EP 149 - What Is the Intangible Drilling Cost (IDC) Deduction for Oil & Gas?

Why does the intangible drilling cost deduction makes oil and gas investing so attractive for high-income earners?  Faster write-offs and more control over timing. Learn about the rules, limits, and risks so you can weigh tax savings against real-world investment economics.
• defining IDC versus tangible drilling costs with clear examples
• why prepaid IDC can create a current-year deduction before a well produces
• how working interest can make losses non-passive and usable against W-2 and other income
• why Congress designed these incentives for domestic energy production and jobs
• a $100,000 example showing how year-one deductions can translate into tax savings
• the importance of binding drilling obligations, economic performance, and ethical operators
• why you should not invest for tax savings alone
• how oil and gas can complement real estate loss planning
• future-year tax impact, profit timing, and the depletion allowance
• state conformity differences, including California limits
• potential constraints from AMT and the excess business loss limitation
• year-end planning in Q4 and using deductions to target a better bracket
If at any time you would like to get personalized insight on how this may apply to you and how we could help, I suggest you go to https://www.prosperalcpa.com/apply. 

Transcript

Why High Earners Use IDC

SPEAKER_00 0:00

One of the greatest reasons why high income earners love to invest into oil and gas is because of something called the intangible drilling cost deduction. And most people don't fully understand how powerful this is or what it even means. So stay close attention if you ever wanted to learn more. And what you're gonna learn today is what is this IDC or intangible drilling cost deduction? How is it calculated? Why is it important? And what could this possibly mean for you and your overall tax reduction investing and wealth building strategy? A little bit about me, in case you don't know me, my name is Mark Perlver, CPA. I specialize in advanced tax reduction for real estate investors, entrepreneurs, and high-income earners. I'm also a certified tax player and I have advised hundreds of clients across hundreds of millions of dollars on strategies just like these. Now, if at any time you would like to get personalized insight on how this may apply to you and how we could help, I suggest you go to prosperalcpa.com slash apply. That's prosper with an LCPA.com slash apply. Now let's get into

IDC Explained With Simple Examples

SPEAKER_00 1:21

it. So first let's talk about IDC or intangible drilling costs. What does this mean? What is the intangible drilling cost? These are the costs associated with the drilling and preparing of an oiling gas well that have no salvage value in the future, right? Compare this to the money you would spend on real estate where you're improving the real estate and eventually that real estate is more valuable and you sell it at a profit in the future. There's no value in the future for these IDC costs. So, in other words, once the money is spent, there's nothing tangible left to sell. Think of the IDC, like paying for a construction crew to dig a hole and perform the work. And once the labor is done, there's no asset value to resell from that labor. So some of the examples of deductions that we will be creating with this is labor, wages, survey work, site preparation, fuel repairs, hauling, engineering, and drilling services. Now, this is different from tangible drilling costs. Tangible drilling costs are the costs that of items that may have some value in the future, like pipes, equipment, pump jacks, and machinery. Now, this may not sound so exciting to you yet, but hold on. Well, of course, you can deduct these things because it's part of the business. But why is this so valuable for us? Well, two reasons. First, let's talk about the timing of

Prepaying Costs For Same-Year Deductions

SPEAKER_00 2:50

this. Because when you invest into oil and gas, you can prepay these intangible drilling cost deductions, meaning you can write off all these anticipated costs before you've actually paid all these different people or they performed all the work. We're doing cash basis accounting. And in many oil and gas programs, you will contribute the capital up front, and then the operators will enter a binding drilling obligation. The funds become contractually committed to the drilling, and this allows a current year deduction, even if the people who they've eventually will pay haven't started working on the project, and maybe this well won't even be up and running yet, and this business may not have generated any revenue yet. Even if the drilling starts taking place the following year, you can get the deduction immediately. This is where it is so incredibly valuable. Because let's say I have a big tax bill at the end of 2027, I want to drop myself into a lower bracket and I don't know where to put my money, I can deploy hundreds of thousands of dollars into when these oil and gas projects, and even if they don't have any up and running project that I'm putting my money in, I still get the immediate deduction. Now, normally the business or even real estate has to be placed in service before you can create any deduction at all. Not the case with oil and gas. Far greater flexibility in terms of timing, and timing is important. And you may have heard me talk about this in some of the other episodes. Because generally speaking, when it comes to the timing, we generally want to write off our take our tax deductions and recognize those write-offs as soon as possible. We want to see the economic benefit of the write-off. The write-off reduces our taxes and gives us more cash and liquidity to invest into other stuff that can build our wealth. So the sooner we get the write-offs, the sooner we have the tax savings, the sooner we have more money that we can do stuff with to make us even more money, like put it into an index fund, put it back into our business, buy more real estate, etc. etc. etc. So, why does a government allow us to have this deduction? Actually, let me backtrack. So, first you can take that write off immediately, even if you pay it the end of December, and even if the oil and gas well is not yet placed in the service.

Working Interest Losses Offset Any Income

SPEAKER_00 5:20

The other thing here, and we talked about this in the past, if you are a general partner and most investors will be considered general partners, and you have what is called working interest into this oil and gas project, this partnership, your losses will be treated as non-passive, meaning you create all these write-offs before you even have any money coming in. So you have a big loss from your investment for all these IDC deductions or any other deduction, and those losses can offset any other type of income. You don't see nearly as much flexibility when you create losses from businesses or real estate. It's becomes you can be passive, you don't do anything at all. You don't have to worry about all these other rules like material participation and all these other hoops you have to jump through to use your losses to offset other sources of income when you invest in real estate or you have a side business. In this example here, you invest, but the losses are non-passive, even though you're just an investor and they offset your real estate income, your W-2 income, your business income, capital gains income, any type of income.

Why Congress Built This Incentive

SPEAKER_00 6:26

Now, why does the government allow for this? Well, think about what the tax code is meant to do. The tax code is meant to incentivize certain behaviors and things that the government wants to see take place, like domestic energy production, independence, energy independence, economic development, and job creation in the US. So Congress creates these tax incentives to encourage private capital to fund the drilling projects. This isn't just a loophole. This is so this isn't some sort of accidental strategy that we've uncovered. This is an intentional incentive into the tax code that's been available since 1916. And the general rule here on how we would expect this to play out, right? A large portion of an oil and gas investment is deducted in year one. And the typical structure, what we see, is around 70-75% to 90% of your year one investment being deducted against your taxes. Now, there may be additional deduction that you may incur, and that may be for equipment costs or other capitalized costs that have not been incurred yet. So let me give you

A $100K Investment Walkthrough

SPEAKER_00 7:41

an example. Let's say you're an investor, you put in $100,000, and you get an $80,000 intangible drilling cost deduction. So in year one, you get an $80,000 deduction against your federal taxes. If you are in the 30% tax bracket, that saves you $24,000 in taxes. If you're a high income, by the way, you're probably in a much higher bracket, in a higher bracket than that. Now, there may be an additional $20,000 that you put into this fund that is reserved for equipment. Now, because you're not equipment's not placed in service and the drilling hasn't begun yet, you can't write off equipment. So you may see an additional $20,000 of tangible drilling costs, such as that equipment for the depreciation deductible in year two. Now, this is incredibly powerful, as I said earlier, because it can offset any type of income. You may even use it to offset a Roth conversion. And this is very powerful for people like doctors or business owners, high W2s, really anyone who is at risk of overpaying in taxes. And what we really like to see is if you see a spike in your income, you can bring it back down by putting that raise or that bonus or that sale, take those proceeds and you can put it into oil and gas. And the way it works is when you invest, right? The way it's calculated is a portion of your investment is allocated to those intra tangible drilling costs. Eventually, you're gonna have the tangible drilling costs, which can only be incurred once the oil is placed into service, once the well is actually up and running, and you may have some leasehold costs and some general overhead along the way.

IRS Rules And Ethical Deal Structures

SPEAKER_00 9:25

Now, you also gotta make sure that you're doing this right and you you're working with the right people because economic performance rules matter. This gets technical quickly, and you don't have to know all of this. But the IRS will examine whether costs were truly incurred, whether the drilling obligations were binding and you were actually committing that money, whether there was genuine economic performance, and whether the funds were merely escrowed or truly committed to the future development of the oil. And you again, what you need to see is here is that you have you have a legitimate prepaid and tangible drilling costs with binding drilling contracts, actual drilling commitments, and real economic risk transferred, meaning you are legitimately investing and having money that is going to be deployed into this activity with no promise of return of capital. Just like every investment, oil and gas investing comes with its own risk. And the government is encouraging you to take that risk and invest into energy with these tax incentives. Now, you could potentially see if you work with the wrong people, problematic structures where the funds are not really committed. There could be sham timing, circular financing, all sorts of fraud. So you want to make sure you're working with ethical people on these types of investments. Another thing I want to add here, you may have heard don't let the tax tail wag the dog. With oil and gas, while the tax savings can be pretty good, you cannot justify investing in oil and gas for the tax savings alone. You're never gonna save more in taxes than the cash outlay in year one, or really ever. So you need to still see economic performance and profit on these investments. So don't be seduced by the tax tables. And an important point here is that also if you're feeling a little overwhelmed by some of the technical jargon I throw it at you, don't worry, the investor usually doesn't have to calculate the IDC themselves. The operator and their accountants will determine the allocation and calculation of the intangible drilling cost deductions.

Real Estate Comparison And Future Taxability

SPEAKER_00 11:41

Now, real quick, because we have so many people who love real estate, I just want to contrast the two. Um, with real estate losses, often they're treated as passive per se income unless you have real estate professional tax status or you're investing in short-term rentals. Meanwhile, when you have an oil a working interest in oil and gas, you bypass all these loss limitations. Another thing that's really cool though, and why I encourage a lot of our real estate investor clients to consider oil and gas is they pair well together because when the profits come in from oil and gas, they're treated as passive, even though the losses are non-passive and can offset other income. And the cool thing about that is now we have real estate losses, rental losses, even if you don't have rep status, even though you don't have short-term rentals, those rental losses can offset your oil and gas. Now, it's really great that we create this immediate tax deduction. And as I said, as I said earlier, timing is so important. We want to create the deduction as soon as we can so we can have the economic benefit of the tax savings created from the losses so we can reinvest our cash into other places. But if we're gonna create that deduction now, what does that mean in the future for us? Well, this means that you are gonna show more profit in the future when the money starts coming in from your profits from the oil and gas. And the future income is gonna be taxable. You're gonna show a high profit margin because in the future years, when you're actually deploying the cash is actually being deployed for and you're using the funds for all those expenditures we mentioned earlier, like the engineering and the hauling and the IDC deductions, you're not gonna be able to write that off again. So you're gonna show a high profit margin and you're gonna have more taxable income. So if you're accelerating that deduction in year one, you don't get to use it again, and you're gonna lose those deductions in the future years. But that's okay, because the name of the game is to create immediate tax savings, which creates more cash that can be used for other things and grow your wealth and build your wealth as the money comes in. And you can also reinvest some of those tax savings into other things that'll mitigate the taxes. Now, another thing I wanted to discuss here is if you're really excited about using these deductions, there are some things that are a little bit maybe misleading or a little bit disappointing to you. A couple

State Rules AMT And Loss Limits

SPEAKER_00 14:14

of things I want to point out here. On the state side, each state is gonna treat these deductions differently. So if you're thinking, well, I pay 50% of my income to California, this could really help me out. I can get, you know, uh in the example earlier, an $80,000 deduction says before you grand in taxes. I get 40 grand percent of my income of my investment back in year one. Well, that's not gonna work in California because California will not allow you to use those deductions to offset your California income. But other states can, and we have found states like Georgia, North Carolina, and New York to actually allow those IDC deductions from oil and gas to offset your state income and create state level tax savings as well. Now, that's one of the reasons why you want to make sure you're working with a tax specialist who understands the rules of oil and gas. Not only so you file your return properly, but you understand the tax savings opportunities. Some other potential limitations. Uh, you have alternative minimum tax. So if you are in a high bracket, you may find that you are getting hit by this thing called AMT, which limits the amount of IDC deductions for oil and gas that you can use to offset your income. Because they're essentially going to say based on how much you're making, you got to pay a certain percentage to federal taxes. And we're not gonna let you use this deduction for this alternative calculation of how much you should be paying. Another potential limitation is something we call excess business loss limitation as of 2026. That is $512,000 if you're married filing jointly, or $256,000 if you're single. Any deduction beyond that amount cannot be used in that year and it's carried forward to offset future income. So if you are a high income earner and you want to create a million dollar deduction, some of that million dollar deduction is going to be carried forward to offset future years income. Now the deductive, so that obviously it's really exciting that we can create deductions so easily with oil and gas. We can be an investor, we don't have to make any decisions, we don't have to start a business, we don't have to materially participate, we don't need rep status, we can just put our money into an investment vehicle that creates immediate tax savings. And while that is great, it can be even greater when you understand how to be strategic here. And this is where you can maybe put some gasoline on the fire here when you understand how the tax law works.

Year-End Planning And Tax Bracket Sweet Spots

SPEAKER_00 16:49

So many investors love to invest in Q4, especially in December, because this is around the time where you actually know how much income you're making. And when you're working with a tax strategist, you can run the numbers and see what's your tax bill looking like before and after the oil and gas investment, and you can optimize and strategize on the optimal amount to put in here. And another thing here on how we can really make the most of this opportunity you can really be strategic in navigating the sweet spots of the tax code. Remember where I talked about optimizing and the timing here. When we look at your situation and how much income we make, we can navigate you into the ideal tax bracket. Because as you know, the federal brackets are marginal. You pay X percentage on the first amount and then Y percentage on the next amount, and it's all different percentages. And we may find that there is a certain sweet spot that we can get you into. So oftentimes there are these tax incentives and tax credits and tax deductions where if you make too little, it's based and it's based on a percentage of your income, you don't qualify for the credit or the deductions. Or if you make too much, they say, Hey, you make too much, you don't deserve this incentive, you're doing too good, right? So we want to sometimes put you right in the middle. And if we take your taxes too low, we reach a point of diminishing returns where you don't really need to spend that much more money and invest into too much more strategy because you're already in a favorable bracket. So we want to help you get into that sweet spot where we're in the we're in a good healthy tax bracket. We can potentially qualify you for things like the child tax credit, where if you make too little, you don't take the full amount. But once you start making over $400,000 or $200,000 if you're single, then it starts phasing out and going away. We can also phase you in so you can take the full around, because it always adjusts for inflation. I'm gonna say around $40,000 of state deductions against federal taxes, so we can bring your income low enough so you can you can phase in those deductions and it still matters. And then if you are uh a business owner, there's something called QBI deduction, which could be a deduction as much as 20% of your profits. But that's another deduction where if you make too much, you may lose it in certain circumstances, or if you make too little, it's not that valuable. So we can show you the optimal amount where you're preserving your liquidity and you're getting meaningful tax savings with the optimal investment amounts.

Depletion Allowance And Final Takeaways

SPEAKER_00 19:29

Now, let's talk about what happens later. So you find these oil and gas projects, you find reputable people with integrity, with a proven track record. You invest not just for tax savings, but also for the economic benefit, future cash flow of these oil and gas projects. Now, in the future, if you succeed, obviously there's gonna be taxable income down the line from the working interest. But again, that's okay because you're also gonna have something called depletion allowance, and this is another tax deduction. So the depletion allowance is typically gonna be a 15% of revenue deduction, meaning whatever revenue comes in, not your net profit, but the revenue, you multiply that by 15%, and that's an additional deduction to offset your income. So there's a second layer of benefit in year two, and while you will eventually pay taxes on the profits, now you get this I this um the depletion allowance deduction, so you're not actually paying taxes on all the money that hits your bank account from this investment, which is not why not only is it tax advantage in that it creates an immediate deduction, but the profits are tax advantage as well. So I really hope this gave you deeper insight into what is this IDC deduction and why it could be so helpful in your overall tax reduction and wealth building strategy here. And if you think this is maybe a great strategy, or you're not sure, maybe you're looking at this and saying, Okay, this is great, but I don't have enough cash yet. Maybe you want to do a strategy that creates additional liquidity, or maybe you think it might pair well with another strategy, or you're not sure when to do it, then maybe it's time to talk to a professional. So if you want to talk to us and see how this may fit in, I strongly suggest you go to prosperalca.com slash apply, and we will send you personalized insight. And maybe this could be one of your next tax strategies. Hope you enjoyed this conversation and stay tuned. We got more tax savings, fun, and wisdom coming your way.