Tax Benefits of Oil Investment

Tax Benefits of Oil Investment: Reasons Why You Should Invest

Tax benefits of oil investment as well as gas investment are plentiful and can be written off as a loss in the year the investment was made. Taxpayers, who are engaged in oil and gas production or transportation through pipelines, can deduct their operating expenses as business deductions. Taxpayers who sell refined products such as gasoline and diesel fuel can deduct their expenses as well as their gross income from those sales.

This makes investing in oil a lucrative endeavor with many tax benefits. Learn more about the tax benefits of investing in oil.

How Do Oil Tax Benefits Work?

Oil and gas investors are entitled to several major tax benefits that are not available anywhere else in the tax code. In the following paragraphs, we will explain the tax advantages of oil investments and how you can use them to energize your portfolio. These tax benefits of oil investments include Intangible drilling costs, tangible drilling costs, lease costs, etc.

Are There Tax Benefits Associated With Oil and Gas Investments?

There are three major tax benefits associated with oil and gas investing, intangible drilling costs, tangible drilling costs, and lease costs. Investing in oil and gas also involves tax benefits for small and large oil producers alike.

Is There a Unique Benefit to Investing in Oil and Gas?

Net losses from oil and gas investments are considered active income for tax purposes and can be offset against other types of income. Working interest in oil and gas wells cannot be considered a passive investment or passive activity under US tax laws. If you lose money while producing oil and gas, you may be able to offset it against other incomes like salaries, interest, and capital gains

Intangible Drilling Costs

All drilling costs other than the actual drilling equipment are considered intangible. As part of the drilling process, grease, chemicals, labor, mud, and various other items are considered intangibles. The expenses for drilling a well usually account for 60-80% of the total cost and are deductible 100% the year they are incurred.

When drilling a well costs $300,000, and 25% of that cost is considered intangible, the investor may deduct $225,000 in current income tax. In addition, it isn’t important whether the well produces oil or even reaches oil. Deductions can be taken if the company starts operating by March 31 of the next year.

Tangible Drilling Costs

Costs directly related to drilling equipment are called tangible costs. Expenses related to this process are depreciated over seven years and are 100% deductible as well. As a result, the remaining $75,00 could be written off on a seven-year schedule according to the example above.

What Is the Tangible and Intangible Cost of Drilling?

These are all the costs associated with buying intangible drilling equipment, such as labor, grease, chemicals, mud, and other items. As opposed to tangible drilling costs, tangible drilling costs are the costs incurred to buy drilling equipment. Both tangible and intangible drilling expenses can be deducted at 100%.

Active vs. Passive Income

Working interests (instead of royalty interest) in oil and gas wells are not considered passive activities under the tax code. In other words, all well-head losses are active income that can be offset against other forms of income, such as interest, wages, and capital gains.

Small Producer Tax Exemptions

For small producers and investors, this is arguably one of the most attractive tax breaks. Tax incentives are frequently referred to as “depletion allowances,” which allow oil and gas companies to exempt from taxation 15% of all gross income from oil and gas wells. Small companies and investors are the sole beneficiaries of this tax benefit. An oil producer or refiner whose daily output exceeds 50,000 barrels is ineligible. Excluded are oil and gas companies that own over 1,000 barrels of gasoline per day or 6 million cubic feet of natural gas per day.

Lease Costs

Expenses associated with the lease and mineral rights purchase, lease operating costs, as well as all legal costs, accounting expenses, and administrative expenses are included in this category. Capitalization and depletion allowances are required for these expenses.

Alternative Minimum Tax

Intangible drilling costs have been specifically excluded from the alternative minimum tax (AMT) return as “preference items.”. Introducing the Alternative Minimum Tax ensured that taxpayers paid the “fair share” of income tax by recalculating the income tax owed, adding back specific preferential tax deductions and items.

How Does the Alternative Minimum Tax Work?

For US tax purposes, the Alternative Minimum Tax (AMT) is applied to adjusted gross income after all tax preferences have been added. As an example, all intangible costs associated with drilling an oil and gas well are considered as ‘tax preferences’ and are thus exempt from the alternative minimum tax.

What Are Some Lesser-Known Tax Benefits?

Definitely. Oil and gas investments offer a lesser-known tax benefit called the enhanced recovery credit. Oil wells dry up with time as a result of drilling activities. Oil is difficult to extract from a well once its level drops below a certain point due to low pressure. Governments offer enhanced recovery credits of 15% in such cases to oil producers who extract oil from the lowest levels of oil wells in order to encourage the extraction of oil in the lowest levels.

Net Revenue Interest (NRI) and Oil Taxation

Even when the income from a given project is ultimately distributed to investors, it is split into gross and net revenue. In raw terms, gross revenues are simply how many barrels of oil and cubic feet of gas are produced each day, while net revenues remove both the royalties paid to landowners and the state-imposed severance tax on minerals. Royalties or working interests are generally valued based on the number of barrels of oil produced each day or the amount of gas produced each day.

When a project produces 10 barrels of oil a day and the going market rate is $35,000 per barrel-which can fluctuate constantly due to a number of factors-then the wholesale cost of the project is $350,000.

If the price of oil is $60 per barrel, severance taxes are 7.5% and the net revenue interest percentage is 80%, then the net revenue interest would be 80%. There are currently 10 barrels of oil being produced per day, which means a $600 gross production per day. If this figure is multiplied by 30 days–the standard method used in calculating monthly production–the project is generating gross revenue of $18,000. Afterward, we deduct 20 percent from $18,000, which brings us to $14,400 as net revenue.

There follows the payment of 7.5% of $14,400, which is the severance tax (Landowners should also pay this tax on their royalty income). Approximately $159,840 in revenue is generated per year when net income is $13,320. These earnings must then be used to pay for all operating expenses and any additional drilling costs. As a result, assuming no new wells are drilled, the project owner is only likely to generate $125,000 per year from the project. If new wells are drilled, they will benefit the project in terms of a substantial tax deduction as well as extra production.