The recent plunge in the price of oil has hurt many stock portfolios. Yet, as with most market corrections, some people see great opportunity going forward, while others see portfolio pain.
As an accountant I cannot provide investment advice and thus will not state my opinion on where I see the price of oil going. However, I can provide income tax planning advice, and today I give you two tax planning considerations in relation to the price of oil.
The first tax planning consideration is whether or not you should sell some of your oil and oil related stocks to realize a capital loss. Any decision to sell should not be a tax loss tail wagging the dog decision, but based on a considered investment decision by you and/or your investment advisor.
If you decide it is prudent to sell some or your oil stocks to realize a capital loss (whether today or later in the year), you can use that loss against any capital gains you realize in 2015, or carry the loss back up to three years. I have a very detailed discussion of how to use capital losses in my blog “Tax-Loss Selling”.
A second, less obvious consideration, is the use of a flow-through limited partnership (“flow-through”). I had not really put my mind to this alternative until a client recently told me that they felt that the price of oil was at a bottom, or near a bottom, and was there anything they could do if they were willing to wait up to two years for a rebound. Once they said two years, a light bulb went on in my brain, as most flow-throughs must be held approximately two years until they convert to publicly sale-able stocks.
Before I get into the details, I think a quick primer on flow-throughs would be useful.
An oil and gas flow-through, in very simple terms, is a limited partnership that invests in shares issued in a variety of junior oil and gas companies. The essence of this type of investment is that the partnership vehicle provides for the various oil and gas exploration deductions to “flow-through” to individual investors.
In simple terms, if you pay $10,000 for a unit of an oil and gas flow-through that is exploration based (development based flow-throughs will have lower deductions allocated), you will receive approximately $10,000 in income tax deductions that can be utilized in your personal income tax return. Most of the deductions are in year one and the remaining in year two. Assuming you are in the highest marginal tax rate, you would save almost $5,000 in taxes making your out-of-pocket cost $5,000 after claiming the flow-through deductions.
Most limited partnerships are subsequently rolled on a tax-deferred basis into a mutual fund that can be sold on the market within two years. Carrying on with our example, let’s say that in two years the limited partnership is rolled into ABC Mutual Fund and you immediately sell your unit for $10,000. The cost base of the investment is reduced to zero because of the deductions noted above, so you would owe capital gains tax of approximately $2,500 at the highest marginal tax rate ($10,000 gain x 25%). Your after-tax return on your investment would be $2,500 ($10,000 proceeds on the sale of your mutual fund, less $2,5000 tax + $5,000 tax savings − $10,000 initial cost). Flow-throughs provide some downside protection for your investment risk, as you would break even in this case in two years if you could sell your shares/mutual fund units for approximately $6,700. If you have capital loss carryforwards you do not expect to use, the flow-through becomes even more attractive as the capital gain can be offset by your capital loss carryforwards.
Of course, you and/or your advisor may feel it more prudent to purchase oil stocks or oil ETFs in lieu of a flow-through. I am just providing a tax option, not an investment opinion.
Back to my client’s original question. Since they believe the price of oil is at, or near a low, and they are willing to hold their investment for at least two years, a flow-through can be very effective in two ways. First, they will receive the income tax deductions resulting in current tax savings. Second , if they are correct in their assessment on the current and future price of oil (again, this is their thought, not my opinion) and say the partnership value grows to $15,000 within two years and they sell when the flow-through is converted to a mutual fund; using the $10,000 original purchase price from above, they will realize an after-tax return of $6,250 on their $10,000 investment ($15,000 proceeds on the sale of the fund, less $3,750 tax plus the tax savings of $5,000, less $10,000 initial cost).
To re-iterate; I have just set forth a tax planning option if you and/or your advisor feel it is a good time to purchase oil stocks. This is first and foremost an investment decision and I provide no guidance on such.
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As an accountant I cannot provide investment advice and thus will not state my opinion on where I see the price of oil going. However, I can provide income tax planning advice, and today I give you two tax planning considerations in relation to the price of oil.
Tax-Loss Selling
The first tax planning consideration is whether or not you should sell some of your oil and oil related stocks to realize a capital loss. Any decision to sell should not be a tax loss tail wagging the dog decision, but based on a considered investment decision by you and/or your investment advisor.
If you decide it is prudent to sell some or your oil stocks to realize a capital loss (whether today or later in the year), you can use that loss against any capital gains you realize in 2015, or carry the loss back up to three years. I have a very detailed discussion of how to use capital losses in my blog “Tax-Loss Selling”.
Flow-Through Limited Partnership
A second, less obvious consideration, is the use of a flow-through limited partnership (“flow-through”). I had not really put my mind to this alternative until a client recently told me that they felt that the price of oil was at a bottom, or near a bottom, and was there anything they could do if they were willing to wait up to two years for a rebound. Once they said two years, a light bulb went on in my brain, as most flow-throughs must be held approximately two years until they convert to publicly sale-able stocks.
Before I get into the details, I think a quick primer on flow-throughs would be useful.
What is a Flow-Through?
An oil and gas flow-through, in very simple terms, is a limited partnership that invests in shares issued in a variety of junior oil and gas companies. The essence of this type of investment is that the partnership vehicle provides for the various oil and gas exploration deductions to “flow-through” to individual investors.
In simple terms, if you pay $10,000 for a unit of an oil and gas flow-through that is exploration based (development based flow-throughs will have lower deductions allocated), you will receive approximately $10,000 in income tax deductions that can be utilized in your personal income tax return. Most of the deductions are in year one and the remaining in year two. Assuming you are in the highest marginal tax rate, you would save almost $5,000 in taxes making your out-of-pocket cost $5,000 after claiming the flow-through deductions.
Most limited partnerships are subsequently rolled on a tax-deferred basis into a mutual fund that can be sold on the market within two years. Carrying on with our example, let’s say that in two years the limited partnership is rolled into ABC Mutual Fund and you immediately sell your unit for $10,000. The cost base of the investment is reduced to zero because of the deductions noted above, so you would owe capital gains tax of approximately $2,500 at the highest marginal tax rate ($10,000 gain x 25%). Your after-tax return on your investment would be $2,500 ($10,000 proceeds on the sale of your mutual fund, less $2,5000 tax + $5,000 tax savings − $10,000 initial cost). Flow-throughs provide some downside protection for your investment risk, as you would break even in this case in two years if you could sell your shares/mutual fund units for approximately $6,700. If you have capital loss carryforwards you do not expect to use, the flow-through becomes even more attractive as the capital gain can be offset by your capital loss carryforwards.
Of course, you and/or your advisor may feel it more prudent to purchase oil stocks or oil ETFs in lieu of a flow-through. I am just providing a tax option, not an investment opinion.
Back to my client’s original question. Since they believe the price of oil is at, or near a low, and they are willing to hold their investment for at least two years, a flow-through can be very effective in two ways. First, they will receive the income tax deductions resulting in current tax savings. Second , if they are correct in their assessment on the current and future price of oil (again, this is their thought, not my opinion) and say the partnership value grows to $15,000 within two years and they sell when the flow-through is converted to a mutual fund; using the $10,000 original purchase price from above, they will realize an after-tax return of $6,250 on their $10,000 investment ($15,000 proceeds on the sale of the fund, less $3,750 tax plus the tax savings of $5,000, less $10,000 initial cost).
To re-iterate; I have just set forth a tax planning option if you and/or your advisor feel it is a good time to purchase oil stocks. This is first and foremost an investment decision and I provide no guidance on such.
This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.
