As we all know, the Tax Cuts and Jobs Act of 2017 constitutes once-in-a-generation tax reform. This legislation amended the Internal Revenue Code, reducing tax rates, increasing the standard deduction, and limiting various deductions. In addition to these much-publicized changes, the law also changed the tax treatment for the recovery of tangible equipment costs, allowing for an immediate deduction for the costs of certain types of tangible property. This change in tax treatment has a significant bearing on the potential tax benefits associated with oil and gas drilling partnerships, which may also impact the manner in which drilling partnerships raise and deploy capital.
Recovery of tangible drilling costs
One of the reasons that oil and gas drilling partnerships have been so prevalent in the alts space is that they typically provide investors significant tax benefits, including deductions for intangible drilling costs (IDCs) and tangible equipment costs. Let’s review the difference between intangible and tangible costs:
- IDCs are expenses that are necessary for drilling and preparing oil and gas wells for production but have no salvageable value, such as labor, fuel, chemicals, and installation costs.
- Tangible costs are the costs of equipment that potentially have salvageable value, for example casings, tubing, pumps, and tanks.
Total drilling costs typically consist of 60%-80% IDCs and 20%-40% tangible costs.
As we’ve previously discussed, the primary tax benefit for drilling partnerships is the ability for investors to deduct 100% of IDCs as a current business expense in the first year eligible costs are incurred. Additionally, prior to the Tax Cuts and Jobs Act, the tax code allowed for investors to recover tangible drilling costs through depreciation deductions under a seven-year modified accelerated cost recovery system (MACRS). As such, when evaluating the potential tax benefits associated with drilling partnerships, tangible costs have historically been an afterthought compared to IDCs because they did not provide a significant upfront write-off.
However, thanks to the Tax Cuts and Jobs Act, when it comes to tangible equipment costs, the times, they are a-changin’. Specifically, the law amended Section 168(k) of the Internal Revenue Code to allow a depreciation deduction equal to 100% of the costs of “qualifying property” in the year the property is placed into service. (Qualifying property includes tangible property that has a recovery period of 20 years or less). The 100% bonus depreciation rate will remain in effect for tangible property placed into service prior to January 1, 2023, and will be phased out 20% each subsequent year through the end of 2026. This means that, for the near future, investors in drilling partnerships may deduct 100% of their tangible drilling costs in the year the partnership places tangible equipment for wells into use, which significantly condenses the timeline for writing off tangible costs.
Potential impact on drilling partnerships
Now that the tax code allows for immediate recovery of all tangible costs, when will investors in drilling partnerships actually receive those deductions—in year 1 or year 2? For investment programs, the answer may depend on when during the year the sponsor syndicates the program and deploys the proceeds.
The Tax Cuts and Jobs Act did not alter the tax treatment of IDCs, and the ability for investors to deduct IDCs in the first year they are incurred remains the primary tax benefit associated with drilling partnerships. IDCs that are paid to an operator, without recourse, are deductible in the tax year they are paid as long as the wells associated with those IDCs are spudded (i.e., drilling begins) in that year or within the first 90 days of the following year. In other words, drilling partnerships only need to prepay IDC costs by the end of the year in order for investors to receive the full IDC deduction in the year of their investment, and the partnership does not actually need to start drilling until the beginning of the following year.
Accordingly, drilling partnerships have often raised significant capital near the end of the year, prepaid IDC costs by year-end, and then started drilling in year 2. With changes to the tax law, this typical drilling timeline would result in investors receiving their IDC deduction in year 1 and their entire depreciation deduction for tangible costs in year 2, assuming the partnership could equip all of the wells in year 2. However, under the amended provision, drilling partnerships may now be incentivized to drill, complete, and equip its wells by the year end, so investors would receive both the IDC deduction and the tangible equipment deduction in year 1. Will we see more oil and gas sponsors raising money mid-year as opposed to the final months as they’ve historically done?
Drilling partnerships have not been as prominent over the last few years because of suppressed oil prices. However, recent upward trends in oil prices may trigger more activity for oil and gas in the alternative space, and if it does, it will be interesting to see how the change in tax treatment for tangible equipment costs impacts the timing and fundraising success of these programs.
The IDC deduction and tangible equipment deduction are significant tax benefits; however, investors in drilling programs should be aware of other tax considerations and should consult their tax advisors regarding the tax consequences associated with investment and their individual circumstances.