Intangible Drilling Cost (IDC)
100% deductible the first year. Generally, 65-85% of the entire cost of the well are IDC.
When an oil and gas well is drilled there are many expenses that are incurred that are not salvageable, even if the well is a dry hole. These expenses do not produce a physical asset for the producer and include such things as labor, drilling rigs time, drilling fluids and etc. These expenses are deducted since there is zero salvage value to them after they have been incurred. IDC’s are typically 65-85% of the overall cost of a well. Investors are able to deduct this expense immediately and the deductions are generally taking in the year that the costs were incurred. IDCs can also be spread out of 60 months if the investor so chooses. Depending on the accounting principle used the deduction period could change. (See Section 263 of the Tax Code)
The IDC tax deduction has been around since 1913 and allows for producers and investors to recover investments quickly. This enables them to turn around and invest again in exploring for oil and gas. The IDC also allows investors to offset the risk of drilling for oil since there is no guarantee of hitting production. This deduction is a way of recovering some capital invested into a dry hole.
Passive Loss Exception
The Tax Reform Act of 1986 introduced a tax code specifically stating that a Working Interest in an Oil & Gas well is not a “Passive” activity, therefore, deductions can be offset against income from active stock trades, business income, salaries, etc. (Section 469(c)(3) of the Tax Code)
The passive loss exception enables working interest owners in oil and natural gas production to achieve some parity between their investments and those of corporate shareholders. With investors being able to count any working interest investment loss as an active instead of passive activity, the investor is able to treat their normal business deductions in the same way that a corporation would.
“Small Producers Exemption” was introduced in the 1990 Tax Act allowing 15% of the GROSS income from an Oil & Gas property to be tax-free.
Once the well is on line and producing income the investors are able to shelter a portion of the gross revenue earned from the sale of the oil and/or gas through a depletion deduction.
Depletion is a form of depreciation for mineral resources that allows for a deduction from taxable income to reflect the declining production of reserves over time. The percentage depletion deduction has been a part of the U.S. tax code since 1926.
This depletion deduction is to take into account the decline in production over time. For “stripper production” (wells producing 15 barrels/day or less), the depletion percentage is often up to 20%. [See Section 613A of the Tax Code] Percentage depletion is only allowed for independent producers and royalty owners. It is calculated by applying a 15 percent reduction to the taxable gross income of a productive well’s property. It is also capped at the net income of a well and limited to 65 percent of the taxpayer’s net income. Because of these restrictions, only small independent producers and royalty owners are users of the percentage depletion deduction.
Consult your CPA or tax attorney to verify that you qualify for these tax exceptions and deductions. With the tax code changing soon we cannot predict what tax incentives will be moving forward.