Instituciones Financieras Privadas

When a property is determined to be unproductive, the lessee will want to write off the costs associated with the unproductive property. The amount of the deduction for

timing of the deduction for abandonment is based on certain identifiable events. For the lessee, losses from unproductive properties may be deducted in the following situations:

1. Abandonment of Unproved Property: A lessee will incur G & G costs, along with other costs of developing a project area and areas of interest, long before any leases are entered into. Many times a lease is not acquired or the project is put aside for a while to wait for the "right time" for further development. Often, a taxpayer will use this hiatus in activity to claim an abandonment loss, even though the taxpayer has no present intent to abandon the property. If no reserves are found in a project area or an area of interest, the costs associated with the area are allowed to be written off as an abandonment loss. Once reserves are determined to exist, Rev. Rul. 77-188 and Rev. Rul. 83-105 require that an "identifiable event" occur before a write off will be allowed. These rulings hold that an identifiable event would occur when one of the following exists:

a. There is a lease sale that includes the area of interest involved and the entity is unsuccessful in obtaining a lease.

b. There is an indication that the area of interest will not be included in a lease sale.

c. There is an event that establishes that the area of interest is worthless. Rev. Rul. 83-105 suggests that where exploration is conducted offshore, or on Government interests onshore, the passage of 10 years without the areas having been included in a lease sale, or without an indication that the area will be so included, is considered to be an event warranting a deduction of related costs. For onshore interests, other than Government interests, the passage of 5 years is considered to be an identifiable event if no earlier identifiable event occurs. 2. Abandonment of Lease: An abandonment loss may be deducted in the year in

which the property is deemed worthless. A property is deemed worthless if the title is abandoned through relinquishment. Title relinquishment is considered to be a closed and completed transaction, thereby proving worthlessness. Without the relinquishment of title, leasehold costs should not be written off. A copy of the lease should be secured to determine if it has been relinquished. The lease will have a primary-term clause and a delay-rental clause. (Exhibit 1-1 is an example of a mineral lease.) Delay rentals are paid to defer the drilling activity for designated periods of time within the primary term. Drilling cannot be deferred beyond the primary term by payment of delay rentals. The timely payment of delay rentals and timely drilling keeps the lease in effect. However, if delay rentals are not paid timely or drilling has not commenced within the primary term, then the taxpayer must forfeit the lease.

Another way a taxpayer may relinquish title to a lease is to execute a quit claim deed. A quit claim deed transfers the title to the mineral interest back to the lessor. Once the taxpayer relinquishes title to the lease, the taxpayer will be allowed an abandonment loss. The amount of the loss will be the adjusted basis of the

leasehold costs and the costs associated with any unamortized IDC, if the taxpayer previously elected to capitalize IDC.

3. Abandonment of Lease and Well Equipment: When a reserve is depleted, the adjusted basis of lease and well equipment may be written off when the well(s) are abandoned, even when the lease is not abandoned. A plug and abandonment report may be filed with the appropriate state agency when a well is abandoned. (Exhibit 3-2 is an example of Form W-3, which is required by the State of Texas.) This report should be inspected to determine when the abandonment actually occurred. The examiner should determine what happened to the equipment after its removal from the lease, since it could have been transferred to another lease or a warehouse facility awaiting assignment to another lease. Any salvage value received for the lease and well equipment should reduce any loss claimed on the equipment.

4. Abandonment of Dry Hole Costs: When a well is determined to be a dry hole, the taxpayer is allowed to write off the IDC incurred as "dry hole costs." A separate election to expense dry hole costs is required if the taxpayer capitalizes IDC. By expensing IDC as dry hole costs, the taxpayer is not required to include these costs as an IDC tax preference item in computing alternative minimum tax. Thus, a determination must be made that the well never produced oil or gas. If the amount of the dry hole costs written off is material, examiners should request the plug and abandonment report to substantiate that the well was abandoned. Leasehold costs cannot be written off when a dry hole is drilled until title to the lease is

relinquished.