Heather purchased undeveloped land to drill for oil and gas.She spent $800,000 on intangible drilling costs during the year of purchase,which she elected to immediately deduct.During the three years of the well's operation,Heather deducted $1.2 million of cost depletion.Heather has sold the property for a $3 million gain.The gain will be treated as
A)$3 million Sec.1231 gain.
B)$3 million ordinary gain.
C)$2 million ordinary income and $1 million Sec.1231 gain.
D)$1.2 million ordinary income and $1.8 million Sec.1231 gain.

Question

Quizplus · Accepted Answer

The $800,000 that Heather spent on intangible drilling costs can be immediately deducted in the year of purchase per IRC Section 263(c)(1).

During the three years of well operation, Heather claimed $1.2 million of cost depletion, which is a type of depreciation on natural resources like oil and gas. This depletion is deducted against base in the property determined by the depletion unit.

When Heather sells the property, she will recognize a $3 million gain. This gain will be split into two components: ordinary income (from the recapture of previously deducted depreciation) and capital gain (from the sale of a capital asset).

Since Heather claimed $1.2 million of cost depletion, she must recapture that amount as ordinary income (IRC Section 1254). Therefore, Heather will have $1.2 million of ordinary income and $1.8 million of capital gain.

The $1.8 million capital gain will be treated as a Sec. 1231 gain (assuming Heather held the property for more than one year). Therefore, the answer is C.

Heather Purchased Undeveloped Land to Drill for Oil and Gas