Tax Benefits
Oil and gas investors benefit from substantial tax breaks:
Intangible drilling costs (IDC's) - IDC's usually make up about 60 to 65 percent of an investment in an oil and gas well and can be written off in the first year.
These costs include the amounts necessary for the drilling of wells and the preparation of wells for the production of oil and gas, such as wages, fuel, repairs, hauling, supplies, clearing of ground and geological work in preparation for the drilling, construction of derricks, tanks, pipelines, and other physical structures necessary for drilling. If it were not for the preferential income tax treatment, these types of expenditures would be considered nondeductible capital expenditures.
Tangible Drilling Costs (TDCs) - TDC's make up the remaining 35 to 40 percent of well costs and are written off over time, but are subject to the expensing deduction allowable in section 179 of the Internal Revenue code of 1986, as amended.
TDC's are tangible personal property, commonly referred to as lease and well equipment, and include, pipe, casing, tubing, tanks, engines, and machines.
Dry Holes - If the well is a dry hole, the entire investment can be written off in the first year.
Depletion - In addition to a depreciation deduction on TDC's, there is a deduction for the depletion of the mineral reserves. The depletion deduction is the greater of (1) an allocated portion of the adjusted basis of the depletable property (cost depletion); or (2) a statutory percentage of the gross income from the property (percentage depletion). The statutory percentage depletion allowance for independent gas producers is 15%.
90 Day Spud Rule - Gulf Coast Midwest Energy's partnerships are accounted for using the accrual method of accounting. Gulf Coast investors can take advantage of the fact that the IRS allows accrual basis entities a deduction for IDC's paid in the current year, even if the drilling operation commences after the end of the year. As long as there is a binding obligation to pay the drilling costs at the end of the year and the drilling of the well begins within 90 days after the end of the year, the deduction for prepaid drilling costs is allowed. This is commonly referred to as the "90 day spud rule".
Section 1031 Exchanges - Investors can diversify their real estate holdings and maximize cash flow by exchanging their real estate properties for oil and gas interests. An investor can exchange an office building, land, an apartment building, and any other type of real estate investment for oil and gas interests.
In some cases, tax incentives related to oil and gas investments can reduce an investor's tax bracket entirely. At a minimum, the tax breaks associated with oil and gas investments materially reduce the investors cost of investment, thereby increasing their after-tax return.
Investors should consult with their tax advisors regarding the applicability and impact of these tax laws to their personal tax situation. The above tax law illustrations are for general information only and not intended to be interpreted as individual tax advice. The tax laws do change from time to time and their applicability can change depending on each individual's method of investment and personal tax situation.
