The Complete Guide
A working interest in a new well is one of the few investments whose losses can offset a salary with no hours test. Here is how the deduction works, the limits that cap it, and what comes back when you sell.
Most investment losses are passive, so they can only offset passive income. A working interest in an oil or gas well is an exception written into the statute.
Section 469(c)(3)(A) says a working interest in oil or gas property is not a passive activity if you hold it directly or through an entity that does not limit your liability. Section 469(c)(4) adds that material participation is not required. Compare that with the short-term rental strategy, where you have to log 100 or 500 hours and defend them. Here there is no hours test at all.
The common assumption is that any oil and gas investment works this way. Only a working interest does, only in the right legal form, and the deduction still runs through three other limits before it reaches your W-2 income.
A working interest is the share that pays the costs of drilling and operating the well. A royalty interest takes a cut of production and pays none of those costs, so it creates no drilling deduction, and its income is portfolio income under §469(e)(1) and Reg. §1.469-2T(c)(3).
The statute turns on whether the entity limits your liability. Reg. §1.469-1T(e)(4)(v) lists three forms that do: a limited partnership interest where you are not also a general partner, stock in a corporation, and an interest in any other entity whose state law caps your liability at a fixed amount.
That third category catches the LLC. State law limits a member's liability, so a working interest held through your own LLC is passive. It is an easy mistake to make. An investor forms an LLC for protection, buys the working interest through it, and loses the exception the deal was bought for.
Insurance does not change the answer. The same regulation disregards indemnification agreements, stop-loss arrangements and insurance when it asks whether your liability is limited. A sponsor can insure you against a blowout and you are still treated as holding the interest without limited liability.
General partner now, limited partner later.
Many drilling programs admit investors as general partners for the drilling year, then convert them to limited partners once the wells are drilled. Once you have taken a non-passive loss from the property, §469(c)(3)(B) keeps its net income in every later year non-passive. That cuts both ways. The income is taxed like any other active income, and it cannot absorb passive losses from your rentals.
The conversion date matters too. Reg. §1.469-1T(e)(4)(ii) looks at when the drilling work is actually performed, ignoring the December prepayment rule below. Costs for work done after you become a limited partner are treated as passive.
A well's budget splits into three kinds of cost, and each is deducted on a different clock.
Take a married couple filing jointly with $732,200 of wages, no other income and the standard deduction. In December 2026 they put $200,000 into a drilling program as general partners. The program's budget puts 75% into IDC, 20% into equipment and 5% into the lease. Those splits belong to this example. Every program publishes its own, and if the sponsor keeps a carried interest, the costs allocable to its share are capitalized, which can lower the share you deduct.
Both taxable income figures sit inside the 35% bracket for 2026 joint returns, which runs from $512,450 to $768,700, so every dollar of the deduction comes off at 35%. State tax is left out because state treatment varies.
The couple wrote a $200,000 check and got $52,500 back in federal tax for 2026. The other $147,500 has to come back from the well. Judge the well first, and treat the deduction as a discount on it.
Normally a cost is deductible when the work is performed. Section 461(i)(2) makes an exception for drilling. It applies to programs that count as tax shelters under §461(i)(3), which includes any offering that had to be registered with a federal or state agency and any program that allocates more than 35% of its losses to limited partners or other passive investors. For those programs, money paid for drilling in 2026 can be deductible in 2026 if drilling of the well starts before the close of the 90th day after year-end. For a calendar-year 2026 return, that day is Wednesday, March 31, 2027.
Two things to check before you wire money in December. The deduction is limited to your cash basis, which leaves out partnership debt and any loan for your share that the sponsor arranged or that is secured by partnership assets. And ask the sponsor for the drilling schedule in writing, and whether the program itself pays the drilling contractor before December 31, since the rule covers amounts paid for drilling, not money sitting in the program's account. If the rig starts after March 31, the deduction for that well moves to 2027.
The working-interest exception gets you past one limit. Three others still apply, in this order.
Basis comes first: a partner cannot deduct more than the basis in the partnership interest under §704(d). At-risk is next. Section 465(c)(1) lists exploring for or exploiting oil and gas reserves as an activity it covers, so the loss is limited to what you have at risk. Cash you contribute counts. Nonrecourse financing generally does not.
The excess business loss limit in §461(l) is last, and it is the one most promoters leave out. It caps the net business loss that can offset wages, interest and other non-business income at $512,000 on a 2026 joint return and $256,000 for other filers. Scale the couple's check above to $800,000, paid in cash, and IDC becomes $600,000. Drilling starts in February 2027, inside the 90-day window, so the IDC still counts in 2026. The equipment is placed in service and depreciated in 2027. In 2026 they clear basis and at-risk, skip the passive rules, and hit the cap. $512,000 offsets wages in 2026, and the cap pushes the other $88,000 forward as a net operating loss, which can offset up to 80% of taxable income in a later year.
Once the well produces, you recover the lease cost through depletion. Independent producers and royalty owners can use percentage depletion under §613A(c): 15% of gross income from the property, on up to 1,000 barrels a day of average oil production or an elected gas equivalent. That allowance is shared with your spouse and minor children. If you qualify, you take the larger of cost depletion or percentage depletion each year. Everyone else gets cost depletion only.
Two limits apply. Depletion on a property cannot exceed 100% of your taxable income from that property under §613(a), and total percentage depletion cannot exceed 65% of your overall taxable income under §613A(d)(1). Depletion the 65% limit blocks carries over to the next year.
Percentage depletion is not capped by what you paid for the lease. Cost depletion stops once the lease cost is recovered. The 15% keeps coming for as long as the well produces income. Retailers and refiners above set sizes cannot use percentage depletion at all.
Section 1254 recaptures the IDC you deducted, plus depletion that reduced your basis, as ordinary income when you sell the interest. The recaptured amount is the lesser of those deductions or your gain. If the couple above sells their interest at a gain of $150,000 or more, $150,000 of that gain is taxed at ordinary rates, not capital gain rates.
That makes the deduction a timing benefit for anyone who plans to sell. Model the exit before you invest, the same way you model the drilling year.
An LLC limits liability under state law, so the working interest becomes passive and the loss stops offsetting wages.
A dry hole is fully deductible, and at a 35% bracket you still lose about 65 cents of every dollar of IDC you put in.
Above $512,000 of net business loss on a joint return, the excess becomes a net operating loss for later years.
A December payment only counts for the year paid if drilling starts by the 90th day after year-end.
Section 57(a)(2)(E) switches off the IDC preference for anyone who is not an integrated oil company, though that relief cannot cut alternative minimum taxable income by more than 40%. Very large checks relative to income can reach that limit.
Recapture under §1254 turns the deducted IDC into ordinary income on a sale.
We model the deal before you sign. We work out which of the four limits binds for you, what the deduction is worth at your bracket and what recapture looks like on a sale, then prepare the return from the program's K-1. Bring the program's budget, the offering memo and your last two returns.
Book a callThis guide is general information, not tax advice for your situation. Outcomes depend on your facts and on current law, which changes. Figures are federal and current as of November 2026.