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Tax Advantages of Domestic Oil and Gas Investments

In 1986, the U.S. Congress passed the Tax Reform Act. This Act makes a direct investment in domestic oil and gas one of the most tax-advantaged investments available to today's investor. This act exempts oil and gas working interests from being classified as "Passive Income" (see Section 469(c)(3) of the Tax Code).

Other major tax incentives available to oil and gas investors:

Intangible Drilling Costs (IDCs): For a producing well, 70% - 85% of your investment constitutes what are known as IDCs and are deducted from your ordinary income in the year of investment. IDCs include labor-intensive costs such as the drilling contractor and professional services and are reported to the investor at the end of the year by Pennaco.

Tangible Drilling Costs (TDCs): For a producing well, 15% - 30% of your investment constitutes TDCs which have been historically depreciated over a seven-year period using the Accelerated Cost Recovery System (ACRS). TDCs include pipe, storage tanks, and wellhead equipment. Section 179 of the Code provides for a Modified Accelerated Cost Recovery System ("MACRS") for the exhaustion, wear and tear of property used in a trade or business. For those not versed in tax rules, Rule 179 (Form 4562) of the tax code provides the business taxpayer an increased depreciation deduction for the year in which equipment is purchased within certain limitations. Generally, the taxpayer accelerates depreciation in the year of purchase, adjusts the basis (cost) downward for the deduction and then used MACRS to write off the balance. In response to the 911 attack Congress passed legislation designed to give taxpayers immediate tax relief. One of the methods is a 30% depreciation bonus in the year in which equipment is purchased provided the equipment is placed in service after 9/10/2001 and before 12/31/2003. Congress also increased the total amount allowable for Rule 179 deduction for this two year period from $24,000 (2002) and $25,000 (2003) to $35,000 for each of these years. In addition, the total qualifying property total increased from $200,000 to $325,000 for the period. As written, everything returns to "normal" for tax years beginning in 2004. Together the two changes enable the taxpayer to deduct a little over 60% of the initial cost of the equipment in the first year. However, under a recently passed tax code change, a taxpayer may now deduct up to a full $100,000 of any equipment cost in the first year.

Depletion Allowance: If you are an investor in an independent oil and gas project, the current depletion allowance is 15% of your share of the gross income from the property based on average daily production, up to the depletable oil or natural gas quantity. This makes fifteen cents of every gross income dollar non-taxable, therefore producing tax-sheltered income.

Dry Hole: In the event that you invest in a nonproducing well, 100% of all dollars invested are written off as a loss against your ordinary income in the first year.

Most direct investments in drilling operations qualify for the tax benefits listed above, which are not available to those purchasing stock in publicly-traded oil companies.

The above examples are for general information only and not intended to be construed as individual tax advice. Consult your personal tax advisor concerning the applicability and effect on your personal tax situation. Tax laws change from time to time and there can be no guarantee of the interpretation of the tax laws. Your individual Pennaco Investment Advisor can help answer specific oil and gas tax questions.

Pennaco Natural Gas, LLC
Tulsa, Oklahoma

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