Intangible drilling costs: drill a well, deduct most of it this year

The numbers

Picture a business owner in the 37% bracket who invests $500,000 in a working interest in a new well during the year. Assume 75% of the cost is intangible drilling costs: labor, drilling services, fuel, mud, and other costs with no salvage value.

For illustration purposes. Tax law may change, which may change these calculations slightly.

Personal tax in year one (federal)

The remaining $125,000 is tangible equipment, such as casing and wellhead equipment. It’s depreciated, and it may qualify for bonus depreciation, which can add to the first-year deduction. Oklahoma tax is figured separately; we confirm how Oklahoma treats the deductions for your return.

The savings is a deduction, not a refund of the investment. Of the $500,000 invested, the illustration saves $138,750 in federal tax. The rest depends on how the well performs.

How it works

1. Invest in a working interest. A working interest shares in the cost of drilling and operating a well, and in its production. It’s different from a royalty interest, which receives income but doesn’t pay drilling costs.
2. Hold it without limited liability. To be treated as nonpassive, the working interest is held directly or through an entity that doesn’t limit your liability, often general partner units during the drilling year.
3. Deduct intangible drilling costs. Costs with no salvage value are deducted in the year paid. Prepaid drilling costs can be deducted in the year paid if drilling starts within 90 days after year end.
4. Depreciate the equipment. Tangible costs are depreciated, and may qualify for bonus depreciation.
5. Production income and depletion. Income from production is taxable, and independent producers and royalty owners can often deduct percentage depletion of up to 15% of gross income from the property, subject to limits.

Who it fits

• Business owners with strong, steady active income in a high bracket.
• Owners with a one-time spike in income, such as a big year or a bonus, who want a large deduction in that year.
• Investors who already want energy exposure and understand the risk.

When it doesn’t work

• Anyone who can’t afford to lose the investment.
• Owners whose main income is wages or investments: the excess business loss limit can cap how much of a net business loss offsets that income in one year.
• Interests held through a limited partnership or LLC, which are generally passive.

The rules

• Working interest exception. Under IRC §469(c)(3), a working interest held without limited liability isn’t a passive activity. Once you’ve taken losses this way, later income from the interest is also treated as nonpassive.
• At-risk rules. You can deduct only what you have at risk in the investment.
• Recapture. When you sell the interest, the intangible drilling costs you deducted can be recaptured as ordinary income.
• Alternative minimum tax. Intangible drilling costs can be an AMT preference item. For independent producers, relief rules usually limit the effect; we model it.
• Excess business loss limit. Net business losses above an annual threshold carry forward instead of offsetting other income in the current year.

Risks and costs to weigh

• Investment risk. Wells can be dry or underperform, and oil and gas prices move. You can lose money.
• Liability during drilling. The same structure that makes the interest nonpassive can expose you to liability. Sponsors usually carry insurance; review it.
• Fees and illiquidity. Sponsor fees reduce returns, and interests are hard to sell.
• Choose sponsors carefully. We don’t sell or recommend specific investments. We model the tax side with you and your financial adviser.

How we handle it for clients

With a Cannon & Brown tax plan, we look at intangible drilling costs as part of your full picture: how much active income you have, how the deduction interacts with the excess business loss limit and AMT, and how it compares with other options like retirement plans or cost segregation. Because our technology keeps your numbers current all year, we can show you the before-and-after with your real numbers before you invest. Your tax strategist reviews every recommendation.

Illustrative example. The investor and figures on this page are hypothetical, used to explain how the strategy works. They are not a client, not a promise of results, and not a recommendation of any investment. The example assumes a $500,000 working interest held without limited liability, 75% intangible drilling costs paid in the year, enough active business income to absorb the deduction, and the 37% federal rate. This page is educational and is not tax, legal, or investment advice for your situation; tax rules and limits change.