There are many parts to the new Federal income tax law that was signed into law in 2012, with somegreat news for oil and gas investors. Practically all taxpayers will pay higher taxes in the future, which makes IDC and depletion deductions more valuable than they have been in years.
The 2012 Tax Act did not change any of the rules regarding deduction of intangible drilling costs (IDC’s) or percentage depletion. IDC’s remain deductible against all income for general partners and against passive income for people whose initial investment is as a limited partner.
Percentage depletion remains deductible to the extent that you have net income from the oil and gas property, subject to a limit of 65% of taxable income. Any percentage depletion deductions that are limited due to the 65% limit are carried over to the next year.
The 2012 Tax Act extended some tax incentives that had expired at the end of 2011 or were scheduled to drop significantly at the end of 2012. These extensions are retroactive to the first of 2012. These extensions include the “immediate expensing” of up to $500,000 of equipment, and the “immediate deduction” of 50% of the remaining cost. These “extenders,” are available to all businesses including the oil and gas industry, but only “bonus depreciation” is of significant value to oil and gas partnerships. The $500,000 limitation on “immediate expensing” is applied both at the partnership level and at the investor level, with the effect that it is of little benefit to partnerships with numerous partners, regardless of the type of business conducted by the partnership.
- Taxable Income The top tax rate for people with taxable income of more than $400,000 ($450,000 for married filing jointly) has risen from 35% to 39.6%. This is an increase of more than 13% in the top tax rate.
For people with taxable income above $250,000 ($300,000 for married couples), the new tax law reduces the value of personal exemptions and many itemized deductions, such as mortgage interest and state income taxes. In some cases, this limitation will effectively raise the maximum income tax rate by 1.2%, which for a taxpayer in the top bracket, can be an additional 3.4% increase in total income taxes.
- Capital Gains and Qualified Dividends The tax rate on capital gains and qualified dividends has risen from 15% to 20% for people who are in the 39.6% tax bracket–a full 1/3 increase in the tax on capital gains and most dividends for the top 1% of taxpayers (5% increase divided by old rate of 15% = 1/3 increase).
- Medicare Tax A new Medicare Tax of 3.8% on investment income that was enacted in 2011 as part of the Patient Protection and Affordable Care Act (PPACA), became effective on January 1. This tax applies to investment income of people who have “modified adjusted gross income” more than $200,000 ($250,000 for married couples). “Investment income” subject to this Medicare tax includes, but is not limited to, interest, dividends, some rents and income from passive activities, and oil and gas properties owned through limited partnership interests. For taxpayers in the top bracket, this is an additional 10.9% increase in taxes on investment income.
- Social Security Tax For all taxpayers with earned income, the Social Security Tax has increased by 2%. This tax is an expiration of a temporary tax relief provision that was enacted in 2009. In addition to this 2% increase, beginning in 2013, the Affordable Care Act added a new 0.9% tax on earned income above $200,000 ($250,000 for married couples). This is a tax on the employee, not the employer. The net tax increase is the same for self-employed people.
For people in the highest tax bracket:
- The top tax rate on investment income has risen by 9.4% from 35% to 44.6% (39.6% + 1.2% + 3.8%), which is a 26.9% increase (9.4% increase divided by 35% old maximum rate = almost 26.9%).
- The top rate on capital gains has risen by 10% from 15% to 25% (20% + 1.2% + 3.8%), which is a 2/3 increase (10% increase divided by 15% old maximum rate = almost 66.7%).
- Social security taxes have risen by 2% of earned income up to $113,700.
- Tax Benefits Example for a Typical $100,000 Investment: $100,000 investment x 80% IDC x 39.6% tax bracket = $31,680 real dollar savings.
- This represents an estimated 32% return of investment from the tax benefit alone.