Tax Advantages of Oil and Gas Drilling
In light of the fact that oil and natural gas from domestic reserves helps to make our country less dependent on foreign imports, Congress has provided tax incentives to encourage domestic natural gas and oil production financed by private sources. Few investments can offer the outstanding tax benefits and incentives that participants in a natural gas well drilling program enjoy. If it is structured properly and the economics are viable, an investment in an oil and gas drilling program can be your most advantageous single-year tax advantaged investment. The information provided in this section is designed to give interested parties a basic understanding of the tax benefits that may be available by directly participating in an oil and gas drilling venture. Interested parties should consult their Tax Professional or Financial Advisor in regard to their personal tax situation and how participating in such a venture will affect it.
Intangible Drilling Cost Tax Deduction (IDC)
The immediate deduction of intangible drilling and completion costs (labor, rig time, chemicals, etc.) are considered the most significant tax benefit. The IDCs are service and labor related expenses that account for 75%-85% of well costs. These costs may be business expensed and deducted in the year of investment (75% to 85% of the participants contribution) thus decreasing your federal and possibly self-employment, state and local income tax basis. (See section 263 of the tax code)
Tangible Drilling Cost Tax Deduction
Tangible drilling costs are the expenses incurred for salvageable equipment used on the well. This is the remaining 25 to 15% of your contribution. As opposed to materials and services that offer no salvage value, equipment used in completion and production of a well that is salvageable may be deducted as depreciation over a 7 year period utilizing the Modified Accelerated Cost Recovery System or MACRS.(See section 263 of the tax code)
Depletion Allowance
After the well is producing, you are allowed to shelter a percentage of your gross production income through the percentage depletion allowance afforded small companies and individuals under the small producer tax exemption. The depletion allowance will vary by year but under current tax codes it will not be less than 15% of your gross production revenue. Percentage depletion can shelter a portion of you well income indefinitely, even after the full amount of investment has been recovered.
Active vs. Passive Income
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 or capital gains.(See Section 469(c)(3) of the Tax Code)