Tax Code: Simplified

Summary:

• The IDC deduction has been allowed in the US since 1913 in order to attract investment capital to the high-risk business of oil and gas exploration 

• IDC can be deducted in the year incurred, whereas tangible drilling costs are amortized over 7 years 

• Owners of working interests in wells can typically deduct 60-80% of total well cost as IDC

• The IDC deduction can grant a $24 dollar-for-dollar tax reduction for every $100 invested, reducing the net investment to $75

• Another way that most investors like to think is that the $24 IDC deduction can be used to immediately offset other income 

Overview:

• Operators of a domestic US oil. gas or geothermal well may elect to currently deduct intangible drilling and development  costs rather than charge such costs to capital, recoverable through depletion or depreciation. 

• Intangible drilling costs are defined as costs related to drilling and necessary for the preparation of wells for productions, but that have no salvageable value. 

• The election is binding upon future years.

• An integrated oil company must reduce the allowable IDC by 30% 

• An independent producer can expense the full IDC amount.

Tax Year:

IRS Code Section 461 has a special provision that allows IDC's paid before 12/31 of any given tax year to still be deducted in such tax year provided the drilling of the well commences before the close of the 90th day after the close of the taxable year 3/31 and other certain conditions are met as per regulations

Active v.s. Passive:

The US 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 the net losses are active income incurred in the conjunction with well-head production and can be offset against other forms of income such as wages, interest and capital gains.  

Drilling :

In general, the taxpayer can take the IDC in the proportion to his share of costs paid, which may not be the same as the WI. For example, if a WI holder paid 1/3 of the cost for a 1/4 interest, the WI holder would be eligible for the 1/3 of the IDC.

SECONDARY RECOVERY WELLS

Wells recognized as secondary recovery, such as water and gas injection wells are costs incurred in the preparation of oil wells for production, and the cost of such wells is subject to the IDCS

Foreign v.s. Domestic

Operators may not deduct IDCs for wells located outside the US. Such costs must be recovered over a 10-year straight-line amortization schedule or added to the adjusted basis of the property for cost depletion

Alt Min Tax:

All excess Intangible drilling  costs have been specifically exempted as a "preference Item· on the alternative minimum tax return.

Water Wells:

Drilling water wells to provide water in drilling oil and gas wells, or for hydraulic fracturing would preparation for production and should qualify as an IDC. Drilling water wells to use as secondary recovery will likely to be capitalized as lease and well equipment.

Saltwater Disposal Wells:

Wells drilled for the purpose of water disposal are typically capitalized as lease and well equipment because they are related to operations. not to the drilling or an oil or gas well, or preparing It for production

IDC Recapture:

For property placed In service after 1986. when oil, gas or mineral properties are disposed of, certain expensed costs are recaptured as ordinary Income. Exploration and Intangible drilling and development costs are recaptured to the extent that they would have been Included In the adjusted basis of the property If they and not been deducted. Depletion is subject to recapture to the extent that It reduced the adjusted basis of the property.