Intangible Drilling Costs (IDC): How the Oil and Gas Tax Deduction Works
Key Extract
A plain-English guide to the intangible drilling cost deduction (IRC 263(c)), tangible equipment depreciation (168(k)), the depletion allowance and the working interest exception to passive loss rules: the tax benefits of oil and gas investing.
Oil and gas has some of the most generous tax treatment in the US tax code. The biggest piece is the deduction for intangible drilling costs, usually called IDCs. This guide explains what they are, how the deduction works, and what else goes with it.
WHAT ARE INTANGIBLE DRILLING COSTS?
Intangible drilling costs are the costs of drilling a well that have no salvage value once they're spent: labor, fuel, drilling mud, chemicals, site preparation, surveying and similar items. In a typical well, these are the largest share of the total cost.
Tangible costs are the opposite. They're the equipment you could, in theory, pull out and reuse: casing, wellheads, pumps and tanks.
THE IDC DEDUCTION: SECTION 263C
Under IRC section 263(c) and its regulations, working interest owners can choose to deduct intangible drilling costs in the year they're incurred, instead of spreading them over the life of the well.
In practice, that means a large part of your investment in a new well can be deducted in the first year.
TANGIBLE EQUIPMENT: SECTION 168K
The tangible equipment is depreciated. Under IRC section 168(k), qualifying equipment may be eligible for bonus depreciation, which lets more of that cost be written off up front instead of over several years.
THE DEPLETION ALLOWANCE
Once a well produces, a portion of the income can be sheltered through the depletion allowance. For many smaller producers and royalty owners, percentage depletion under IRC section 613A allows 15% of gross income from the property to be deducted, subject to limits.
WHY THE WORKING INTEREST MATTERS: PASSIVE LOSS RULES
For most investments, losses are "passive" and can only offset passive income. Oil and gas working interests are an exception. Under IRC section 469(c)(3), a working interest held directly or through an entity that doesn't limit your liability is not treated as passive. That's why IDC deductions from a working interest can generally offset W-2, business or professional income.
This is the main reason high-earning professionals, especially physicians and business owners, look at oil and gas.
| Provision | What it covers | When it applies |
|---|---|---|
| IRC 263(c) | Intangible drilling costs | Generally deductible in the year incurred |
| IRC 168(k) | Tangible equipment | Bonus depreciation, if the equipment qualifies |
| IRC 613A | Depletion on production income | Each year the well produces |
| IRC 469(c)(3) | Working interest exception | Lets deductions offset active income |
WHAT TO WATCH FOR
How the investment is structured decides whether you get these benefits. Ask whether you hold a working interest and how your liability is set up.
Alternative minimum tax, at-risk rules and state taxes can all change the outcome.
The deduction should never be the only reason to invest. A tax write-off on a bad well is still a bad investment. Look at the operator and the project first; see our Oil and Gas Investing Guide for what to ask.
THE NEXT STEP
Bring these questions to your CPA, then meet with our team to see how a specific project is structured. You can also learn more in our free Education series.
This article is general education, not tax, legal or investment advice. Tax law changes, and your own situation decides what you can deduct. Consult a qualified tax professional.
CrownForge Energy team