Tax Benefits Associated with Investments in Oil & Gas Drilling Joint Ventures
There are significant tax advantages associated with private investments in domestic oil and gas drilling and production in the U.S. today. The Internal Revenue Code of 1986, as amended (the "Code") currently provides tax advantages for joint venture direct investments in oil and gas drilling and production in order to encourage investment in oil and gas exploration within the United States. However, in order to benefit from these tax incentives investors must meet certain requirements – investing in a publicly traded stock does not generate the same types of tax advantages. This overview sets forth some of the tax benefits associated with investing in joint ventures. Of course, prior to making any investment you are encouraged to consult with your tax advisor regarding how any specific investment will be treated given your particular circumstances.
Investments in Oil & Gas Ventures Allow Investors to Offset Other "Active" Income
The Code classifies investments in joint ventures formed to purchase working interests in oil and gas properties as an "active" business activity. This is beneficial because it allows individuals to offset costs from oil and gas joint ventures against other income from "active" business income from salaries, businesses in which they participate, and stock trades. The same benefits are not associated with "passive" investments, such as investments in stock in corporations. Intangible Drilling Costs include everything but the actual installed equipment. Labor, chemicals, mud, grease and other miscellaneous items necessary for well re-working are considered intangible. These expenses generally constitute 65-80% of the total cost of working a well and are 100% deductible in the year incurred and will potentially generate a write off against active or portfolio taxable income.
Intangible Drilling and Completion Costs (IDCs) Generate Significant Deductions
IDC costs comprise a substantial portion of the expense associated with drilling and developing a well, and include drilling expenses, such as site preparation, rig costs and the expensive, high-pressure fracturing of rock formations. A substantial portion (approximately 65%-80%) of a direct investment in a domestic oil and gas venture may constitute IDC and be deductible.
Partner Tax Benefits of Investments in Oil & Gas Drilling Joint Ventures
Tax incentives from limited partnerships are available on a pass-through basis. The partner will receive a Form K-1 each year detailing his or her share of the revenue and expenses termed the Net Revenue Interest (NRI). For any given project, regardless of how the income is ultimately distributed to the investors, production is broken down into gross and net revenue. Gross revenue is simply the number of barrels of oil or cubic feet of gas per day that are produced, while net revenue subtracts both the royalties paid to the landowners and the severance tax on minerals that is assessed by most states.
Investments May Also Generate Depreciation Deductions Over Time
Equipment including pipe, well casings, tubing, storage tanks, pumping units and other items that remain with the well after its completion are considered depreciable. These additional expenses may generally be depreciated over a seven-year period. Up to $17,000 of total completion costs per investor can be written off as a one-time charge in any given year with the remaining balance depleted (deducted) over a period of 7 years reducing income tax expense paid to tax authorities. Approximately 15% to 25 % of the amount of your investment is allocated to equipment as "Tangible Drilling and Completion Costs" (TDC's), and may be deducted from your income over a seven (7) year period.
Investments in Domestic Oil & Gas Depletion Allowance
Depletion Allowance applies to revenues from oil exploration and development projects. Participants will pay taxes on only 80-85% of total gas and oil income they receive. The impact of the depletion allowance is to generally make 15% to 25% of the gross income from a direct investment in an oil and gas property tax-free. The owner of an economic interest in a U.S. oil and gas property is generally entitled to claim the greater of "percentage depletion" or "cost depletion." Percentage depletion is generally available only to the domestic oil and gas production of "independent producers." To qualify as an independent producer, the taxpayer either directly or through related parties, may not be involved in the refining of more than 50,000 barrels of oil (or equivalent of gas) on any day during the taxable year or in the retail marketing of oil and gas products exceeding a total of $5. In contrast, cost depletion for any year is determined by multiplying the cost basis of the mineral interest by a fraction, the numerator of which is the number of barrels of oil (or mcf of gas) sold during the year, and the denominator of which is estimated recoverable units of reserves available at the beginning of the depletion period. In no event may the cost depletion exceed the adjusted basis of the property to which it relates. One important limitation on the depletion allowance is that the deduction in any tax year may not exceed 65% of the taxpayer's taxable income from all sources. Typically, any excess depletion allowance may be carried forward.
Please Consult Your Own Personal Tax Advisor
The above examples are for general information only and are not intended as individual tax advice. Federal and state tax laws are complex. Consult your personal tax advisor concerning the applicability and effect of oil and gas investments on your personal tax situation and, more specifically, whether or not oil and gas investments would produce favorable tax advantages in your tax situation. This information was current as of the date this document was first printed. However, tax laws change from time to time and there can be no guarantee of the interpretation of the tax laws. The tax benefits of oil and gas investments are merely one factor to consider in evaluating a potential investment and do not eliminate he risks of such investments.