Oil and Gas Tax Deductions
Start your investing journey by understanding and evaluating your current financial situation. As an accredited investor, you can enjoy attractive tax advantages through oil and gas investment tax benefits and deductions. Below, we outline key oil and gas tax benefits that can significantly impact oil and gas drilling and exploration for investors.
Note: The information provided below is for educational purposes only and does not constitute tax advice. We recommend all investors consult with their own tax professional to ensure their investment decisions comply with current tax laws. Individual financial situations vary, and professional advice tailored to your situation is essential. Oil and gas investments tax deductions may differ by investor.
Tax Deductions for Oil & Gas Investments - The basics
■ Intangible Drilling Cost (IDC) Tax Deduction
Oil and gas projects require substantial labor, services, and non-salvageable materials, resulting in a significant portion of expenditures being classified as Intangible Drilling Cost (IDC). These cost are 100% deductible in the first year. For instance, a $100,000 capital expenditure could yield approximately $70,000 in IDC deductions. Even if drilling does not start until March 31st of the year following the contribution of capital. The remaining $30,000 of tangible costs may be depreciated over a 7-year period. (See Section 263 of the Tax Code).
■ Depreciation Tax Deduction
Unlike non-salvageable services and materials, equipment and other tangible items used in well completion and production are typically salvageable. Subsequently, these items depreciate over 7 years using methods like Straight-line or MACRS. Examples include casing, tanks, well head, and pumping units. Such equipment and tangible expenses usually constitute 20-40% of total well costs.
■ Small Producer’s Tax Exemption- Depletion Allowance
The 1990 Tax Act granted special oil and gas investment tax benefits to small producers for oil and gas drilling projects. Once wells are producing, investors can shelter some of the gross income from oil and gas sales through depletion deductions. This incentive, the “Percentage Depletion Allowance,” aims to promote participation in oil and gas drilling.
In Fact, large oil companies, taxpayers selling oil or gas through retail outlets, or those refining crude oil with runs exceeding 50,000 barrels per day cannot benefit from this tax advantage. Entities with over 1,000 barrels of oil (or 6,000,000 cubic feet of gas) average daily production are also ineligible.
Thankfully, “Small Producers Exemptions” permit 15% of gross Working Interest income from oil and producing property to be tax-free. (See section 613A of the Tax Code)
Tax Deductions for Oil & Gas Investments - How and Why
■ Concretional Incentives
Developing domestic oil and natural gas makes our country more energy self-sufficient by reducing our dependence on foreign imports. To support this, Congress provides oil and gas investment tax benefits, stimulating domestic production financed by private sources. Natural gas and oil drilling projects offer numerous tax advantages. enhancing their overall economic viability.
■ Active, or Non-passive vs. Passive Income
The Tax Reform Act of 1986 added the concepts of “Passive” and “Active” income to the Tax Code. It prohibits offsetting losses from Passive activities against Active business income. However, the new Tax Code clarifies that Working Interest in an oil and gas well is not a “Passive” activity. Therefore, deductions can offset income from active stock trades, business income, salaries, etc. (See Section 469(c)(3) of the Tax Code).
■ Alternative Minimum Tax (AMT)
Prior to 1992, Working Interest participants or “Independent Producers” in oil and gas ventures faced the Alternative Minimum Tax. Congress provided tax relief through the 1992 Tax Act, exempting Intangible Drilling Costs as a tax Preference Item. While AMT taxation still applies to excess IDCs, the consideration of percentage or statutory depletion as a preference item has ceased.
“Alternative Minimum Taxable Income” generally consists of adjusted gross income, minus allowable Alternative Minimum Tax itemized deduction, plus the sum of tax preference items and adjustments. “Tax preference items” are preferences existing in the Code to greatly reduce or eliminate regular income tax deductions. Included within this group are deductions for excess Intangible Drilling and Development Costs and the deduction for depletion allowable for a taxable year over the adjusted basis in the Drilling Acreage and the wells thereon (Standard Cost Depletion).
**An Independent Producer also called Small Producer, also known as small producer, produces 1,000 barrels (or 6,000,000 cubic feet of gas) per day or les
Simplified Example of First Year Oil and Gas Tax Deductions
The Intangible Drilling Cost (IDC) deductions and the depreciation of tangible equipment on a typical oil or natural gas well allow a large income tax deduction of the investment (usually 65% to 80%) for the first year of activity. The tax consequences for a $100,000 capital expenditure can be approximated as follows:
| Intangible Costs | |
|---|---|
| Capital Contribution | $100,000 |
| Intangible Drilling Costs | x 65% |
| Intangible Expenses Deduction | $65,000 |
| Tangible Costs | |
|---|---|
| Capital Contribution | $100,000 |
| Tangible Equipment Costs | x 35% |
| $35,000 | |
| Depreciated over 7 years | ÷ 7 |
| First year Tangible Depreciation Deduction | $5,000 |
First year reduction in Taxable Income $70,000
What Does $70,000 of 1st Year Deductions Actually Mean?
A Virginia Accredited Investor getting $70,000 of additional deductions would realize an incredible in-pocket tax credit of up to nearly $30,000. 100% free and clear.
The potential for a $70,000 tax deduction could deliver a huge 1st year after-tax yield of up to 34.2%. That’s up to $34,200 of tax-free income.
Tax Considerations - The Big Picture
Investment in the oil and gas industry provides very significant tax advantages for the Small Producer. Although the Tax \ Reform Act of 1986 eliminated many traditional “tax shelters,” the tax advantages associated with participation in domestic drilling programs remained in place. A properly structured program can provide excellent means of stretching one’s investment dollar.
The immediate deduction of Intangible Drilling Costs (IDCs) alone holds significant importance. Taking this upfront oil and gas investment tax deduction effectively subsidizes risk capital by reducing federal and possibly state income tax for participants. This creates a tax shelter benefiting high-income earners.
Small Producers of oil and gas can access various deductions. In total, COGJV investors benefit from approximately 180%* of their initial capital investment in deductions, with about 80% of distributed earnings thereafter being tax-free.
The generous tax deductions linked to oil and gas investing offer the greatest benefit: potentially huge increases in realized profits. An Accredited Investor could see COGJV after-tax annual yields increase by up to 76.8% with tax avoidance credits factored in!
*Including the new 20% Qualified Business Income (QBI) for pass-through income that starts in tax year 2018.
Tax Benefits for the Small Producer - A Recap
In a successful oil and gas investment, the IRS permits a tax write-off of approximately 65% – 80% from taxable earned income in the year of investment. The remaining amount is depreciated over seven years.
Even in an unsuccessful oil and gas investment, the IRS allows investors to write off almost 100% of the investment against taxable earned income, unlike stock investments where only a small portion of the loss may be written off (subject to limitations).
The IRS currently allows individuals to derive “tax-free” 15% of their gross Working Interest income from the sale of oil and/or gas (known as a “depletion allowance”)
Investment in oil and gas exploration and/or field enhancement has the potential to lower one’s taxable income bracket in the following ways:
Investors can deduct 65% to 80% of their initial investment as “Intangible Drilling Costs” (IDCs) from their income in the year of investment, subject to certain limitations. (refer to pages 28-29 in IRS publication 535, catalog 15065z)
About 20% to 35% of one’s investment amount is allocated to “Tangible Drilling and Completion Costs” (TDCs) and can be deducted from income over a 7-year period.
Lease operating expenses (LOE) cover the day-to-day costs of operating a well, including re-entry or re-work expenses. These expenses are typically deductible in the year they are incurred, with no AMT consequences.
Small Producers earn oil and gas income subject to the 15% statutory depletion allowance.
