Oil & Gas Investing Tax Advantages
The tax benefits generated in oil and/or natural gas are substantial. The immediate deduction of the IDC is very significant, and by taking this up front deduction, the risk capital is effectively subsidized by the government by reducing the Federal, and possibly State income tax. The following information outlines some of the tax advantages of Oil & Gas Investing. Each individual should consult with their tax advisor to maximize their tax advantages of oil and natural gas.
Intangible Drilling Cost Tax Deduction (IDC)
Intangible costs associated with drilling such as contract driller, well stimulation and treatment, etc. are typically about 65 to 80% of the cost of a well. For tax purposes, these expenditures are considered Intangible Drilling Costs, which are 100% deductible during the first year. For example, a $50,000 investment would yield up to $37,500 in tax deductions during the first year of the venture. These deductions are available in the year the money was invested, even if the well does not start drilling until March 31 of the year following the contribution of capital.
Tangible Drilling Cost Tax Deduction (TDC)
The total amount of the investment allocated to the Tangible Drilling Costs such as casing, wellhead, pipeline, equipment and stock tanks is 100% tax deductible. Tangible Drilling Costs may be deducted as depreciation over a seven-year period.
Active vs. Passive Income
The Tax Reform Act of 1986 introduced into the Tax Code the concepts of “Passive” income and “Active” income. The Act prohibits the offsetting of losses from Passive activities against income from Active businesses. The Tax Code specifically states that a Working Interest in an oil and gas well is not a “Passive” Activity, therefore, deductions can be offset against income from active stock trades, business income, salaries, etc.
Small Producers Tax Exemption
The 1990 Tax Act provides a special tax advantage for small companies and individuals. This tax incentive, known as the Percentage Depletion Allowance, is specifically intended to encourage participation in oil and gas drilling. This tax benefit is not available to large oil companies, retail petroleum marketers, or refiners that process more than 50,000 barrels per day. It is also not available for entities owning more than 1,000 barrels of oil (or 6,000,000 cubic feet of gas) average daily production. The “Small Producers Exemption” allows 15% of the Gross Income (not Net Income) from an oil and gas producing property to be tax-free.
Lease costs (purchase of leases, minerals, etc.), sales expenses, legal expenses, administrative accounting, and Lease Operating Costs (LOC) are also 100% tax deductible through cost depletion.
Alternative Minimum Tax
Prior to the 1992 Tax Act, working interest participants in oil and gas ventures were subject to the normal Alternative Minimum Tax to the extent that this tax exceeded their regular tax. This Tax Act specifically exempted Intangible Drilling Cost as a Tax Preference Item. “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 taxation. 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.