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Drill Down For Three Key Oil And Gas Tax Breaks

For people who aren't averse to a little risk, there is a wide range of investment opportunities to choose from. A case in point: an investment in oil and gas partnerships. You don't have to be an oil baron like J.R. Ewing to get in the ground floor of a deal. What's more, the tax breaks can be bountiful, especially in the early years of ownership.

Specifically, with such an investment you may qualify for three key tax breaks: (1) deductions for drilling costs; (2) depletion deductions; and (3) favorably taxed capital gains when you sell your interest. Also, the tax law provides a safety net against losses for some investors.

1. Drilling cost deductions. You may be able to get a tax deduction for "intangible" and "tangible" drilling costs. Intangible drilling costs (IDCs) are associated with drilling expenses such as labor, fuel, chemicals, hauling, etc. Typically, these will represent from 65% to 85% of the cost of a well. A special tax law provision allows a current deduction for IDCs paid before the end of the year as long as drilling begins within 90 days after the close of the taxable year and certain other technical requirements are met.

Tangible drilling costs--including expenses for oil- and gas-drilling equipment such as casing, pump jacks, and wellheads--generally are depreciated over time.

2. Depletion deductions. Depletion is the oil and gas equivalent of depreciation. There are two types of depletion methods: cost depletion and percentage depletion. Cost depletion must be used if the drilling occurs in a proven area. The deduction is based on the cost basis of potential oil reserves multiplied by annual production. When you have recovered your basis, cost depletion ends.

Cost or percentage depletion may be used in unproven areas. Percentage depletion allows you to recover costs by deducting a percentage of your gross income--generally 15%--from the well each year. Note that other tax law restrictions may limit the annual percentage depletion. Keep in mind, though, that claiming depletion deductions may trigger alternative minimum tax (AMT) consequences. Your professional tax advisor can help you gauge your potential AMT liability.

3. Favorably taxed capital gains. If you sell your oil and gas investment, the deductions you have claimed will reduce your basis, so your taxable gain will increase accordingly. Also, you have to "recapture" income to the extent of depreciation and IDCs that you've claimed previously. The amount subject to recapture is the total amount of the IDC deduction reduced by the amount that would have been deductible had the intangible costs been capitalized and recovered through cost depletion. Other special rules also may apply.

Aside from those caveats, to the extent that you've held the investment for more than one year, the gain from the sale of a partnership interest generally is treated as a long-term capital gain. Currently, the maximum long-term capital gain tax rate is 15%, or 20% for some upper-income investors. That still compares favorably to the top 39.6% tax rate on ordinary income. To complicate matters, however, investors owe a 3.8% surtax on the lesser of "net investment income" (NII) or the amount by which modified adjusted gross income (MAGI) exceeds $200,000 for single filers and $250,000 for joint filers. The income from oil and gas partnerships counts as NII.

Thus, the combined tax rate on long-term capital gains can reach as high as 23.8%, while the effective top rate on ordinary income is almost double that at 43.4%. Finally, investors also may have to contend with state and local income taxes as well as the AMT.

Another twist: Suppose you incur losses from an oil and gas deal. Although investment losses may offset taxable income on your federal tax return, the tax law limits the extent to which you can deduct losses from "passive activities," which include most investment activities. The basic rule is that passive activity losses for the year can't exceed the amount of income generated by passive activities. Instead, the excess loss must be carried over to the next year.

However, there are several exceptions to the passive activity loss rules. One is available for a "working interest" in oil and gas. But you can't take advantage of the exception if you're merely investing from your couch. You actually have to get out in the field.

Beyond thinking about these tax rules, you also will need to consider the risks of the investment itself. There's always the chance that the partnership you choose will come up empty. So it's crucial to understand what you're getting into.