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Depletion Allowance

If you are looking for general gas royalty tax help please visit our Royalty Tax Guide.

Depletion is the using up of a natural resource by mining, quarrying, drilling, or felling. Depletion allowance, then, is the allowance available through the IRS code allowing an owner to account for the reduction (production) of reserves as a product is produced and sold. For purposes of this article, the depletion allowance we are concerned with is the depletion allowance associated with the production of oil and/or gas. The depletion allowance, like depreciation, is a form of cost recovery for capital investments. There are two ways of calculating depletion allowance: cost depletion and percentage depletion. Oil and gas royalty owners have the availability of using either, yet for mineral properties you must generally use the method that gives you the larger deduction.

Who Can Claim a Depletion Allowance?

If you have an economic interest in mineral property (which includes royalty income), you can take a deduction for depletion. You have an economic interest if both of the following apply:

  • You have acquired by investment any interest in mineral deposits
  • You have a legal right to income from the extraction of the minerals to which you look for a return of your capital investment

Cost Depletion

With cost depletion, a taxpayer recovers the actual capital investment throughout the period of income production. Each year, the taxpayer deducts a portion of the original capital investment, less previous deductions, that is equal to the fraction of the estimated remaining recoverable reserves that have been produced and sold that year. The cumulative amount recovered under this method can never exceed the taxpayer’s original capital investment.

Percentage Depletion Allowance

Under percentage depletion, the deduction for the recovery of one’s capital investment is a fixed percentage of the gross income (sales revenue) from the sale of the oil or gas. For oil and gas royalty owners, percentage depletion is calculated using a rate of 15% of the gross income based on your average daily production of crude oil or natural gas, up to your depletable oil or natural gas quantity. An attractive element of percentage depletion is that the cumulative depletion deductions may be greater than the capital amount spent by the taxpayer to acquire the property.

Taxable Income Limit

There is a taxable income limit for oil and gas royalty owners. Your annual deduction for percentage depletion is limited to the smaller of the following:

  • 100% of your taxable income from the property figured without the deduction for depletion
  • 65% of your taxable income from all sources, figured without the depletion allowance.

More specific details on this topic can be found in IRS Publication 535.