Although not the main reason to participate, one of the most powerful tools for accredited investors to reduce their taxable “ordinary income,” also known as “active income,” are the tax benefits inherent in oil and gas exploration ventures. These benefits are not only real, they were purposely created by Congress in an attempt to strengthen America’s global energy position. Since the tax benefits were created to promote investment, they are designed to substantially reduce the at risk dollars of a project. For high income individuals that find themselves paying at the highest Federal income tax bracket it’s a choice to simply pay the tax bill and lose those dollars with no hope of recovery.

Here’s How It Works:

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 activities. The Tax Code specifically states that a Working Interest in an oil and gas well is not a “Passive” Activity; therefore, deductions can be utilized to offset income from salaries, business, portfolio, capital gains, etc. (See Section 469(c)(3) of the Tax Code.)

Intangible Drilling Cost Deduction: The intangible expenditures of drilling (labor, chemicals, drilling costs, etc.), which are the combined Subscription & Acquisition Funds and the Drilling and Testing Funds, are considered “Intangible Drilling Costs (IDC)”, and are 100% deductible in the year in which incurred. For example, a $100,000 investment, of which $75,000 comprises the two installments mentioned above, could yield up to $75,000 in tax deductions during the first year of the venture. These deductions are available in the year in which the investment was made, even if the well does not start drilling until March 31 of the following year. Additional IDC dollars will be generated in the completion of a successful well (See Section 263 (c) of the Tax Code).

Tangible Drilling Cost Tax Deduction: The amount of the investment allocated to the necessary equipping of a successful well, “the Tangible Drilling Costs (TDC),” are also 100% tax deductible. In the example above, the remaining tangible costs (Completion Funds of $25,000), may also be deducted through straight line depreciation over a five to seven-year period.