Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 78-13

1978-1 C.B. 63

Sec. 165
Sec. 167
Sec. 612

IRS Headnote

Depreciation; oil and gas drilling equipment. Expenditures for steel casing and associated downhole equipment placed in wells drilled for the production of oil and gas must be capitalized. The equipment is placed in service and subject to depreciation when an oil or gas zone is found and the well is made capable of production. The adjusted basis of equipment that is abandoned in dry holes is deductible as a loss under section 165 of the Code.

Full Text

Rev. Rul. 78-13

Advice has been requested as to the proper treatment for Federal income tax purposes of expenditures for steel casing and associated downhole equipment (that is casing shoes, centralizers, and wall scratchers) placed in oil and gas wells under the circumstances described below.

The taxpayer, an oil corporation, made a proper election under section 1.167(a)-11 of the Income Tax Regulations to use the Class Life Asset Depreciation Range (CLADR) system of computing depreciation.

The taxpayer drilled wells for the production of oil and gas and placed steel casings in the bore holes. The initial casing (termed surface casing) was set through a known fresh water zone and cemented in place. During the subsequent drilling operations, strings of casing (intermediate casing) were cemented in the bore holes and drilling operations continued. When an oil or gas zone was found, additional strings of casing (producing casing) were cemented in the bore hole. In some cases, no productive zones were found and a portion of the intermediate casing was recovered and the bore hole abandoned.

Section 1.612-4(c)(1) of the regulations provides that expenditures for drilling tools, pipe casing, tubing, engines, etc., are capital items recoverable through depreciation and do not fall within the option to expense as an intangible drilling and development cost.

Section 165(a) of the Internal Revenue Code of 1954 and the regulations thereunder provide, as a general rule, that there shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance.

Section 1.167(a)-11(b)(3) of the regulations provides that eligible property placed in service in a year for which the taxpayer has made the CLADR election is placed in a vintage account of that year.

Section 1.167(a)-11(c) of the regulations provides rules for computing the depreciation allowance with respect to the vintage account.

Sections 1.167(a)-11(e)(1)(i) and 1.46-3(d)(1) and (2) of the regulations provide that property is first placed in service when it is first placed in a condition or state of readiness or availability for a specifically assigned function, whether in a trade or business, in the production of income, or in a personal activity.

Rev. Rul. 76-238, 1976-1 C.B. 55, holds in part that individual units of machinery and equipment used in a production line are placed in service on the date installation of the entire production line is completed.

Casing and associated downhole equipment are like units in a production line. The assigned function of the casing and associated downhole equipment is to facilitate the production of oil and gas. Until the taxpayer has installed all the casing, tubing, packers, and the Christmas tree so that the well is completed and capable of production, the casing and associated downhole equipment cannot be considered in a condition or state of readiness and availability for their assigned function.

Accordingly, expenditures for the steel casing and associated downhole equipment must be capitalized. These items are placed in service and are subject to depreciation when an oil or gas zone is found, and the well completed and made capable of production. The steel casing and associated downhole equipment are not placed in service and are not subject to depreciation, if an oil or gas zone is not found and the well becomes a dry hole. In the event of a dry hole, the adjusted basis of that portion of the casing and associated downhole equipment abandoned is deductible as a loss under section 165 of the Code and the regulations thereunder.