Exploring for a year-end tax deduction? Sinking some dollars into an oil and natural gas drilling deal can be risky but the rewards can be huge. Such investments can offer robust returns as well as write-offs as well.
In 1986, President Ronald Reagan gave high net worth investors a unique gift that still, 29 years later, stands alone in the US Tax Code as one of the most favorable tax benefits available. Like today, oil prices were low in 1986 and Congress was looking for ways to stimulate drilling, and thus the economy. They drafted a Tax Bill that allowed investors to put money into oil and gas prospects, and write off a substantial amount in the year of the investment, and the full amount over 5 to 7 years. What’s even better is that these deductions can be applied directly to active income, where most investors leave tax breaks on the table, because normally only (generally smaller) active write offs can apply to active income. Intangible Drilling Costs can be written off against active income in the year they are incurred. Here is how it works: • Intangible Drilling Costs: These costs include everything but the actual drilling equipment. Labor, supplies, chemicals, mud, grease and other miscellaneous items necessary for drilling are considered intangible. These expenses generally constitute up to 80% of the total cost of drilling a well and are 100% deductible in the year incurred. For example, if an investor contributed $100,000 to drill a well, and if it were determined that 75% of that cost would be considered intangible, the investor would receive a current year deduction of $75,000. Furthermore, it doesn't matter whether the well actually produces or even strikes oil. As long as it starts to operate by March 15 of the following year, the deductions are allowed.
• Tangible Drilling Costs: Tangible costs pertain to the direct cost of the drilling equipment itself, i.e., the drilling rig, motors, tanks, etc. These expenses are also 100% deductible, and will be depreciated over seven years. Therefore, in the example above, the remaining $25,000 could be written off according to a seven-year schedule.
• Active vs. Passive Income: The tax code specifies that a working interest (as opposed to a royalty interest) in an oil and gas well is not considered to be a passive activity. This means that all net losses are active income incurred in conjunction with well-head production and can be offset against other forms of income, such as wages, interest, capital gains, etc. This is significant because high net worth investors frequently have more passive write offs but higher active income; therefore, many deductions are never utilized. Not so in oil and gas investing.
• Small Producer Tax Exemptions: This is perhaps the most enticing tax break for small producers and investors. This incentive, which is commonly known as the "depletion allowance", excludes from taxation 15% of all gross income from oil and gas wells. This special advantage is limited solely to small companies and investors. Any company that produces or refines more than 50,000 barrels of oil per day is ineligible. Entities that own more than 1,000 barrels of oil per day, or 6 million cubic feet of gas per day, are excluded as well.
• Lease Costs: These include the purchase of lease and mineral rights, lease operating costs, and all administrative, legal and accounting expenses. These expenses are 100% deductible in the year they are incurred.
• Alternative Minimum Tax: All excess intangible drilling costs have been specifically exempted as a "preference item" on the alternative minimum tax return.
One benefit provided by the tax code is an upfront tax deduction. "Often, a large portion of your investments may be deducted in the first year," said Chris Christensen, a certified financial planner in Dallas. In other types of business, more of the costs must be written off over long time periods through depreciation schedules.
The amount you can deduct would vary according to details of the transaction. But suppose you invest $25,000 in a drilling deal this year. With Intangible Drilling Cost credits you get to immediately deduct $18,000 from your 2010 income. In a top 39.6% federal tax bracket, that deduction would save you more than $7,000 in tax payments.
If your drilling investments produce oil and gas, you will likely begin receiving revenue in early 2016. Then your taxable income will be reduced by depletion allowance. That's a second tax break to encourage energy exploration. It takes into consideration that the well in which you've invested loses value as the energy resource is pumped out. You can treat part of your revenue as a non-taxable refund of your original investments rather than as taxable income. The exact amount will vary each year, depending on factors such as the amount of oil and gas produced and income reinvested. This tax shelter can go on as long as the oil and gas keeps flowing.
A third reason to consider making this type of investment is for the sake of diversifying your portfolio. There were six major oil bottoms going back to 1985 and in each case, oil prices rose between 200-500% from the bottom. If history repeats itself a seventh time, we are currently positioned for a substantial upward price movement, which makes the investment all the more valuable.
Another thing to consider is the type of drilling that will be done. Pure "wildcat" exploration looks for previously undiscovered petroleum. On the other hand, "developmental" drilling takes place near fields already producing oil and gas. These wells are typically less risky and seldom produce “dry holes.”
"Ask to see a map of the area to be drilled and ask them for surrounding production information," Christensen said. "There will be less risk if the wells are in the middle of a producing oil or gas field rather than on the outskirts. And check with your tax pro. "IDC deductions are a great way to avoid tax for high income individuals," says Mark Mathers, a partner in an accounting firm in Midland, TX. "Individuals in high tax brackets that need deductions should definitely look at oil and gas drilling programs with heavy IDC costs," Mathers said. Here’s another potential tax advantage concerning Roth IRA conversions. Regular IRA's may be converted to Roth IRA's and then transferred into oil and gas drilling programs. However, deferred income taxes are due upon conversions.
Mathers notes, “You can eventually withdraw all of the money in a Roth IRA tax-free after the latter of five years of age 59 ½. You are eligible to convert only in a year when your adjusted gross income is $100,000 or less. "The first-year deductions from a drilling income below $100,000 for the year. Nevertheless, the underlying economics are critical, so you should pay attention to the investment’s potential as well as the tax advantages," he adds.
Oil and gas drilling prospects may be available through some brokers, financial planners, accountants and other advisers or directly from the sponsoring oil company. Buying directly from the oil and gas company provides the most “bang for your buck.” You should invest only in direct working interest. Then you own the interest directly in the wells and the risks are limited only to your percentage of ownership.
Very few investments enjoy the pure tax shelter benefits by investing in drilling for reserves of oil and natural gas. In a successful drilling deal you may have your cake and eat it too, from the upfront tax deductions to ongoing tax sheltered cash flow.