Oil and Gas Drilling: Majestic Tax deductions against Adjusted Gross Income (AGI)
Note: Following blog article is for educational purposes only, this is NOT to be considered as TAX, LEGAL, FINANCIAL advice. Please consult CPA, Tax, Legal, and Financial professionals for details of your specific tax and investing situation.
There are many reasons why qualified investors choose to take advantage of joint venture oil and gas exploration opportunities, but one of the most compelling reasons is the tax benefits that are afforded by this unique investment opportunity. In fact, when it comes to tax-advantaged investments for wealthy or sophisticated investors, oil and gas commodities stand alone.
Domestic energy production in the United States comes with a large number of attractive tax incentives which, separately or together, complement any tax-advantaged investment strategy. Majestic can help you take advantage of these tax benefits to build wealth, protect your portfolio, and reduce your overall tax liabilities.
Most notably, there are no income or net worth limitations of any kind associated with oil and gas investment tax benefits. As long as inventors limit their ownership to 1,000 barrels of oil per day, even the wealthiest investors can receive all of the benefits afforded to them in the U.S. tax code. This is why virtually no other investment category in America can compete with oil and gas as far as tax-advantaged investments go–and why Majestic has made it our mission to help qualified investors take advantage of these benefits.
Oil and Gas Tax Benefits
Several major tax benefits are available for oil and gas investors that are found nowhere else in the tax code. Some of the tax benefits that are available to investors through a joint venture partnership with Majestic include:
- Intangible Drilling Costs – These include everything but the actual drilling equipment (i.e., labor, chemicals, grease, and other miscellaneous items necessary for drilling). These costs are 100% deductible in the year incurred, regardless of whether the well actually produces or not.
- Tangible Drilling Costs – These pertain to the actual direct costs of drilling. Similar to intangible drilling costs, tangible drilling costs are also 100% deductible but must be depreciated over seven years.
- Working Interest – The tax code specifies that a working interest in an oil and gas well is not classified as a passive activity. This means that all net losses incurred in conjunction with wellhead production can be offset against other forms of income, such as wages, interest, and capital gains.
- Small Producer Tax Exemptions – This allowance, commonly known as the “depletion allowance,” excludes 15% of all gross income from oil and gas wells from taxation. The small producer tax exemption only extends to entities that own, produce, or refine less than 50,000 barrels of oil per day.
TANGIBLE AND INTANGIBLE DRILLING COST DEDUCTIONS
There are many tax advantages available for investors who are sophisticated and wealthy enough to move beyond the most common asset classes. The greatest advantages, perhaps, can be found in the oil and gas industry. The U.S. government wants to build our domestic energy production and one of their methods for doing so is by offering impressive tax benefits for investors who get involved. Two of the major tax benefits come from tangible drilling costs and intangible drilling costs.
TANGIBLE DRILLING COSTS
Tangible drilling costs are the actual direct costs of drilling equipment, such as rigs and machinery. When drilling a new well, about 30% of the drilling costs are tangible. These costs are 100% tax-deductible but must be depreciated over 7 years.
INTANGIBLE DRILLING COSTS
The other 70% of drilling costs are classified as intangible. Intangible costs are expenses that cannot be recovered but are necessary for the drilling and preparation of wells for production. These costs include survey work, drainage, ground clearing, fuel, wages, repairs, hauling, and supplies; basically everything except the actual drilling equipment and leases.
Intangible drilling costs are 100% tax-deductible in the year incurred. It doesn’t matter if the well produces or strikes oil; as long as it is operating by March 31 of the following year, the intangible costs are 100% deductible. In addition, investors are also able to amortize all or a portion of the costs over a 5-year time period instead of taking the entire deduction in the first year.
IRS rules allow investors to receive a substantial ordinary income tax deduction related to intangible drilling costs. These deductions can be used to offset ordinary income or capital gains for those who invest as general partners. Limited partners can use them to offset passive income.
Intangible drilling costs are an above-the-line deduction on the federal Form 1040. That means that they reduce adjusted gross income and also taxable income. As such, taxes due are reduced as well and most states also allow for the deduction. In addition to reducing total taxes due, intangible drilling cost deductions can also lower the tax bracket to which an investor is subject.
The tax benefits of investing in oil and gas are clear and convincing. U.S. Energy Development Corporation even provides an online calculator that can be used to estimate the tax benefits of various investments based on pre-investment taxable income and state tax rates.
Notes from CPA (Certified Public Accountant.)
A working interest in an oil and natural gas joint venture or partnership can provide portfolio diversification with preferential tax treatment. The acquisition, exploration, and development of properties for the production of oil and natural gas require the investment of significant capital and often involve the assumption of higher levels of risk than many other investments. The government, however, has established favorable tax policies to encourage the development and production of oil and gas properties. The tax benefit considerations can materially affect the anticipated return to be realized on the investment and often determine the form and feasibility of the investment.
The major portion of the expenditures paid by a working interest holder in drilling an oil and gas well are classified as intangible drilling and development costs (IDC). Intangible Drilling Costs generally include any cost incurred that has no salvage value but is necessary for the drilling of wells. These costs are comprised of labor, fuel, hauling, chemicals and supplies, logging, drill site location preparation, water, insurance, cementing, equipment rental and other items incidental to, and necessary for, the drilling of wells and the preparation of wells for the production of oil and gas. These types of expenditures are generally considered nondeductible capital expenditures. However, according to Revenue Code section 263 (c), a working interest holder is granted the option of electing to deduct IDC. This benefit makes an oil and gas investment more desirable from a tax standpoint; a significant portion of the investment is written off upon initial investment as opposed to waiting until disposition of the interest as with other types of investments. The IDC deduction is an ordinary deduction sheltering income at the highest income tax brackets as opposed to a capital loss offsetting largely only capital gains. (Note that in certain limited circumstances the IDC deduction may create a preference item for alternative minimum tax purposes.) Most oil and gas partnerships are structured to provide maximum tax benefits allowed by the tax code.
Expenditures for tangible property, such as pipe, casing, tubing, tanks, engines, and machines are recoverable through depreciation allowance over a recovery period of seven years. The equipment will also qualify for the special bonus depreciation allowance under Section 168K as well as Section 179 of the tax code. Rather than depreciating business property over several years, Section 179 allow a taxpayer to expense certain property in the year placed in service. In addition to depreciation allowances for the use of physical properties, there is an annual allowance for the depletion of the mineral reserves. The depletion allowance may be 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%. (Based on certain production criteria, the percentage depletion allowance may be more than 15%.) Limitations may apply to the percentage depletion deduction.
Another advantage of an oil and gas investment is a special exclusion from the passive activity loss limitations. Generally, deductions exceeding income from an investment in a business activity where the investor does not materially participate in the business are not deductible against other income such a salary, interest, dividends, and active business income. The losses are considered passive losses, which are suspended and allowed only against passive income or when the investor disposes of his or her entire interest in the activity. However, according to Revenue Code section 469 (c)(3)(A), a working interest in an oil and gas property, which the investor holds directly or through an entity which does not limit his or her liability with respect to such interest, is not considered a passive activity subject to these rules. Thus, an owner of such a working interest in an oil and gas property is permitted to deduct otherwise allowable losses attributable to the working interest, whether or not he or she materially participates in the activity. Most oil and gas partnerships are structured to provide maximum tax benefits allowing the participants to elect to be general partners, with unlimited liability, thus meeting the requirements of section 469(c)(3)(A).
Internal Revenue Code section 469(c)(3)(B) further states - Income in subsequent years. If any taxpayer has any loss for any taxable year from a working interest in any oil or gas property which is treated as a loss which is not from a passive activity, then any net income from such property (or any property the basis of which is determined in whole or in part by reference to the basis of such property) for any succeeding taxable year shall be treated as income of the taxpayer which is not from a passive activity.
This is very important, but in short this means, a participant in a limited partnership that starts out as a general partner and later converts to limited partner to obtain legal limited liability protection provided by state law, will have income and deductions considered as non-passive items.
Owners of oil & gas working interests have also mitigated some of the costs and risks through the joint development of properties. A Joint Operating Agreement is generally entered into, designating one party as the operator providing for the development and operation of the property and the proportionate sharing of the costs of production. The investor is entitled to his or her proportionate share of the revenues from production of the well (after royalties) during the life of the well.
These benefits certainly enhance the attractiveness of purchasing an investment in a crude oil and/or natural gas field drilling and development project.
Resources:
- IRC Section 263©
- IRS 4.41.1 Oil and Gas Handbook
- Investopedia Intangible Drilling Costs (IDC)
- Oil Tax Breaks
- Robert Kiyosaki and Tom Wheelwright
Intangible Drilling Costs Deduction Calculator
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