One of the biggest appeals to investing in oil and gas opportunities is that it is one of the few tax shelters left to domestic investors. With the capital gains tax rate hike and other tax changes as a result of the recent Fiscal Cliff of 2012, many investors are scrambling to look for a way to sustainably keep their taxable income down while taking some calculated risks for recurring income and appreciation potential. As tax changes keep happening and fewer options become available for profitable investors, oil and gas direct placement programs can be a valuable weapon in the battle against wealth destruction (there now, wasn’t that inspiring)!
This topic is of such interest and consequence for many investors that I have devoted an entire page of this site to further explanation of the topic here. But, to highlight some of the main points, I will mention a few terms and then illustrate them with an example.
The first important term to learn is Intangible Drilling Costs or “IDCs”. These are the costs of drilling and completing the well, such as labor, fuel, supplies and repairs. Because these costs do not have any salvage value, and are simply expenses, they are typically direct write-offs. Because these costs are typically 80-85% of the cost of the well, and thus present a major write-off for the investor. Tangible drilling costs are also 100% tax deductible, and may be taken as a deduction spread over 7 years.
The second term is Depletion. As the well is ‘used up’, either the actual cost or a percentage of the amount produced may be taken as a depletion deduction for taxes. This is the same concept as depreciating the value of the asset over its useful life. For example, if as a business owner you purchase a widget making machine in the factory floor that has a $10,000 value and no salvage value, you can deduct $2,000 a year in depreciation as you capitalized the asset. In an oil or gas well, the oil or gas is the actual asset being depleted, so the investor is able to write off the percentage of the total well that was withdrawn from the formation. So, in a sense you get rewarded by retrieving the oil due to the Depletion allowance. This ability to use the percentage of the gross income of the well is sometimes called the Small Producers Exemption and is not available to investors working with companies of a certain size and scale.
The last major term is Non-Passive Gains or Losses. Because participation in an oil or gas well is typically classified as a non-passive investment, you can use the losses to offset gains in other non-passive activities. This shows how versatile the investment can become. As always, discuss these strategies with your tax advisor (as I am not an accountant or a lawyer).
To put these terms in perspective, let’s say Joe Investor makes a $50,000 investment in a direct placement program drilling for natural gas. The tangible drilling costs are $10,000 and the intangible drilling costs are $40,000. The well produces enough oil to generate $10,000 of gross income in the first year. Joe is able to write off the $40,000 of IDCs immediately and is able to write off an additional $1,428 (this year’s portion of the tangible drilling costs). Joe is also able to write off $1,500 of the gross income. So, before even looking at all of the other tax implications, Joe is able to write off $42,928 this year! Things are looking up for Joe! Again, I am not your accountant and this example is solely for illustration, but your CPA should easily be able to help you verify these numbers, which should really help come tax time!