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 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.
These include the purchase of lease and mineral rights, lease operating cost and all administrative, legal and accounting expenses. These expenses must be capitalized and deducted over the life of the lease via the depletion allowance.
These include everything except the actual drilling equipment. Labor, chemicals, mud, grease, paraffin, and other miscellaneous items necessary for drilling. These expenses generally constitute 65-80% of the total cost of drilling a well and are 100% tax deductible in the year incurred. So, a million-dollar investment could deduct approximately $800,000.00 right away, which would generate a net tax savings of approximately $280,000.00 in year one (assuming a 35% tax bracket), reducing the net investment by 28%. Furthermore, it doesn’t matter whether the well actually produces or even strikes oil. As long as it starts to operate by March 31 of the following year, the deductions will be allowed.
Tangible cost are those directly related to the cost of the drilling equipment. These expenses are also 100% deductible but must be depreciated over seven years. Therefore, in the example above, the remaining $200,000.00 could be written off according to a seven-year schedule.
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, and capital gains.