7867 / How are intangible drilling and development costs treated for purposes of federal income tax?

Intangible drilling and development costs (IDCs) are capital in nature; however, the IRC and regulations provide alternatives for treatment of such costs. The individual or entity that holds the working or operating interest in the oil or gas property (i.e., the operator) may elect to (1) capitalize the IDCs or (2) deduct them as expenses for the taxable year in which they are paid or incurred.¹ (With respect to oil or gas property located outside the United States, intangible drilling and development costs paid or incurred after 1986 must be (1) capitalized, or (2) deducted ratably over 10 years. This, however, does not apply to a nonproductive well.)²

If intangible drilling costs are capitalized, they may be recovered through depreciation or depletion (see Q 7877, Q 716).

In the case of certain enhanced oil recovery projects (generally referred to as tertiary recovery projects) begun or expanded after 1990, the operator may, instead of expensing or capitalizing IDCs, claim a tax credit generally equal to 15 percent of qualified enhanced oil recovery costs (see Q 7885).

In the case of the typical oil and gas limited partnership, it is the partnership that holds the working interest in the oil or gas property and undertakes the drilling and development expenditures. Thus, the election to capitalize or expense intangible drilling costs is made at the partnership level by the general partner.³ The general partner’s intent as to this election is normally stated in the prospectus provided to potential investors by the oil and gas program; however, good faith reliance on the prospectus and general partner (or promoter) will not sustain a deduction if there is a failure by the partnership to satisfy the requirements for deduction.⁴

As to how individual limited partners treat their allocated shares of intangible drilling and development costs after the partnership has made its election to capitalize or expense, see Q 7868 and Q 7869.

Nonproductive Wells

If a limited partnership (i.e., the operator) has elected to capitalize intangible drilling and development costs, the regulations provide an additional option with respect to intangible drilling and development costs incurred in drilling a nonproductive well. Intangible drilling costs incurred with respect to individual nonproductive wells may be taken as a deductible loss for the first taxable year in which such nonproductive well is completed. Apparently, once this election is made, it is binding for all subsequent years and must be applied to all nonproductive wells completed after the election.⁵