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Property Acquisition Costs
Leasehold costs incurred in connection with the acquisition of oil property must be capitalized and recovered through depletion deductions over the producing life of such property, through loss deductions in the year such property is determined to be worthless or is abandoned, or as an offset against the amount realized upon the sale or exchange of such property. Leasehold costs include the amounts paid in connection with the acquisition of an oil lease, including title insurance or examination costs, broker's commissions, filing fees, recording costs, transfer taxes, certain geological and geophysical costs, and professional fees, such as accounting or legal fees, related to the acquisition.
Property acquired as a result of a drilling commitment that provides for a complete payback of drilling costs before reversion generally requires no capitalization of imputed leasehold value. The leasehold capital costs remain with the originating entity.
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Intangible Drilling Costs Are Up to 100% Tax Deductible
Intangible drilling and development costs (IDC) may be deducted as an expense for federal income tax purposes. These costs in general are those expenditures incurred in connection with the drilling and completion of oil wells and which have no salvage value. Examples of such expenditures are amounts paid for labor, services, fuel, repairs, hauling and supplies which are used in the (1) drilling, shooting and cleaning of wells, (2) in the clearing of ground, draining, road making, surveying and geological work as are necessary in preparation for the drilling of wells and (3) in the construction of such derricks, tanks, pipelines and other physical structures as are necessary for the drilling and preparation of wells for the production of oil. Prepayment of intangible drilling expenses is generally allowed only if economic performance occurs within 90 days after the close of the taxable year in which payments are made.
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15% of Revenue is Tax Deductible with Depletion Allowances.
The cost of capital equipment utilized in the completion and preparation for production of oil wells generally must be capitalized and recovered through cost recovery deductions. Cost recovery deductions can either be depreciation schedules with time formulas or units of production. Upon the sale or other disposition of depreciable equipment, all or a portion of the cost recovery deductions previously claimed may be subject to recapture and taxable as ordinary income.
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Depletion
The owner of an economic interest in an oil property is generally entitled to a deduction for depletion with respect to the income derived from the production of oil. The depletion for any year with respect to any specific property is equal to the greater of cost depletion or percentage depletion. Cost depletion for any year is determined by dividing the adjusted basis for the property by the estimated total recoverable units at the beginning of the year to determine the per-unit allowance by the number of units sold during the year. Percentage depletion for oil is allowable only to small producers and is generally limited to an average daily production of up to 1,000 equivalent barrels. Percentage depletion, where applicable, is not limited by the cost basis in the property, but is subject to various tests that have the result of reducing the amount of depletion.
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Limitations on Deductions & Credits from Passive Activities
Deductions from or credits attributable to passive trade or business activities and certain passive investments to the extent that they exceed income from all passive activities, generally may not be deducted from or offset against the income tax attributable to other income such as salary, active business income or portfolio income. A passive activity generally includes the conduct of any trade or business in which the taxpayer does not materially participate throughout the year. Special rules provide, however, that a passive activity will not, in certain circumstances, include any working interest in any oil property which the taxpayer holds directly or through an entity which does not limit the liability of the taxpayer with respect to such working interest.
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At Risk Limitations
The federal tax code prohibits individual taxpayers from taking current deductions for losses incurred in connection with business and investment activities, except to the extent that the taxpayer is at risk with respect to these activities. A taxpayer is not considered to be at risk to the extent that he is protected against loss through non-recourse financing, dollar guarantees, stop loss agreements or other similar activities. Each oil and gas property constitutes a separate activity with respect to which the amount at risk must be determined. Deductions from an activity which are not allowable for that year because they exceed the taxpayers amount at risk may be carried forward.
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Alternate Minimum Tax
To prevent taxpayers from totally escaping federal income taxation, the Code provides for an alternate method of calculating tax liability. Items that are normally deductible can be classified as tax preference items for the alternate minimum calculation. Percentage depletion and intangible drilling and development costs can become items of tax preference subject to the alternative minimum tax. The calculations are very specific to individual situations.
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Operating Income
The income from oil operations will be taxed at ordinary individual rates. Operating expenses will be deductible from the income derived from the sale of oil.
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