4 Reasons to Consider Oil and Gas Investments for Tax Savings - Part 2

Reason 2 - Diving Deeper: Technical Tax Benefits in Oil and Gas Investments

For those ready to get into the details, let’s break down the core technical tax benefits that make oil and gas investments unique.

These provisions: depletion, percentage depletion, and intangible drilling costs (IDCs) are powerful levers for the right investor and can significantly reduce taxable income if applied correctly.

Depletion Deduction

Depletion recognizes that oil and gas reserves diminish as they’re produced, similar to depreciation but tailored to natural resources.

Mechanics:

• Use cost depletion by multiplying units extracted by your per-unit basis.

Advantages:

• Reduces taxable income in line with production, improving cash flow over time.

Percentage Depletion

A more generous method not limited to your original investment.

Mechanics:

• Deduct 15% of gross income from the property (subject to property- and income-based caps) subject to other limitations.

Advantages:

• Can exceed your basis, providing continuing deductions even after full cost recovery. This is a major tax benefit unique to drilling and mining-type industries.

Intangible Drilling Costs (IDC)

Expensing for items with no salvage value such as labor, fuel, supplies, and drilling services incurred in preparing and drilling wells. IDC can be immediately expensed, similar to bonus depreciation, or it can be capitalized and amortized over a number of years.

IDC expensing is UNIQUE to the oil & gas industry and not found anywhere else in the tax code. This is one of the biggest reasons this investment is recommended and popular even with people totally unfamiliar to the industry.

Key caution: IDC is ONLY available to working interest owners. If you have a royalty interest, the IDC deduction is not available to you.

Mechanics:

• Producers (operating and non-operating) can elect to expense 100% of IDCs in the year incurred.

Advantages:

• Offers substantial upfront tax relief, particularly valuable in early, high-cost phases of drilling.

These benefits can vary significantly depending on whether you hold a working interest or a royalty interest, each with different rules governing losses, deductions, and tax classifications. The calculations and elections can be nuanced, so meticulous recordkeeping and proper tax return treatment are essential.

Meliora Consulting PLLC | tax advisory