Tax Advantages for Oil and Gas Investing
The type of tax benefit allowed when investing in oil depends on many things, but the most generous tax incentives are reserved for those accredited investors who invest in the
development and production of oil and gas wells as joint owners.
An investor who supports the early process of striking oil receives benefits in various forms. The first main benefit is that of intangible drilling costs, which include everything but the actual drilling equipment. Any items necessary for the drilling process such as label, chemicals, and grease constitute as intangible costs, which typically amount to up to 80% of drilling a well. The great news: these costs are 100% deductible within the year incurred and the deduction is still valid regardless of whether the well strikes oil or not.
Tangible drilling costs are covered as well, which is the cost of the drilling equipment needed for the well itself. Although these costs are 100% deductible, they are not applied
within the yearly schedule as intangible costs are. Tangible drilling costs must be depreciated over a seven year period. Nonetheless, it is still a strong tax advantage that wealthy investors should appreciate.
There are several other benefits of oil and gas investing. Small producers and investors receive tax exemptions in the form of a depletion allowance, available to those that refine
less than 50,000 barrels of oil each day. Lease costs are 100% deductible within the year incurred, as are intangible drilling costs, and any excess intangible drilling cost are coded as a “preference item” which is exempt on the alternative minimum tax return.
One of the most significant advantages for oil and gas investors is the tax benefits available. The United States is motivated to reduce its reliance on foreign oil supplies by increasing domestic production, for political and economic reasons. Since most of the foreign oil supplies we obtain come from an area of the world that is typically unstable, finding different sources can lead to stabilization of the U.S. economy. To encourage additional domestic production, investment is required, and Congress has created a large number of incentives to encourage investors to take the risk. The tax advantages from investing in oil and gas are additional to the potential revenue generated by the investment. Certain types of investments, such as direct participation programs, offer the most significant benefits.
Intangible Drilling Costs
The intangible expenditures of drilling (labor, chemicals, grease, etc.) are usually about (65 to 80%) of the cost of a well. These expenditures are 100% deductible during the first year. (See Section 263 – Capital Expenditures – of the Tax Code.)
Tangible Drilling Cost Tax Deduction
The total amount of the investment allocated to the equipment is 100% tax deductible. Tangible costs may be deducted as depreciation over a seven‐year period. (See Section 263 of the Tax Code.)
Congressional incentives encourage domestic petroleum development. Congress has provided tax incentives to stimulate domestic natural gas and oil production. Several tax credits in relation to oil or natural gas production. The Enhanced Oil Recovery Credit is applied to certain project costs incurred to enhance a well’s oil or natural gas production. This credit is up to 15% of the costs incurred to enhance production. (See Section 263 of the Tax Code.)
Small Producers Tax Exemption
The “Small Producers Exemption,” or percentage depletion deduction, allows 15% of the Gross Income (not Net Income) from an oil and gas producing property to be tax‐free. Additionally, in the case of marginally producing wells, using an IRS table for referenced prices of oil and gas, the deduction can be as high as 25% of gross well income.
Lease costs sales expenses, legal expenses, administrative accounting, and Lease Operating Costs are 100% tax deductible through cost depletion.
Active vs. Passive Income
The Tax Code specifically states that a Working Interest in an oil and gas well is not a “Passive” Activity, which allows deductions for the cost of developing the well to be offset against income from active stock trades, business income, and salaries.
Geological & Geophysical Deduction
Historically, there were specific costs incurred for geological or geophysical analysis that were not deductible, but congressional legislation changed that and these costs are now deductible over a 24‐month period.