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Home > 1031 Tax Exchange
Intangible Drilling Cost Tax Deduction

The costs to drill a well are, from an accounting perspective, divided into two types: tangible and intangible expenses. The intangible expenditures of drilling (rig rate, labor, chemicals, mud, grease, etc.) are usually about (65 to 80%) of the cost of a well. These expenditures are considered the “Intangible Drilling Cost (IDC)”, which is 100% deductible during the year and investment is made. For example, a $100,000 investment would yield up to $75,000 in tax deductions during the first year of the venture. These deductions are available in the year the money was invested, even if the operator of the well does not start drilling until March 31 of the year following the contribution of capital. Theses deductions are available only when used in conjunction with specific investments structures, the use of limited liability entities do have a negative effect on the ability of an investor to use the IDC deductions as described above. For more info please see Section 263 of the Tax Code and consult a professional tax advisor.

Tangible Drilling Cost Tax Deduction

Just like IDC expenses, “Tangible Drilling Costs (TDC)” are 100% tax deductible. In the example above, the remaining tangible costs ($25,000) may be deducted as depreciation over a seven-year period. For more info please refer to Section 263 of the Tax Code and consult a professional tax advisor.

Active vs. Passive Income

The Tax Reform Act of 1986 introduced into the Tax Code the concepts of “Passive” income and “Active” income. The Act prohibits the offsetting of losses from Passive activities against income from Active businesses. The Tax Code specifically states that a Working Interest in an oil and gas well is not a “Passive” activity; therefore, deductions can be offset against income from active stock trades, business income, salaries, etc. “Active” income deductions are generally more valuable relative to “passive” income deductions. This classification has positive implications for users of IDCs relative to certain other tax advantage investment structures. For more info please refer to Section 469(c)(3) of the Tax Code and consult a professional tax advisor.

1031 Exchange Basics

One of the most unique aspects of the 1031 Exchange process is the ability to rebalance or diversify a real estate investment portfolio by relinquishing a property or properties in exchange for a “fractional interest” in an oil and gas production as a “like kind” property. A “fractional interest’ is considered similar to a “tenant-in-common” ownership structure in real estate by the Internal Revenue service for purposes of a 1031 Exchange. This is an efficient way from a tax perspective to optimize a portfolio of real property assets.

1031 Exchanges for Oil and Gas: Tax Free or Deferred?

As there are so many unique factors involved in a 1031 Exchange for a “fractional interest” in oil and gas production, questions often arises of whether this type 1031 Exchange is tax-free or merely tax-deferred. The outcome of a 1031 exchange can be either. If the 1031 Exchange replacement oil and gas “fractional interest” is later sold outright then the tax benefits are merely deferred. If the oil and gas “fractional interest’ acquired through the 1031 Exchange is either held until death or exchanged until death the deferred tax evaporates with the step-up in basis and the 1031 Exchange is completed effectively tax-free. Due to the steady, predictable income stream and the professional management with the potential for capital gains when the price of oil rises, many choose to hold oil and gas “fractional interests” for extended periods after the initial 1031 Exchange. When this transpires, for investing purposes and tax consequences, the 1031 Exchange can become almost tax-free if held for an extended period due to the effect of inflation on the dollar, greatly reducing its purchasing power.
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