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II. Completion Phase

Funds raised during this phase cover two types of costs:

1. Organization Costs

b) Organization Costs (additional organization costs necessary for this phase) These are the same types of costs defined above in the Drill & Test Phase and will continue to be incurred and carryover into the Completion Phase of drilling and as covered by the Turnkey Completion Contract.

b) Tax Treatment: These costs will be amortized over 60 months as stated above

under the Drill & Test Phase.

2. Tangible Completion Costs (Tangible Equipment)

a) What is Tangible Equipment?

Tangible Equipment is the physical equipment placed down-hole in the well and the physical equipment placed on the surface for the well and lease. It includes the direct costs to install, construct and placed the equipment in working condition. The equipment includes two components:

Intangible Completion Costs (Installation Costs). Installation charges, incurred for equipment, facilities, or structures that are not incident to the drilling of the well, such as structures for storing and treating oil or gas. (Section 1612-4 of the Code.) These costs are installation costs and are capitalized as part of those structures. Note: IDC includes the cost of installation of tangible equipment placed in the well itself, although the equipment is to be capitalized.

Tangible Completion Costs (Physical materials and equipment).

Tangible well and lease equipment include the following:

o Surface Casing (even though permanently cemented and nonsalvageable.

o Well Casing.

o Tubing.

o Transportation of casing and tubing from manufacturer to supply point.

o Stabilizers, guide shoes, centralizers and down-hole equipment. o Wellhead (Christmas Tree)

o Salt Water Disposal Equipment and necessary pipelines, including cost of drilling well.

o Water Tanks

o Production Tanks

o Pump jack, Heater Treaters, Separators

o Recycling equipment, including necessary flowlines.

o Dirt moving necessary for tank battery and operation roads. o Digging, refilling, and backhoe work for installation of flowlines from well to tank battery.

o Installation and labor costs for tank battery, flowlines, pump

jacks, separators and other similar items.

o Construction of turn-around pad at tank battery with additional overflow pits.

It is important to distinguish between the two types of installation costs: (1.) The costs of installing equipment necessary for the drilling of the well and for the preparation of the well for production is regarding as "intangible", if the investor elects to expense IDe. The IRS regards the well as complete when the casing and a "Christmas Tree" have been installed. The cost of installing the equipment to this point, which would include casing, tubing, the Christmas Tree, and other well facilities, is considered intangible. Ifhowever, the taxpayer (investor) elects to capitalize intangibles, such costs become part of the equipment costs and recovered through depreciation. (2.) The IRS considers pumping equipment, flowlines, separators, storage tanks, treating equipment, salt water disposal equipment, and so on, as production facilities, and costs incurred in their installation must be capitalized as equipment costs. (Rev. Reul 70-414).

The inclusion of Intangible Completion Costs (installing equipment placed in the well itself) as part of the Tangible Equipment depends upon Election to Expense or Capitalize IDC by the investor. If the investor elects to expense IDC, these costs are excluded from tangible equipment. If the investor elects to capitalize IDC, these costs are included as part of the tangible well costs and are capitalized and recovered through depreciation.

b) Tangible Equipment Depreciation Expense

The cost of oil and gas property placed in service after 1980 is recoverable under the Accelerated Cost Recovery System (ACRS). ACRS uses statutory accelerated methods to recover the entire cost of the property over periods of time fIXed by the IRC (Internal Revenue Code or "Code"). It makes no distinction between new and used property, and disregards salvage value. The costs of depreciable personal property is recoverable over a 3,5,7,10,15, or 20year period, depending on the type of property. The class to which an asset belong depends primarily on the midpoint of its class life under the ADR rules (Rev Proc. 83-85, 1983-1 CB 745). ADR stands for Asset Depreciation Range . Three-year property includes property with a four-year-or less midpoint life under the ADR system, other than cars, light-duty trucks, which are five years. Five-year property consists of property with an ADR midpoint life of more than four years and less than 10 years. The 7-year class includes: (1) any property with an ADR midpoint of 10 years or more and less than 16 years and

(2) property with no ADR class life that is not assigned to another class. Office

furniture, fIXtures, and equipment (including lease and well equipment), that were previously in the 5-year class are now included in the 7-year class. (IRC 168(e)(J) and (3) (C)).

c) Tax Treatment:

Tangible Equipment Depreciation

The depreciation method for property in the 3,5,7 and lO-year classes is the 200 percent declining-balance method, with a switch to straight-line for the first year in which the latter system will produce the larger deduction. The depreciation method for 15- and 20-year property is 150 percent declining method, also switching to straight-line to maximize the deduction. Most of the equipment deployed on our wells will fall in the 7-year class life. Based upon the property being placed in service for less than 12 months during the first year, a mid-year convention is used. This results in a rate of 14.29% for the first year, 24,49%

for the second year, 17.49%for the third year, and 12.49% for the fourth year, 8.93 % for thefifth year, 8. 92 % for the sixth year and 4.46%for the seventh year. During the fourth year a switch to straight-line method would be necessary. Finally, any depreciation allowable on such tangible property and equipment is subject to recapture as ordinary income if the investor's interest or the property is disposed of before the end of its class life. (IRC Section 167 (a)8(e»

Election to Expense Depreciable Business Assets (Section 179 Expense)

A taxpayer (investor other than a trust or estate) can elect to treat some of the cost of qualifying property as a currently deductible expense. Section 179 of the IRC allows you to elect to deduct all or part of the cost of certain qualifying property (tangible personal property purchased for use in business; i.e. tangible well and lease equipment). The taxpayer can elect to expense rather than recover the cost through depreciation; however, there are limits on the amount you can deduct in a year. For 2001, the dollar ceiling on the amount that can be expensed is $24,000 for taxpayers whose total investment in tangible personal property is less than $200,000. For every dollar investment that exceeds $200,000, the dollar ceiling is reduced by one dollar. (IRC, Sections 179(b)(1) and (2). The section 179 deduction limits apply both to the partnership and to each partner. The partnership determines its section 179 deduction subject to the limits. It then alloctes the deduction among its partners. Each partner adds the amount allocated from the partnership (shown on Schedule K-l) to their non-partnership Section 179 costs and then applies the maximum dollar limit to this total.