Oil & Gas Tax Benefits
The main tax benefits of investing in oil include:
•Intangible Drilling Costs: These include everything but the actual drilling equipment.
Labor, chemicals, mud, grease and other miscellaneous items necessary for drilling are
considered intangible. These expenses generally constitute 65-90% of the total cost of
drilling a well and are 100% deductible in the year incurred. For example, if it costs
$300,000 to drill a well, and if it was determined that 75% of that cost would be considered
intangible, the investor would receive a current deduction of $225,000. Furthermore, it
doesn’t matter whether the well actually produces or even strikes oil. As long as it starts to
operate by March 31 of the following year, the deductions will be allowed.
•Tangible Drilling Costs: Tangible costs pertain to the actual direct cost of the drilling
equipment. These expenses are also 100% deductible but must be depreciated over seven
years. Therefore, in the example above, the remaining $75,000 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 and
capital gains.
•Small Producer Tax Exemptions: This is perhaps the most enticing tax break for small
producers and investors. This incentive, which is commonly known as the “depletion
allowance,” excludes 15% of all gross income from oil and gas wells from taxation. This
special advantage is limited solely to small companies and investors. Any company that
produces or refines more than 50,000 barrels of oil per day is ineligible. Entities that own
more than 1,000 barrels of oil per day, or 6 million cubic feet of gas per day, are excluded as
well.
•Lease Costs: These include the purchase of lease and mineral rights, lease operating
costs and all administrative, legal and accounting expenses. These expenses must be
capitalized and deducted over the life of the lease via the depletion allowance.
•Alternative Minimum Tax: All excess intangible drilling costs have been specifically
exempted as a “preference item” on the alternative minimum tax return.