Why Selling Drilling Program Units for $400,000 Can Mean $400,000 of Ordinary Income

The drilling deduction comes off your income at ordinary rates in year one. If you sell the interest later, much of the gain comes back at ordinary rates too, which surprises investors who assumed the sale would be taxed as a capital gain.

The rule is section 1254 recapture, and for a typical drilling program it can make an entire sale ordinary income. It does not apply to every way out, though, and the exceptions decide whether the deduction was a deferral or a permanent saving.

1. What section 1254 recaptures

When you dispose of oil and gas property, §1254(a)(1) makes part of the gain ordinary income. The amount is the lesser of two figures. One is the drilling costs you deducted under §263, plus "the deductions for depletion under section 611 which reduced the adjusted basis of such property." The other is your gain on the sale.

Three consequences follow. Depletion taken after basis reached zero is outside the first figure, so it is never recaptured. For an interest you hold directly, drilling costs on wells that came up dry generally do not count either, under Reg. §1.1254-1(b)(1)(vi). Recapture can never exceed the gain on the property. And abandoning a well is not a disposition at all under Reg. §1.1254-1(b)(3)(ii)(B), unless a nonrecourse debt on it is foreclosed. Program units follow the §751 rules in section 3.

2. The equipment has its own recapture

Well equipment written off with bonus depreciation is §1245 property. On a sale, §1245 treats the gain on that equipment as ordinary income up to the depreciation taken. Since 100% bonus takes the equipment's basis to zero in its first year, whatever a buyer pays for the equipment usually comes back as ordinary income.

3. Selling program units does not avoid it

Most investors hold through a partnership and sell units, not wells. That changes the form, not the result. Section 751(c) counts as "unrealized receivables" both §1245 property and "an oil, gas, or geothermal property (described in section 1254)," to the extent of the recapture a sale of that property would trigger. The share of your sale price attributable to those items is ordinary income, even though what you sold was a partnership interest.

That share is measured as if the program sold all its property at fair market value, under Reg. §1.751-1(a)(2). So a unit sale can produce ordinary income even when the units sell at an overall loss. The ordinary income is then offset by a larger capital loss, which is less useful against wages.

4. A $400,000 sale, line by line

A couple bought $500,000 of program units in 2026. Over the years the program passed through $350,000 of IDC, $125,000 of bonus depreciation on equipment and $25,000 of depletion that reduced the lease basis to zero. Assume those deductions have brought their basis in the units to zero, all of the IDC was on productive wells, they bought their units from the program and the program carries no debt. In 2031 they sell the units for $400,000. The program's equipment is worth $60,000 and its wells and leases $340,000, and §751 measures the ordinary income as if the program sold its property at those values.

The whole gain is ordinary. For a seller in the top 2026 brackets, that means 37% instead of the 20% long-term capital gain rate, before any qualified business income deduction, which can apply to ordinary gain under §751 and narrow the gap.

5. A sale turns the deduction into a deferral

The couple deducted $500,000 against ordinary income on the way in and recognized $400,000 of ordinary income on the way out. If both happened at similar rates, the tax benefit of the program came down to two things: the years the money was deferred, and the cash the wells paid before the sale. Model the exit before you subscribe, because a plan to sell in five years is a different investment from a plan to hold.

6. Gifts and death are treated differently

Section 1254(b)(1) borrows the gift and death exceptions from §1245. Under Reg. §1.1254-2(a)(1), no recapture gain is recognized on a gift or on a transfer between spouses covered by §1041. The recipient of a gift takes your basis, so the recapture potential moves with the property.

Death is the bigger difference. Section 1245(b)(2) excludes transfers at death, Reg. §1.1254-2(b) does the same for §1254 recapture, and the heirs generally take a basis equal to fair market value under §1014. An interest held until death can leave the drilling deduction as a permanent saving rather than a deferral. For program units, ask whether the program will make a §754 election, which adjusts its basis in its own property for an heir's share; without one, a later sale by the heir can still produce ordinary income tied to the equipment. Giving the units to charity is less favorable than it looks: §170(e) reduces a charitable deduction by the amount that would have been ordinary income on a sale.

7. Planning the exit

• Decide hold or sell before you subscribe. The answer changes how much the deduction is worth.
• Track the recapture figure every year. Keep IDC, depletion that reduced basis and equipment depreciation for each program, so the ordinary portion of a sale is known in advance.
• Time a sale for a lower-income year. Recapture is taxed at ordinary rates. Equipment recapture under §1245 is taxed in the year of sale even on an installment sale (§453(i)), while §1254 recapture on a direct sale of the property can follow the installment method (Reg. §1.1254-1(d)).
• Read the program's repurchase terms. If the sponsor offers to buy units back, the price sets the gain, and the gain caps the recapture.
• Plan estate transfers with the rest of the estate. Holding to death and giving away the units have very different results.

We keep a recapture schedule for each program from the K-1s, model a sale against holding the interest, and report the ordinary and capital split correctly on the return if you do sell. Book a call before you accept a buyback offer, with the offer letter and every K-1 since you invested.

General information, not tax advice for your situation. Figures are federal and current as of November 2026; the example assumes zero basis and a stated price allocation.