In order to take a loss from the oil well investment you need to determine whether this investment is an active or a passive activity.
An active activity in an oil well means that you basically have invested in a "working interest" and all income received in this form is reportable on Schedule C of the 1040. A working interest refers to a form of investment in oil and gas drilling operations in which the investor is directly liable for a portion of the ongoing costs associated with exploration, drilling and production. In a similar fashion, working interest owners also fully participate in the profits of any successful wells. This stands in contrast to royalty interests, in which an investor's cost is usually limited to their initial investment, also resulting in a lower potential for large profits.
A passive activity or a "Royalty Interest" is reportable on Schedule E of Form 1040. Generally your investment in an oil well is a passive activity when you actually own the land where oil and gas wells are drilled. Landowners assume no liability of any kind relating to the leases or wells. However, landowners also are not eligible for any of the tax benefits enjoyed by those who own working or partnership interests. You generally are also a passive investor if you invest into the well via a limited partnership.
Assuming that your investment here is in fact an active activity then the losses would be reported on Schedule C. You stated that you invested 10K for "drilling." If that is the case then your 10K needs to be "bifurcated" (broken up) between tangible and intangible drilling costs as each one of these costs carry different tax treatments.
Intangible drilling costs are 100% deductible in the year incurred. it doesn't matter whether the well actually produces or even strikes oil. As long as it starts to operate by March 31 of the following year, the deductions will be allowed. These costs include everything but the actual drilling equipment. Labor, chemicals, mud, grease and other miscellaneous items necessary for drilling are considered intangible. If the well does not start to operate by March 31st of the following year then the costs must be capitalized and amortized (expensed) over a 5 year period.
Tangible drilling costs pertain to the actual direct cost of the drilling equipment and must be depreciated (expensed) over seven years.
So to wrap up you would report this activity on Schedule C assuming that you are in fact an active investor. The intangible drilling costs would be reported on line 27a as "other expenses" (if you qualify to expense immediately). If you don't qualify you would list the amortization on line 27a as well. The tangible drilling costs would also be reported on line 27a.
I hope this helps. Please let me know if you have any further questions.
Ok. The letter you received about the Percentage Depletion Allowance applies when oil is in fact found and is sold. You can expense the cost of the "oil well" itself over time via the depletion allowance. The letter should state how much of your 10K is attributable to the purchase of the well. This deduction is not available until oil production starts. If it is never found then it can be expensed. Here is an article on the Percentage Depletion Allowance which may help clarify things for you. - http://www.mineralweb.com/owners-guide/leased-and-producing/royalty-taxes/depletion-allowance/
Basically your 10K was used for a number of things and you need to determine how your 10K was used by the well manager. This will drive how you calculate the deductions/income from the activity on your tax return. (I see three potential components to how your 10k was used)
1. Acquisition of an asset (the potential oil well) - the portion of your 10K attributable to this is expensed when the well produces oil and it is sold. (via the percentage depletion method)
2. Cost of drilling the well
a. Intangible drilling costs (75-80% of total cost of drilling the well) - expensed as described above either in year of drilling or capitalized and amortized over 5 years.
b. Tangible drilling costs (20-25% of total cost of drilling the well) - amortized over 7 years.
3. Administrative expenses - expensed in initial year on Schedule C line 27a.
I hope this helps, let me know if something is not clear.
Just a friendly follow up. You have not yet accepted or rated my answer so I am wondering if there is something which is not quite clear or understood. Please let me know if you have any further questions.