There are various expenses associated with land use and acquisition, especially in the field of oil and gas speculation and extraction. One of those expenses is the leasehold cost, an expense that must regularly be considered since it cuts into the profits of those involved in this industry. These leasehold costs will vary based on each separate lease agreement.
Leasehold costs are not necessarily limited to the oil industry, but this industry provides one of the simplest explanations for understanding how the leasehold works. A leasehold cost refers to the amount of money that is paid by a company or individual to a landowner when the company believes that it can drill for and find enough oil to exploit the land's resources. To do so, the oil company must acquire rights to use the land though the establishment of a lease agreement. The amount which the company and the landowner agree upon is known as the leasehold cost.
The leasehold cost is important when it comes to tax considerations. Oil companies will typically exhaust most of their resources in the drilling effort. What this means, in terms of tax write-offs, is that the leasehold cost can be capitalized through a process known as cost depletion. Cost depletion involves subtracting the cost of the lease from the profit made on the oil over the course of the tax year. However, the process of applying the leasehold cost is not as simple as just subtracting the annual cost. The Internal Revenue Service has specific and complex formulas for doing so. There are limits to the amount that can be subtracted for the leasehold cost also. Champ Oil Company, Inc. notes that the deduction cannot be greater than 65 percent of the taxpayer's net taxable income.
In some industries, the leasehold cost is also associated with improvements made to the land by the lessee while holding the rights to the land of the lessor. Depending upon the industry, there may be a capitalization threshold, or a limit to which these improvements may be used as a tax write-off. For instance, schools like the University of Michigan regularly lease property from individuals in the near vicinity of the school when the school undergoes expansion. At the time of publication, necessary improvements to property are written off as part of a leasehold cost that is not allowed to exceed $50,000 per year. In this sense the leasehold cost is not only the cost of the land itself, but also the money used for its improvement and upkeep.
Other factors may also have an impact on the amount that can be capitalized and deducted as part of the leasehold cost. For instance, in the oil industry, in the event that a productive well is not produced, the costs for a dry well will differ somewhat from one that produces oil. Any intangible or prepaid costs are usually depreciated before being subtracted.