If you’ve invested in real estate for any length of time, you already know the move: sell, 1031 into the next property, defer the gain, repeat. Some of you have been doing this for twenty years. Swap till you drop, as the saying goes.
It works. Right up until the moment it doesn’t.
At some point, most real estate investors hit a wall that has nothing to do with returns. You’re just done. Done with tenants. Done with termites. Done with the toilet that fails at 11pm on a Friday. You want to simplify: move into T-bills and chill, shift into something more passive, or just take some chips off the table after a good run.
And that’s exactly the moment the tax bill you’ve been deferring for years finally comes due. The second you sell and don’t roll into another like-kind property, the IRS wants its money: depreciation recapture, capital gains, all of it, in a single year.
This is a conversation I have with investors in my world constantly (professionals and experienced investors, most of you sitting on $1M to $10M in net worth), and it’s what I dug into recently on the podcast with a director of 1031 exchanges who now specializes in oil and gas.
This Is Not a Literal 1031 Exchange
I want to be precise here, because this gets oversimplified a lot. A 1031 exchange requires like-kind real property. Individually owned mineral rights (the actual, direct ownership of oil and gas in the ground) qualify as real property under the tax code, so in narrow cases, a real estate investor really can 1031 directly into mineral rights they personally acquire and hold.
But that’s not how most people access oil and gas, and it’s not what a blended oil and gas fund is. A fund interest is a security: personal property, not real property. You cannot 1031 exchange into it. Full stop. Anyone who tells you otherwise is wrong, and you should hang up the phone.
So why bring it up at all? Because the logic behind a 1031 (using a specific, well-established part of the tax code to manage the tax consequences of a transition) is exactly the same logic that applies here. It’s just a different mechanism, used at a different moment: not to defer the gain indefinitely, but to soften the hit in the year you finally take it.
Two Separate Tax Mechanisms, Not One Workaround
A blended oil and gas fund typically holds a mix of working interests and royalty or mineral interests, and each one does something different for you tax-wise.
Working interest, intangible drilling costs. A significant share of the capital deployed into drilling a well is classified as an intangible drilling cost, deductible up front rather than depreciated over years. Because of a specific carve-out in the passive activity rules for working interests, that deduction isn’t stuck offsetting only passive income. It can offset active income and, depending on your facts, other income you recognize in that same tax year, potentially including the depreciation recapture and gain you’re staring at the year you finally sell real estate outright.
Royalty interest, percentage depletion. The royalty side of the fund gets a depletion allowance, which shields a portion of that income from tax every year the wells produce. Conceptually similar to how depreciation shelters rental income, except it’s baked into the royalty check itself, going forward, for as long as the asset produces.
Put together: the working interest piece can help in the specific year you’re unwinding real estate and recognizing a gain, and the royalty piece keeps working for you every year after that. Neither one is a loophole. Both have existed in the tax code for decades because the government wants to incentivize domestic energy production, the same way it incentivizes real estate investment through depreciation and 1031 exchanges.
What This Is Actually For
This isn’t a pitch to abandon real estate. I still like real estate. It’s how most of the people in my world built their net worth in the first place. This is for the specific moment when you’re ready to diversify away from being a landlord and you know a tax bill is coming with it.
A few things worth being upfront about:
- You have to be an accredited investor. This isn’t a retail product.
- It’s illiquid. This is a long-hold asset class, not something you trade in and out of.
- The tax outcome depends on your specific return, your specific gain, and your specific year. This is not a guarantee, and it’s not one-size-fits-all. It has to be modeled with your CPA against your actual numbers, including at-risk rules and how much of your investment is even eligible for the IDC deduction versus the depletion side.
- Oil and gas has its own risks: commodity prices, drilling timelines, operator execution. It’s a different risk profile than real estate, not a risk-free alternative to it.
If you’ve been swapping properties for a decade and you’re finally ready to stop, it’s worth understanding that the tax code still has tools for you. They’re just not the ones you’ve been using.
If you want to go deeper on this and the other ways we help investors manage this exact transition, join our community at thewealthelevator.com/club.
This article is for educational purposes only and is not tax, legal, or investment advice. Oil and gas fund investments are speculative, illiquid, and available only to accredited investors. Tax outcomes depend on individual circumstances, are subject to at-risk and passive activity limitations, and can change with future legislation. Consult your own CPA and attorney before making any tax or investment decision.