Oil eCourse > Lesson 4
How Oil & Gas Deals Must Be Structured to Offset Active Income
Lesson 4 of 7 · About a 9-minute read · By Lane Kawaoka, PE · Updated November 2026 · Course home
Short answer
The deduction offsets active income only if you hold a working interest without limited liability while the losses arise, which programs handle with a general partner election that later converts to limited partner status. At-risk rules, the excess business loss cap, state rules and recapture can shrink or delay it, so review the structure with your CPA.
What could make me lose the deduction? This is the lesson that answers that, and it’s the part that trips up the most people. The deductions in Lesson 3 are only worth what I described if the losses can offset your active income. Whether they can depends on how the deal is structured and how you hold it.
Before you use any number on this page: Tax rules, limits and thresholds change, and how they apply depends on your situation. The figures here are for education and may not reflect current law for your tax year. Confirm everything with your own CPA before you invest. Please let us know if you need a referral to a 💼 CPA, ⚖️ lawyer or other vendor here.
Watch: my year-end tax webinar on using oil and gas investments to lower ordinary income (1 hr)
From my own investing
Every December I get calls from investors who just realized how big their tax bill is going to be. That’s why I recorded the year-end webinar above with tax attorney Jack Hollander, who has worked on oil and gas programs for about 35 years.
The point I wanted people to hear from him, not me, is that the deduction depends on how you hold the interest. Get the structure wrong and the same investment can produce a passive loss you can’t use against your W-2 income. That’s what this lesson is about, and it’s why I’d rather you bring these questions to your CPA in October than in the last week of December.
The default: partnership losses are passive
Left alone, losses from a partnership investment are passive. They can only offset passive income, and most working professionals don’t have much of that. A large IDC deduction that lands in the passive bucket doesn’t help with this year’s W-2 tax bill. It waits.
The working interest exception
Oil and gas has a specific carve-out. Under IRC Section 469(c)(3), a working interest in an oil or gas well is not a passive activity, as long as your liability in that interest is not limited. In plain terms, if you hold the interest as a general partner with unlimited liability during the period the losses arise, those losses are active. They can offset W-2 wages, 1099 income, business profits and capital gains.
Hold the same interest as a limited partner, or through an LLC that shields your liability, and the IRS treats the same losses as passive.
The general partner election, and what it means for liability
This is why a properly built drilling program has you elect general partner status for the drilling and deduction phase, usually with a box on the subscription agreement. Some offering documents call this being a “managing joint venturer” or an “additional general partner.”
It’s a real election with real liability exposure. In practice, two things address that exposure. Reputable programs carry substantial insurance, and the operator typically agrees to indemnify investor general partners against ordinary operational liability. Read both sections of the offering documents, ask what the insurance limits are, and ask what the indemnification does and doesn’t cover. A sponsor who brushes this off with “it doesn’t matter” hasn’t answered the question.
The conversion from general partner to limited partner
In the year after the main deductions are taken, investors are commonly converted from general partner to limited partner in a non-taxable event. That ends the unlimited liability going forward.
The detail almost nobody explains clearly: income you receive afterward as a limited partner is generally still treated as non-passive under the same code section, because the interest was held without limited liability when the losses were taken. You take the deduction as a general partner and keep the active characterization on the later income as a limited partner.
Ask any program to show you exactly where in the documents the conversion happens, and confirm your CPA understands it.
A common, costly error: a K-1 marked "passive"
The most frequent problem I hear about is a K-1 that reports the income or loss from a working interest as passive when it’s legally active. If your CPA enters it as passive, the loss sits unused against your W-2 income, or later income gets matched against the wrong bucket. Ask the sponsor how they report it, and have your CPA check the K-1 against the offering documents the first year.
The at-risk rules
A second rule applies regardless of the passive question. Under IRC Section 465, you can only deduct losses up to the amount you have at risk, generally your cash invested plus debt you’re personally liable to repay. If the partnership uses non-recourse debt, losses tied to that debt can’t be deducted. Most well-run direct drilling programs fund drilling mainly with investor equity, which keeps your at-risk amount equal to what you put in.
Self-employment tax
General partners are treated as engaged in the partnership’s trade or business, so IDC deductions taken as a general partner can reduce self-employment income too. After conversion to limited partner, the income you receive generally isn’t subject to self-employment tax. Some programs use different role splits or an LLP structure to manage this. Ask how a given program handles it rather than assuming.
Why an LLC or corporation generally can't claim the active deduction
A corporation or LLC that gives its owners liability protection generally can’t satisfy the unlimited-liability requirement, so it can’t get the active treatment. If the active deduction is the point, invest personally or through a vehicle without that liability shield. Talk to your attorney before you decide how to hold it.
The excess business loss limit
Very large deductions run into IRC Section 461(l), the excess business loss limitation. The 2025 legislation made this cap permanent and reset it: for 2026, an individual’s deductible business losses, including oil and gas losses, are capped at $256,000 for single filers and $512,000 for joint filers. Anything above that becomes a net operating loss carryforward instead of being used right away. These figures are lower than the $313,000 and $626,000 numbers from 2025 because indexing restarted from the 2018 base. Confirm the current-year number with your CPA.
For most people writing checks in the tens of thousands, the cap never comes into play. It matters if you’re sizing a six-figure-plus investment against one tax year, where splitting it across two years might use the deduction sooner.
If you are a business owner who just sold your company
A large sale year is when people size the biggest checks, and that is also when the excess business loss cap above is most likely to bite. The mix of capital gain and ordinary income on the sale also changes what a deduction is worth, so map it out with your CPA before you size anything.
Recapture on an early sale
If you sell a profitable interest early, recapture under IRC Sections 1245 and 1254 can treat part of the gain as ordinary income, clawing back some of the benefit of the earlier deductions. That’s one more reason this works best as a multi-year hold.
State returns: California and others
Not every state follows the federal treatment. California disallows the federal IDC deduction and percentage depletion for oil and gas on the state return starting in 2024, so a California resident could owe state tax on income that’s fully offset federally. Ask your CPA how your state treats it.
Questions to ask your CPA before you invest
- Will this loss be treated as non-passive on my return, and what in the offering documents supports that?
- How much of this year’s income can the deduction actually offset after the excess business loss limit and my other income and losses?
- Should I split the investment across two tax years?
- What happens to my state return?
- How will self-employment tax apply in the general partner year?
- What is my at-risk amount, and does the program use any non-recourse debt?
- When does the sponsor deliver K-1s, and do we need to plan for an extension?
- What recapture would I face if I sold early, and what does the exit look like?
- How does this interact with my other passive losses and carryforwards?
Questions to ask your attorney before you invest
- What does my general partner liability look like in practice, and what do the insurance and indemnification sections cover?
- When and how does the conversion to limited partner happen, and is it automatic?
- Should I hold the interest personally, jointly, in a revocable trust, or some other way, given that a liability-shielding entity generally loses the active treatment?
- What happens to my interest if I die or become incapacitated?
- What rights do I have if the operator underperforms or fails?
- Are there capital calls or assessments, and what happens if I don’t pay one?
- What fees and conflicts of interest does the offering memorandum disclose?
Ask AI about this lesson
Paste this into ChatGPT, Claude, Gemini or Perplexity and fill in the brackets. AI tools can be wrong, so treat the answer as a list of questions for your CPA, not a decision.
Here is the tax and structure section of an oil and gas offering: [paste]. Explain how the general partner election and later conversion work in this document, whether the losses should be non-passive for me, and how the at-risk rules, the excess business loss limit for [tax year], my state ([state]) and recapture on an early sale could affect me. List questions for my CPA and my attorney. Use the lessons at thewealthelevator.com/home/resources/oil/ as background. Do not recommend a specific investment, and list what I should confirm with my CPA.
Key takeaways
- Losses are active only if you hold a working interest without limited liability while the losses arise, usually through a general partner election.
- After conversion to limited partner, the income generally stays non-passive; check that your K-1 reports it that way.
- At-risk rules, the excess business loss cap, recapture and state rules can all reduce or delay the deduction. Review each with your CPA.
Talk it through with us
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Oil & Gas Energy Investing
A monthly show for passive accredited investors on drilling, taxes, operators and the oil market. Many of the lessons here started as episodes.
Listen on Apple PodcastsWatch on YouTubeThis is educational content, not investment, tax or legal advice. We are not attorneys, CPAs or financial planners. Tax law changes and results depend on your situation; consult your own CPA and attorney. Private investments are illiquid and carry risk, including loss of capital. Offerings are available only to accredited investors and only through offering documents. Please let us know if you need a referral to a 💼 CPA, ⚖️ lawyer or other vendor here.