As the end of 2023 looms, many high net worth individuals find that now is the perfect time to reevaluate their investment portfolio strategies––specifically from a tax perspective. Direct oil and gas investments right now in 2023 in an oil and gas drilling partnership can be a smart move to reduce one’s overall tax burden this year. Instead of paying more to Uncle Sam, money that was slated for the 2023 tax bill can be put to work instead, providing significant write-offs while also providing the added benefit of consistent cash flow and return on investment potential.
Congress has enacted several tax incentives in previous years to encourage private investors to participate in the exploration and development of oil and natural gas within the United States. These incentives are not “loop holes” in the tax code. They are specific statutes designed to help stimulate domestic production with the goal of making our country more energy self-sufficient. Every barrel of oil produced helps reduce our dependence on foreign imports. The U.S. Tax Code is currently structured to help support aggressive production, making direct oil and gas ventures one of the best tax advantaged investments available.
Intangible Drilling Costs (IDCs) are drilling expenditures related to expenses such as labor, fuel, chemicals, hauling, etc. IDCs usually represent 70% to 85% of the cost of a well and are eligible to be deducted 100% against taxable income in the first year. For example, investing $50,000 in a project that had 85% of its costs in IDC’s would mean the investor could elect to deduct $42,500 from their taxable income for that year. In a top 39.6% federal tax bracket for individuals, that deduction would save approximately $14,875 in federal income taxes for that tax year. IDCs deductions are available in the year the money was invested, even if the well does not start drilling until March 31 of the year following the contribution of capital.
Oil and gas drilling equipment such as casing, pump jacks, and wellheads are considered Tangible Drilling Costs (TDCs). Continuing with the example above, the remaining $7,500 (15% of the cost of the well) would be classified as TDCs. These costs are capitalized and depreciated over a five-year period.
As with IDCs, Intangible Completion Costs are generally related to non-salvageable goods and services, such as labor, completion materials, completion rig time, fluids etc. ICCs are also generally deductible in the year they are incurred, and usually amount to about 15% of the total well cost.
While services and materials used during the drilling process offer no salvage value, equipment used in the completion and production of a well is generally salvageable. Items such as these are usually depreciated over a seven-year period, utilizing the Modified Accelerated Cost Recovery system or MACRS. Equipment in this category includes casing, tanks, wellhead and tree, pumping units etc. Equipment and tangible completion expenses generally account for 25 to 40% of the total well cost.
Once a well is in production, the working interest owners in the well are allowed to shelter some of the gross income derived from the sale of the oil and/or gas through a depletion deduction. Two types of depletion are available, cost and statutory (also referred to as percentage depletion). Cost depletion is calculated based upon the relationship between current production as a percentage of total recoverable reserves. Statutory or percentage depletion is subject to several qualifications and limitations. This deduction will generally shelter 15% of the well’s annual production from income tax.
Lease Operating Expenses cover the day-to-day costs involved with the operation of a well. The expense also covers the costs of re-entry or re-work of an existing producing well. Lease operating expenses are generally deductible in the year incurred, without any AMT consequences.
Lastly, the tax benefits from oil and natural gas production have historically triggered potential taxation under the Alternative Minimum Tax (AMT). However, Congress provided some tax relief in the early 1990’s for “independent producers”. An independent producer was defined as an individual or company with production of 1,000 barrels per day or less. Although there is still the potential for AMT taxation for excess IDCs, percentage or statutory depletion is no longer considered a preference item.
Just a quick look at the seven advantages provided above shows that the tax benefits generated by a direct participation in oil and/or natural gas could be substantial. The immediate IDC deduction is significant––the government effectively subsidizes the capital risk by reducing the participant’s federal, and possibly state income tax. And, on top of reducing your tax burden, you can enjoy the satisfaction of keeping more of your money working for you…while helping support domestic energy independence.
We invite you to contact us today to discuss whether a direct investment in oil and gas is a suitable option for you.
The above general discussion on direct oil and gas investments is provided for background information only. This information is not intended to be individual advice. Prospective participants should consult with their personal tax professional regarding the applicability and effect of any and all benefits for their own personal tax situation. In addition, tax laws change from time to time and there is no guarantee regarding the interpretation of any tax laws. For more information, please visit www.irs.gov.