Tax Benefits of Oil and Gas Investments (Note: The following is for general informational purposes only. Please seek the advice of a licensed tax professional.) What is the tax advantage of an oil and gas investment? After the Tax Reform Act of 1986 which eliminated many tax shelters, direct participation programs in oil and gas wells are one of the few remaining investments that allow investors to shelter income, making it one of the most tax advantaged investments today. To offset the risk associated with the investment you may now deduct the entire investment, regardless of the success or failure of the investment, from ordinary income. What are the tax incentives specifically?
- Percentage Depletion Allowance (or Small Producers Exemption) – This is a special tax advantage to encourage participation by small companies and individuals.
- ALLOWANCE: 15% of the gross income from a producing property is tax free.
- EXAMPLE: for every $1 million gross income earned, $150,000 is tax-free (Tax Code Section 613A)
- Tangible Drilling Cost Tax Deductions (TDCs) – Expenses including hard assets such as the wellhead & production equipment.
- DEDUCTION: TDCs tend to account for around 20% of the total investment and may be depreciated 7 years. (Tax Code Section 263)
- EXAMPLE: At 20%, $1 million dollar investment would deduct $200,000 over a 7-year period to generate a total tax savings of around $70,000 and an annual savings of $10,000 to reduce the net investment by 1%.
- Intangible Drill Costs (IDCs) – This includes labor intensive items like services, labor, chemicals, mud, leases and rentals.
- DEDUCTION: IDCs account for approximately 80% of total expenses and are 100% deductible during the first year (regardless of whether or not the well was completed that year).
- EXAMPLE: $1 million dollar investment could deduct approximately $800,000 right away, which would generate a net tax savings of approximately $280,000 in year one (assuming a 35% tax bracket), reducing the net investment by 28%.
- Active vs Passive Income – The Tax Reform Act of 1986 introduced into the Tax Code the concepts of “Passive” income and “Active” income. The Act prohibits the offsetting of losses from Passive activities against income from Active businesses. The Tax Code specifically states that a working interest in a well is not a “Passive” Activity, therefore, deductions can be offset against income from active stock trades, business income, salaries, etc. (See Section 469(c)(3) of the Tax Code).
- Lease Costs – Items such as purchase of leases, minerals, sales expenses, legal expenses, administrative accounting, and Lease Operating Costs (LOC) are also 100% tax deductible through cost depletion.
- Alternative Minimum Tax – Prior to the 1992 Tax Act, working interest participants in oil and gas ventures were subject to the normal Alternative Minimum Tax to the extent that this tax exceeded their regular tax. This Tax Act specifically exempted IDCs as a Tax Preference Item. “Alternative Minimum Taxable Income” generally consists of adjusted gross income, minus allowable Alternative Minimum Tax itemized deduction, plus the sum of tax preference items and adjustments. “Tax preference items” are preferences existing in the Code to greatly reduce or eliminate regular income taxation. Included within this group are deductions for excess Intangible Drilling and Development Costs and the deduction for depletion allowable for a taxable year over the adjusted basis in the Drilling Acreage and the wells thereon.
- Marginal Wells – The US Senate and House of Representatives have passed a tax incentive bill to help small producers. This bill provides a tax credit of up to $9 per well per day for marginal wells. A typical marginal well pumps 15 barrels of crude or 90 thousand cubic feet of gas per day. There are 650,000 “marginal” or “stripper” wells in the USA. Marginal wells provide as much as 25 percent of the nations’ crude supply (on par with Saudi Arabia) and about 10 percent of gas stocks.
By utilizing these tax incentives, real rates of return can increase by 20 to 40%, when compared to cash on cash rate of return from an investment without the favorable tax treatment..