Oil and Gas
Gregory J. Cook, EA, CPA, Accredited Tax Advisor
Investments in oil and gas have potential for both
income and tax benefits. Some are risky in the "wildcat" style, while others
pose much smaller risks for investors. Some have the potential for a
rags-to-riches story, too, although a stable income and substantial tax
advantages are more likely. Much depends on the type of investment.
Intangible Drilling Costs
One of the tax benefits of oil and gas investments is the ability to deduct
intangible drilling costs, or IDCs. IDCs are expenses connected with drilling
and preparing wells for production. Included are such items as wages, fuel,
repairs, hauling charges and supplies. Initially, as much as three-fourths of an
investment can go to pay for these intangibles, allowing a large deduction early
into the investment.
Depletion Allowance
Depletion is similar to depreciation in that it is a deduction made to recover
capital invested in the oil and gas as it is removed from the ground and
sold--being depleted. Just as real estate is assumed to depreciate (drop in
value) as it grows older, the oil and gas is assumed to be depleted and drop in
value as it is used up.
One of two types of depletion allowance may be available to an investor. Cost
depletion is always available, while percentage depletion is available only for
certain types of products and certain producers and retailers. Where both types
are available, the investor is required to compute the depletion allowance which
would be provided by each, and must deduct whichever produces the greater
amount.
Under the cost depletion method, the amount of the allowance is determined by a
formula based on actual costs and units (such as barrels of oil). Cost of Units
divided by Estimated Number of Units to be Recovered, times Units Sold in
Period.
While cost depletion is based in part on the investor's actual costs, percentage
depletion has no direct relationship to the individual investor's costs in the
initial calculation. Instead, it is a percentage of the property's gross income
less royalties and rents. The percentage is determined by law.
Percentage depletion is limited to amounts received for actual production. This
excludes lease bonuses, advance royalties, or any amounts unrelated to actual
production. The deduction, however, is limited to no more than 50% of the
taxable income the individual investor receives from the investment.
Another limitation also applies to the percentage depletion. When determining
whether to use cost or percentage depletion, the investor must determine whether
using the percentage depletion allowance will result in a deduction that is more
than 65% of total personal income for the year (not just income from the
investment). If it does exceed 65%, but if the investor still must use
percentage depletion (because it is greater than cost depletion), the excess
over the 65% limit may be carried forward to any future years where it may be
used as a deduction under the limitations specified.
Passive Loss Rule Exception
Similar to the rental real estate exception mentioned previously, investors with
a working interest in oil and gas are not subject to the passive loss rule,
whether or not they materially participate. In this case, a working interest
refers to the investor's responsibility for the costs of both developing and
running the activity. A limited partnership does not represent a working
interest.
Other Features Of Oil And Gas Investments
We've looked primarily at features that are peculiar to oil and gas investment,
such as IDCs and depletion allowance. There are other features this type of
investment has in common with other investments, such as tax benefits available
for tangible drilling costs--piping, tools, and machinery.
Capital gains offsets are available for oil and gas investments if the program
sells oil reserves while they are still in the ground. Investors may also
benefit from capital gains offsets for selling their interests.
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