Too Good to Be True? Unique Tax Aspects of the Oil and Gas Industry
This “have your cake and eat it too” result can be accomplished with the right type of investment and proper planning.
Drilling Costs can be written off against active income in the year they are incurred. Here is how it works:
- Intangible Drilling Costs: These costs include everything but the actual drilling equipment. Labor, supplies, chemicals, mud, grease and other miscellaneous items necessary for drilling are considered intangible. These expenses generally constitute up to 80% of the total cost of drilling a well and are 100% deductible in the year incurred. For example, if an investor contributed $100,000 to drill a well, and if it were determined that 75% of that cost would be considered intangible, the investor would receive a current year deduction of $75,000. Furthermore, it doesn’t matter whether the well actually produces or even strikes oil. As long as it starts to operate by March 15 of the following year, the deductions are allowed.
- Tangible Drilling Costs: Tangible costs pertain to the direct cost of the drilling equipment itself, i.e., the drilling rig, motors, tanks, etc. These expenses are also 100% deductible, and will be depreciated over seven years. Therefore, in the example above, the remaining $25,000 could be written off according to a seven-year schedule.
- Active vs. Passive Income: The tax code specifies that a working interest (as opposed to a royalty interest) in an oil and gas well is not considered to be a passive activity. This means that all net losses are active income incurred in conjunction with well-head production and can be offset against other forms of income, such as wages, interest, capital gains, etc. This is significant because high net worth investors frequently have more passive write offs but higher active income; therefore, many deductions are never utilized. Not so in oil and gas investing.
There are numerous issues to consider before adopting this type of structure that are not addressed here. This article is intended merely to demonstrate that proper planning can make major differences in outcomes when it comes to income taxation of oil and gas operations. For More In Depth information Click Here