The U.S. government has done much to ease the tax burden for those trying to save for retirement or just trying to make money for a rainy day. Several major pieces of legislation are geared toward creating tax incentives for workers to help create a huge savings plan for retirement. Even the capital gains tax rules have been overhauled, allowing for cheaper disposal of appreciated assets.
But when it comes to tax-advantaged investments for wealthy or sophisticated investors, one investment class continues to stand alone above all others: Oil. With the backing of the U.S. government, domestic energy production has created many tax incentives for both investors and small producers.
Congress looks at oil and natural gas from domestic reserves as helping to make our country more energy self sufficient by helping to reduce our dependence on foreign imports. Because of this they have created advantages for the smart investor who chooses to place their money into this business. These are not so called “loop holes”, these are legal and encouraged advantages in the tax code.
Expenses - Intangible Drilling Costs (IDC)
These are expenditures for items that have no salvage value and are needed for the drilling and for the preparation of the oil and gas wells. These costs are usually 65 to 80% of the cost of the well:- Surveying, building roads, and the preparation of the well location
- The transportation of all the drilling equipment to the well site
- Cementing, logging, coring drill-stem testing.
- Consumable supplies for all your workers, including water, fuel, and other incidentals.
- Installation of casing (but not the cost of the actual casing.)
At the decision of the taxpayer, these expenditures can be classified into one of two different categories:1. Expenses deductible from current (as opposed to future) gross income.
2. Amortizable capital expenditures.
How you decide which one to choose is based on each person’s situation and dependent wholly on timing. Meaning if the intangible drilling costs are treated as expenses for the purpose of computing Federal income tax obligations, the total amount of these costs are deducted from gross income in the year incurred.
On the other hand if they are treated as capitalized expenditures, then the total amount of these same costs are deducted in installments over a number of years. According to the time value of money concept, a dollar received today is worth more than the same dollar received years in the future. The same holds true for an income tax deduction.
Oil and Gas reserves are not easily discovered. They can only be discovered at the cost of millions by drilling a well, and if that well comes up dry, then the well has zero market value. Take an investment in a building for example, your market value will go up and down, but will never be worth zero.
The opportunity to treat intangible drilling costs as currently deductible expenses may allow the investor to protect some of his income. This provides incentive for a taxpayer to invest in the exploration for oil and gas.