Tax Advantages for Gas &Oil Investments

The U.S. Federal Government, realizing that it desperately needed to encourage domestic oil and gas exploration in an effort to reduce our dependence on foreign supplies, passed the Tax Reform Act of 1986. With the passage of this act, oil and gas drilling programs are now one of the most tax-advantaged investments. The Act specifically exempts oil and gas working interest from being classified as “passive income.”  Thus, all deductions can be used to offset “active” or “ordinary” income. Generally, there are two areas that are immediately deductible in the first year, listed below:

Intangible Drilling and Development Cost (IDC’s):
IDC’s are the costs of labor, fuel, repair, geology and engineering work, roadways, rock, geophysical logging, testing, hauling, supplies, etc., incident to and necessary for the drilling and preparation of wells for the production of oil and gas, including work done by contractors under any form of contract and including the drilling of a well by turnkey contract. The IDC does not include the pipe and equipment that becomes part of the well.  The IDC’s generally run between 70% and 80% for oil wells and 90% for gas wells of the total investment.

Example A:
An investment in an oil and gas well of $68,000 would result in an initial tax write-off of $47,600 ($68,000 X 70%). For an individual in the 38.60% tax bracket this would be savings of $18,373 (47,600 X 38.60%) in accordance to the IDC’s tax savings.

Tangible Drilling and Development Costs (TDC’s):
Tangible drilling costs (well equipment: including, but not limited to, well casing, surface and subsurface equipment, and well flow/sales lines) attributed to the venture are reported as depreciation on the tax return as an expense. In “Example A” the difference between $68,000 and $47,600 (i.e. $20,400) would be the amount subject to depreciation.

Example A (cont.):
For simplicity assume a straight-line depreciation on all tangible equipment for five years--a deduction of $4,080 per year. Again assuming a 38.60% investor tax bracket, this would equate to additional savings of $1,575 increasing total savings in the first year to $19,948.

Thus on a $68,000 investment an investor would have
first year federal tax savings of:
$19,948
(30% of your investment is actually paid by Uncle Sam!)
Plus, any additional tax savings on state and local taxes.

You would also realize additional tax savings of $6,300 ($1,575 X 4 years) over the next four years. All remaining costs would be deducted at completion of the program making the investment 100% deductible over the life of the investment.

This is only a brief and simplified explanation of the federal tax considerations of investing in oil and gas drilling programs. The Federal Tax Laws are very complex and this discussion is not intended to be comprehensive or complete. Each investor should consult his or her own personal tax advisor concerning the applicability and effect on him or her of federal, state, local, and foreign tax law.

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