When an owner develops a property for oil or gas production, there are two classes of costs: Intangible expenditures, such as chemicals, grease, labor and drilling mud, are fully deductible as expenses in the first year. The tangible drilling costs for the equipment used in the operation, such as well rigs and machinery, are treated as capital items. All capital equipment is also fully deductible, but it must be depreciated and deducted proportionally over its useful life.
Calculating Tangible Drilling Costs
Generally, energy property owners determine the intangible and tangible drilling costs using the allocation method. Tangible drilling costs usually constitute between 20 and 35 percent of the total cost of bringing a well into production. For example, if the total cost of bringing a well into production is $400,000, and the tangible drilling costs are determined to be 30 percent of the total, the tangible costs allocation is $120,000 and is capitalized. The remaining $280,000 is allocated to intangible costs and is deducted as an expense in the first year.
Depreciating Tangible Drilling Costs
Depreciation of tangible drilling costs is governed by Section 263 of the tax code. This section assigns a seven-year useful life to the equipment. This means, theoretically, that the equipment will become worn out or obsolete after being in use for seven years. For example, if the tangible drilling costs are $120,000, the owner can deduct $17,142.86 each year for seven years from the gross income of the well.
Recapture on Sale of Tangible Equipment
Tangible drilling equipment is designated in the tax code as Section 1245 property. If the sale price of the equipment is more than the remaining basis (original cost less accumulated depreciation), there is a gain. Capital gains are usually taxed at the capital gains rate, which is lower than tax on ordinary income. However, because tangible drilling equipment is section 1245 property, any gain is taxed as ordinary income at the owner's marginal tax rate. This recaptures a part of the tax the government "lost" through the depreciation deduction in prior years.
Structuring the Sale of Energy Property to Minimize or Avoid Recapture
When an owner sells his energy property, Section 1245 applies to all the remaining tangible drilling equipment, increasing the sale price the owner must report and the taxable net gain on the sale. One way to mitigate the effect of this additional taxable amount is to allocate the sale price between the tangible equipment and the remaining value of the property so that the sale price of the tangible equipment is approximately the same as the adjusted basis (cost less accumulated depreciation). This eliminates Section 1245 gain. It is important to make sure this value is close to the market value of the equipment for this plan to withstand Internal Revenue Service scrutiny.
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