How does the working interest exception work?
Depends on how the interest is held
IRC §469(c)(3)(A) says a working interest in an oil or gas property is not a passive activity if you hold it directly or through an entity that does not limit your liability, regardless of participation. Losses can then offset nonpassive income, subject to basis, the §465 at-risk rules, and the 2026 excess business loss limit. Under §469(c)(3)(B), later net income from the interest is also treated as nonpassive.
Reviewed by Ebot Mbi, CPA, EA · Last reviewed · Law and figures current as of September 17, 2026
Key takeaways
- The exception depends on unlimited liability for the interest, not on hours worked.
- Insurance, indemnity, and stop-loss arrangements do not count as limiting liability.
- Interests held as a limited partner or LLC member are passive unless you materially participate.
- Losses remain subject to basis, at-risk, and excess business loss limits.
- Once losses are treated as nonpassive, later income from the same interest is nonpassive too.
What it is
A working interest is an interest in an oil or gas property that bears the costs of exploring, developing, and operating it. Royalty interests, by contrast, share in production without bearing costs.
Normally, losses from a business you do not materially participate in are passive and can offset only passive income. Congress carved out working interests held with unlimited liability, reflecting the financial exposure the owner accepts.
Many drilling programs offer investors a choice between general partner units, which carry unlimited liability and can qualify for the exception, and limited partner units, which do not. Some programs convert general partner units to limited partner units after the drilling phase.
What the law says
IRC §469(c)(3)(A) provides that a passive activity does not include any working interest in any oil or gas property that the taxpayer holds directly or through an entity that does not limit the taxpayer's liability with respect to the interest. Treasury regulations define working interest, and Temp. Treas. Reg. §1.469-1T(e)(4)(v) provides that protection against loss through indemnification, stop-loss arrangements, insurance, or similar arrangements is not taken into account in deciding whether liability is limited.
IRC §469(c)(3)(B) provides that if a loss from a working interest is treated as nonpassive for any year, net income from that property in later years is also treated as nonpassive. The exception does not override the at-risk rules of §465 or the excess business loss limit of §461(l).
Requirements and tests
For the exception to apply:
- You hold a working interest that bears a share of costs, not a royalty or net profits interest.
- You hold it directly, as a general partner, or through another entity that does not limit your liability for the interest.
- Converting the interest to a limited-liability form later does not change the nonpassive character of later income from the property under §469(c)(3)(B).
- If the interest is held through a limited partnership interest, an LLC, or an S corporation, the exception does not apply, and the loss is passive unless you materially participate.
- Losses are allowed only to the extent of basis and amounts at risk.
- For 2026, noncorporate net business losses above $256,000 ($512,000 joint) are carried forward under §461(l).
How it works
If the exception applies, your share of the working interest's loss, often driven by intangible drilling costs, is nonpassive and can offset wages, interest, and other nonpassive income, after the at-risk and excess business loss limits. If the exception does not apply and you do not materially participate, the loss is suspended until you have passive income or dispose of the activity.
Unlimited liability is a real cost: you can be responsible for your share of the operator's obligations, including cost overruns, environmental cleanup, and plugging and abandonment, beyond your initial investment.
Before investing, read the program documents to confirm how the interest is held, what liability you accept, and whether any conversion is planned. The at-risk rules require that you be personally liable for any borrowed amounts counted as at risk, and nonrecourse financing generally does not count.
Because income from the property is nonpassive after a nonpassive loss year, that income cannot be used to absorb passive losses from other activities.
Assumptions: Tax year 2026; each investor is married filing jointly with W-2 wages of $250,000, the $32,200 standard deduction, and no other income.; Each has a $40,000 share of loss from the same well; both are fully at risk and below the $512,000 §461(l) threshold.; Investor A holds a general partner interest in the drilling partnership, which does not limit liability.; Investor B holds a limited partner interest, does not materially participate, and has no passive income.; 2026 joint brackets from Rev. Proc. 2025-32.
| Investor A: taxable income without / with the loss | $217,800 / $177,800 |
|---|---|
| Investor A: 2026 federal tax reduction | $8,928 |
| Investor B: loss allowed in 2026 | $0 (suspended) |
| Investor B: 2026 federal tax reduction | $0 |
| Investor A: later net income from the well | Nonpassive under §469(c)(3)(B) |
Investor A's loss reduces 2026 federal tax by $8,928, while Investor B's identical loss is suspended until passive income or a disposition.
Illustration only; not a projection of your results.
Risks and IRS scrutiny
The IRS reviews how the interest is held, the program documents, whether liability is actually limited, at-risk amounts, and any conversion of interests. Programs marketed for their tax results receive particular scrutiny. Misapplying the exception results in suspended losses, additional tax, interest, and accuracy-related penalties.
Examiners may also ask whether an investor who converted a general partner interest to a limited one correctly treated later income as nonpassive under §469(c)(3)(B).
Who it is not for
The exception is not available to royalty owners, limited partners, or LLC members who do not materially participate. It is also not a fit for anyone unwilling to accept unlimited liability for the property's obligations.
Investors who hold their interest through an S corporation or a limited liability company for asset protection should expect passive treatment unless they materially participate, and should weigh that trade-off with their advisers.
How ebotCPA helps
We review how the interest is titled and documented, test the at-risk and excess business loss limits, and project how the §469(c)(3)(B) income rule will affect later years. We coordinate with your attorney, who drafts the legal documents.
Book a $497 Case Analysis to have Ebot Mbi, CPA, EA review your facts before you act.
We coordinate with your attorney, who drafts the legal documents.
Frequently asked questions
Is an oil and gas working interest a passive activity?
Not if you hold it directly or through an entity that does not limit your liability, under IRC §469(c)(3)(A), regardless of participation.
Does holding a working interest through an LLC keep the exception?
No. An LLC limits liability, so the loss is passive unless you materially participate.
Can working interest losses offset my salary?
They can if the exception applies, but only within your basis, at-risk amount, and the 2026 excess business loss limit.
Does insurance limit my liability for this test?
No. Temp. Treas. Reg. §1.469-1T(e)(4)(v) disregards insurance, indemnity, and stop-loss arrangements.
Have facts like these?
Book a $497 Case Analysis to have Ebot Mbi, CPA, EA review your facts before you act.