The federal income tax provisions impinging on participants in oil and gas exploration and production ventures are complex, and frequently subject to substantial uncertainty in their application to specific transactions.

The summary below is provided solely for informational purposes. The full implications of the federal, state and local tax laws that determine the tax consequences of participating in a working interest program are complex and beyond the scope of this document.

To ensure you thoroughly understand the income and tax consequences of oil and gas, or any other investment, consult your tax advisor. Our Partners Directory lists professionals that specialize in the application of oil and gas purchases within various investment vehicles such as a self-directed IRA, as a 1031 Exchange purchase, or simply as part of a balanced portfolio.

Oil and Gas Drilling Investments
Development of domestic oil and gas reserves helps reduce our country's dependence on foreign imports. To encourage domestic exploration and production, Congress provides tax incentives to private investment sources that finance U.S. operations. As a result, oil and gas ventures are now one of the most tax-advantaged investments available.

Specifically, these federal tax subsidies allow energy companies to write off the majority of their costs immediately, and many are allowed deductions for "percentage depletion" - which have no connection with actual expenses. In addition, the Tax Reform Act of 1986 exempts oil and gas working interests from being classified as "Passive Income." (See Section 469 (c)(3) of the Tax Code.)

Exploration and Development Costs
Normally, businesses can write-off their investments in plants and equipment only as those investments wear out. Oil and gas investors, however, can write off their "intangible drilling costs," that is, much of their investment in finding and developing domestic oil and gas wells, even for successful wells, during the first year of the investment.

Typically, these Intangible Drilling Costs ("IDC's") represent 70% to 90% of the total investment, creating a tax-reduction effect. IDC costs are deductible in the current tax year even if the well does not start drilling until March 31 of the year following the investment.

Tangible Drilling Cost Tax, Leasehold, and Organizational Cost Deductions
The remaining 10% to 30% of oil and gas investments include tangible drilling costs, leasehold costs, etc., which are not fully deductible in the current tax year, but may be depreciated over a five to seven-year period using the Accelerated Cost Recovery System. (See Section 263 of the Tax Code.)

Percentage Depletion Allowance
The 1990 Tax Act also provided special tax advantages for the typical investor in oil and gas drilling projects. Currently, the Percentage Depletion Allowance allows an investor to treat 15% of oil and 22% of gas income as tax-free. All investors should look into claiming the "Small Producers' Exemption" in their annual Federal tax returns (refer to Section 613A of the Tax Code).

Oil and Gas Exception to Passive Loss Limitation
Although owners of working interests in oil and gas properties are subject to the Alternative Minimum Tax, they are exempted from the "passive income" limitations. This means that the "working-interest holder," who finances the development of wells and incurs the cost of operations, may use oil and gas "losses" to offset income from other sources.