How the tax deduction works
Why can General Partner investors receive a substantial ordinary income tax deduction in the year of investment?
IRS Code §263(c), Treas. Reg. Section 1.612-4(a)
Section 263(c) of the IRS tax code provides for the option by the taxpayer to fully deduct, as expenses, intangible drilling costs (or “IDCs”) incurred for new oil and gas wells. As IDCs are normally paid in the first year and are allocated first to General Partner Investors, this deduction generally results in a significant ordinary income tax write-off in the year of investment. Typical IDCs include costs from drilling, hydraulic fracturing (“fracking”), wages, fuel, repairs, hauling, supplies and other expenses necessary for drilling and preparing a well for the production of oil and/or natural gas. For investors, IDC deductions flow from the Schedule K-1, to Schedule E, to Schedule 1, to Line 8 of the Form 1040 as described starting on page 18.
IDCs, however, do not include lease or equipment costs paid for an oil and gas well, which are classified as tangible expenses. The typical allocation of intangible costs and tangible costs when drilling a new well is shown in the graphic below.
± 70%
Intangible drilling costs
Income classification:
Ordinary income
± 30%
Tangible drilling costs
Income classification:
Passive income
Intangible costs typically include:
Expenses made by an operator that cannot be recovered and are necessary in the drilling and preparation of wells for the production of oil and gas, such as survey work, ground clearing, drainage, wages, fuel, repairs and supplies.
Tangible costs typically include:
Costs pertaining to the actual direct cost of the drilling equipment, such as well rigs and machinery.