Drill for Year End Write Offs With Oil and Gas Investments

Chris Faulkner, CEO Breitling Oil and Gas

Exploring for a year-end tax deduction? Sinking some dollars into an oil and natural gas
drilling deal can be risky but the rewards can be huge. But such investments can offer robust
returns as well as write-offs.

The main benefits of investing in oil and gas include:

Intangible Drilling Costs: These costs include everything but the actual drilling
equipment. Labor, chemicals, mud, grease and other miscellaneous items necessary for
drilling are considered intangible. These expenses generally constitute 65-80% of the
total cost of drilling a well and are 100% deductible in the year incurred. For example, if
it costs $300,000 to drill a well, and if it was determined that 75% of that cost would be
considered intangible, the investor would receive a current deduction of $225,000.
Furthermore, it doesn't matter whether the well actually produces or even strikes oil. As
long as it starts to operate by March 15 of the following year, the deductions will be
allowed.
Tangible Drilling Costs: Tangible costs pertain to the actual direct 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 $75,000 could be written
off according to a seven-year schedule.
Active vs. Passive Income: 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,
capital gains, etc.
Small Producer Tax Exemptions: 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 of oil 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.
Lease Costs: These include the purchase of lease and mineral rights, lease operating
costs, and all administrative, legal and accounting expenses. These expenses are 100%
deductible in the year they are incurred.
Alternative Minimum Tax: All excess intangible drilling costs have been specifically
exempted as a "preference item" on the alternative minimum tax return.

One benefit provided by the tax code is an upfront tax deduction. "Often, a large portion of
your investments may be deducted in the first year," said Chris Christensen, a certified financial
planner in Dallas. In other types of business, more of the costs must be written off over long
time periods through depreciation schedules.

The amount you can deduct would vary according to details of the transaction. But suppose you
invest $25,000 in a drilling deal this year. With Intangible Drilling Cost credits you get to
immediately deduct $18,000 from your 2010 income. In a top 39.6% federal tax bracket, that
deduction would save you more than $7,000 in tax payments.

If your drilling investments find oil or gas, you may get revenue starting in late 2010 or 2011.
Then your taxable income will be reduced by depletion allowance. That's a second tax break to
encourage energy exploration. It assumes the well in which you've invested loses value as the
energy resource is pumped out. You can treat part of your revenue as a non-taxable refund of
your original investments rather than as taxable income. Imagine you have paid $4,000 in 2010
for your 2010 investments. Because of the depletion allowance, you would only report $3,000
as taxable income. The exact amount will vary each year, depending on factors such as the
amount of oil and gas produced and income reinvested. This tax shelter can go on as long as the
oil and gas keeps flowing.

A third reason to consider making this type of investment is for the sake of diversifying your
portfolio. When stocks or bonds are weak, oil and natural gas prices may rise.

One precaution is to check the background of the oil and gas company running the drilling
operation. Ask for references so you can speak to prior and current investors, banking
managers, geologists and CPAs. Second, the type of drilling that's planned can impact your
return. "Wildcat" exploration looks for previously undiscovered petroleum. On the other hand,
"developmental" drilling takes place near fields already producing oil and gas. These wells are
typically less risky and seldom produce “dry holes.”

"Ask to see a map of the area to be drilled and ask them for surrounding production
information," Christensen said. "There will be less risk if the wells are in the middle of a
producing oil or gas field rather than on the outskirts. And check with your tax pro. "IDC
deductions are a great way to avoid tax for high income individuals," says Mark Mathers, a
partner in an accounting firm in Midland, TX. "Individuals in high tax brackets that need
deductions should definitely look at oil and gas drilling programs with heavy IDC costs,"
Mathers said. Mathers points to another potential tax advantage concerning Roth IRA
conversions. Regular IRA's may be converted to Roth IRA's and then transferred into oil and gas
drilling programs. However, deferred income taxes are due upon conversions.
“You can eventually withdraw all of the money in a Roth IRA tax-free after the latter of five
years of age 59 ½. You are eligible to convert only in a year when your adjusted gross income is
$100,000 or less. "The first-year deductions from a drilling income below $100,000 for the
year," Mathers said. "Nevertheless, the underlying economics are critical, so you should pay
attention to the investment’s potential as well as the tax advantages."

Oil and gas drilling deals may be available through some brokers, financial planners,
accountants and other advisers or directly from the sponsoring oil company. Buying directly
from the oil and gas company provides the most “bang for your buck.” Be careful because
some of these investments typically are structured as partnerships or joint ventures. However,
Joint Ventures come with lots of liability. You should invest only in direct working interest. Then
you own the interest directly in the wells and the risks are limited only to your percentage of
ownership.

Very few investments enjoy the pure tax shelter benefits by investing in drilling for reserves of
oil and natural gas. In a successful drilling deal you may have your cake and eat it too, from the
upfront tax deductions to ongoing tax sheltered cash flow.

THIS ARTICLE AND THE CONTENT CONTAINED HEREIN IS NEITHER AN OFFER TO SELL NOR A SOLICITATION TO BUY SECURITIES; NEITHER ARE
SECURITIES BEING OFFERED TO NOR WILL SALES BE EFFECTED WITH PERSONS IN THE STATE OR JURISDICTION IN WHICH YOU (THE VIEWER)
RESIDE WITHOUT EXEMPTION. IN ADDITION, THE AFOREMENTIONED GENERAL INFORMATION IS NOT INTENDED TO BE INDIVIDUAL TAX
ADVICE. CONSULT YOUR PERSONAL TAX ADVISOR CONCERNING THE CURRENT TAX LAWS AND THEIR APPLICABILITY AND EFFECT ON YOUR
PERSONAL TAX SITUATION.