One Big Beautiful Bill Act signed in 2025.
Oil and gas is one of several asset classes we offer on the Anchor1031 platform, alongside multifamily, industrial, ground leases, and more. If you're evaluating how oil and gas might fit alongside your other replacement property options, we're happy to walk through the specifics.
How Anchor1031 Helps You Evaluate Oil and Gas Tax Benefits
If you're evaluating how oil and gas tax advantages compare to your current real estate holdings, or if you want to walk through the depletion math with your specific basis numbers, we're happy to dig into it with you.
Browse Current Oil and Gas Offerings
View curated oil and gas, multifamily, NNN, and other investment properties.
Build a Custom Portfolio
Diversify your 1031 exchange across oil and gas, DSTs, and other asset classes.
Schedule a Call
Walk through the depletion math with your specific basis numbers.
Frequently Asked Questions About Oil and Gas Tax Advantages
What are the main tax advantages of investing in oil and gas?
The primary tax advantages include percentage depletion (a 15% annual deduction of gross royalty income that does not expire when basis reaches zero) and cost depletion (a basis-recovery deduction calculated on annual production). Investors take the greater of the two each year. Additionally, intangible drilling cost deductions may apply to certain structures. Consult a qualified tax advisor.
Can percentage depletion exceed my original investment?
Yes. Unlike real estate depreciation, percentage depletion is not tied to your cost basis. It is calculated as 15% of gross royalty income each year, subject to certain IRS limitations. Total depletion deductions can exceed the original cost of the investment over time.
How does percentage depletion work for 1031 exchange investors with eroded basis?
For 1031 exchange investors, the adjusted basis is generally whatever carries forward from the relinquished property. Cost depletion is calculated off this lower basis. But percentage depletion (15% of gross royalty income) is based on production revenue, not basis. Once cost depletion drops below percentage depletion, the investor switches to percentage depletion permanently.
Is oil and gas royalty income passive or portfolio income?
Royalty income is classified as portfolio income under IRC Section 469, not passive income. It cannot offset passive losses from DSTs or rental properties. Learn more about the distinction in our oil and gas tax benefits overview.
Are oil and gas tax benefits still available in 2026?
Yes. Percentage depletion and related oil and gas tax incentives have been in the tax code for over a century. They survived the 1986 Tax Reform Act and were reinforced by the One Big Beautiful Bill Act signed in 2025. Tax law can change, and investors should consult their tax advisor.
Sources
About the Author
Trevor Sybertz, Partner
Trevor Sybertz is a Partner at Anchor1031, where he specializes in educating clients about 1031 exchanges, private real estate offerings, and REITs. With over a decade of experience in commercial real estate and capital markets, Mr. Sybertz has helped clients invest more than $100M in equity across a wide range of real estate assets and markets.
Continue Learning About Oil & Gas Investing
Why 1031 Investors Are Moving Into Oil and Gas
How royalties work, the scale of the Permian Basin, and why this asset class is gaining traction.
Oil and Gas 1031 Exchange Guide
Which investments qualify, exchange mechanics, and the step-by-step process.
Oil and Gas Royalties Guide
How royalties work, how they're taxed, and what to evaluate.
Want to Run the Depletion Math on Your Exchange?
Our team can walk through cost depletion vs percentage depletion with your specific basis numbers and help you evaluate oil and gas alongside your other replacement property options.
Disclosure
Tax Complexity and Investment Risk
Tax laws and regulations, including but not limited to Internal Revenue Code Section 1031, bonus depreciation rules, cost segregation studies, and other tax strategies, contain complex concepts that may vary depending on individual circumstances. Tax consequences related to real estate investments, depreciation benefits, and other tax strategies discussed herein may vary significantly based on each investor's specific situation and current tax legislation. Anchor1031, LLC and Great Point Capital, LLC make no representation or warranty of any kind with respect to the tax consequences of your investment or that the IRS will not challenge any such treatment. You should consult with and rely on your own tax advisor about all tax aspects with respect to your particular circumstances. Please note that Anchor1031 and Great Point Capital, LLC do not provide tax advice.
The information contained in this article is for general educational purposes only and does not constitute legal, tax, investment, or financial advice. This content is not a recommendation or offer to buy or sell securities. The content is provided as general information and should not be relied upon as a substitute for professional consultation with qualified legal, tax, or financial advisors.
Tax laws, regulations, and IRS guidance regarding 1031 exchanges, opportunity zone investments, and related real estate strategies are complex and subject to change. Information herein may include forward-looking statements, hypothetical information, calculations, or financial estimates that are inherently uncertain. Past performance is never indicative of future performance. The information presented may not reflect the most current legal developments, regulatory changes, or interpretations. Individual circumstances vary significantly, and strategies that may be appropriate for one investor may not be suitable for another.
All real estate investments, including 1031 exchanges and opportunity zone investments, are speculative and involve substantial risk. There can be no assurance that any investor will not suffer significant losses, and a loss of part or all of the principal value may occur. Before making any investment decisions or implementing any 1031 exchange strategies, readers should consult with their own qualified legal, tax, and financial professionals who can provide advice tailored to their specific circumstances. Prospective investors should not proceed unless they can readily bear the consequences of potential losses.
While the author is a partner at Anchor1031, the views expressed are educational in nature and do not guarantee any particular outcome or create any obligations on behalf of the firm or author. Neither Anchor1031 nor the author assumes any liability for actions taken based on the information provided herein.