Tax Advantages of Oil and Gas Investing
As a joint venture participant, each partner benefits from the tax deductions available for oil and gas drilling including intangible drilling costs, depreciation, operating costs, and percentage depletion. Structured properly, partners may offset their taxable income gained from other sources with the substantial deductions available from investing in oil and gas wells.
Overview
Domestic production of oil and natural gas is an essential part of our nation's energy supply. Domestic production reduces our dependence on foreign imports, providing a measure of stability against fluctuations in the global energy market. To promote U.S. oil and gas drilling, Congress has provided tax incentives for investment in oil and gas exploration. As large oil companies move their operations abroad, these tax incentives are providing a necessary economic advantage that encourages an increase in drilling activity.
Intangible Drilling Costs
Intangible Drilling Costs (IDCs) are drilling expenditures related to expenses such as labor, fuel, chemicals, hauling, etc. IDCs usually represent 70% to 85% of the cost of a well and are eligible for the election to be deducted 100% against taxable income in the first year. For example, investing $50,000 in a project that had 85% of its costs in IDC's would mean the investor can deduct $42,500 from their taxable income for that year. In a top 39.6% federal tax bracket for individuals, that deduction would save approximately $14,875 in federal income taxes for that tax year. To encourage expenditures for oil and gas drilling, IRS code section 461 has a special provision that allows IDC's paid before 12/31 of any given tax year to still be deducted in such tax year provided the drilling of the well commences before the close of the 90th day after the close of the taxable year and other certain conditions are met as per the regulations.
Tangible Drilling Costs
The costs of oil and gas drilling equipment such as casing, pump jacks, and wellheads are Tangible Drilling Costs (TDCs). Continuing with the example above, the remaining $7,500 (15% of the cost of the well) would be TDCs. These costs are capitalized and depreciated over a period of seven years.
Depletion Deductions
When a producing well is drilled, the venture can recover the capitalization cost of the oil and gas property through depletion deductions. There are two ways to calculate the allowable depletion deduction: the cost depletion method and the percentage depletion method - and the taxpayer may take a deduction for the greater of the two.
Cost depletion is computed on the basis of initial capitalization costs. Over the life of the well, a portion of these costs can be recovered each year based on the percentage of the production for the year as compared to the estimated recoverable oil and gas reserves at the beginning of the year.
Percentage depletion is computed on the basis of the income from the property rather than capitalization costs. The tax shelter provided by percentage depletion may result in a larger deduction than cost depletion. Percentage depletion allows a tax deduction equal to 15% of the gross revenue from and oil or gas producing property. This deduction is limited to 100% of the net income of the property. Also called the "Small Producers Exemption," this provision is generally only available to independent producers and royalty owners. Percentage depletion applies to producing oil and gas wells with average daily production less than 1,000 barrels of oil or 6,000,000 cubic feet of gas. The tax shelter provided by the percentage depletion allowance endures for as long as the well produces.
THERE ARE SIGNIFICANT RISKS ASSOCIATED WITH INVESTING IN OIL AND GAS VENTURES. THE ABOVE INFORMATION IS FOR GENERAL PURPOSES ONLY AND IS NOT A SOLICITATION TO BUY OR AN OFFER TO SELL ANY SECURITIES. ANY SUCH SOLICITATION OR OFFER WILL ONLY BE MADE THROUGH A PRIVATE PLACEMENT MEMORANDUM ACCOMPLISHED IN ACCORDANCE WITH SEC REGULATION D, RULE 506. IN ADDITION, THE AFOREMENTIONED GENERAL INFORMATION IS NOT INTENTED TO BE INDIVIDUAL TAX ADVICE. CONSULT YOUR PERSONAL TAX ADVISOR CONCERNING THE CURRENT TAX LAWS AND THEIR APPLICABILITY AND EFFECT ON YOUR PERSONAL TAX SITUATION.