How to Calculate the Depletion Allowance for Oil and Gas

The depletion allowance is a tax deduction for owners of mineral properties, like oil and gas reserves, that accounts for the asset’s reduction as it is extracted. This deduction recognizes the mineral deposit as a finite asset, allowing the owner to recover their capital investment over the property’s life. It functions similarly to depreciation for other business assets, providing a way to offset income generated from the sale of the extracted resources.

Eligibility for the Depletion Allowance

To claim the depletion allowance, a taxpayer must hold an “economic interest” in the oil or gas property. An economic interest exists when a party has acquired an interest in the minerals through an investment and must look to the income from extraction for a return on that investment. The right to the deduction is not based on legal title alone but on the potential for economic gain or loss from mineral production.

A working interest owner, often the operator of the well, bears the costs of development and operations and is entitled to a share of the production, qualifying them for the deduction. Royalty interest owners, who receive a share of the production revenue without bearing the operational costs, also hold an economic interest and are eligible to claim depletion on their royalty income.

A distinction exists between “independent producers and royalty owners” and “integrated oil companies.” Integrated oil companies are large corporations involved in the refining and retail sale of petroleum products, in addition to production. The more favorable percentage depletion method is restricted to independent producers and royalty owners, which determines the calculation method a taxpayer can use.

Calculating Cost Depletion

The formula for cost depletion is the property’s adjusted basis divided by the total number of recoverable units of oil or gas, which creates a per-unit rate. This rate is then multiplied by the number of units sold during the tax year to determine the annual deduction. This method ensures that the total deductions taken over the life of the property do not exceed the initial capital investment.

The “adjusted basis” of the property includes its acquisition costs, such as purchase price or lease bonuses, plus any capitalized exploration and development costs, reduced by any depletion deductions taken in prior years. The “total recoverable units” represents the estimated amount of oil or gas in the reservoir that can be commercially produced, established by an engineer’s report and updated as new information becomes available.

“Units sold” refers to the barrels of oil or thousand cubic feet (Mcf) of natural gas produced and sold within the tax year. For taxpayers using the cash method of accounting, this is based on units for which payment was received, while for those on the accrual method, it is based on units sold regardless of payment timing.

Calculating Percentage Depletion

Percentage depletion is an alternative method not tied to the property’s original cost. The calculation multiplies the “Gross Income from the Property” by a statutory percentage, which is 15% for most oil and gas production for independent producers and royalty owners. “Gross Income from the Property” is defined as the amount received from the sale of oil or gas in the immediate vicinity of the well and does not include other payments like lease bonuses or advance royalties.

This initial calculation is subject to two limitations. The first is the 100% Net Income Limitation. Under this rule, the percentage depletion deduction for a specific property cannot exceed 100% of the taxable income generated by that same property during the year, calculated before taking the depletion deduction. For example, if a well generates $100,000 in gross income and has $90,000 in expenses, its net income is $10,000. The 15% calculation would be $15,000, but this limitation would cap the deduction at $10,000.

The second constraint is the 65% Taxable Income Limitation. This rule states that a taxpayer’s total percentage depletion deduction from all oil and gas properties combined cannot exceed 65% of their overall taxable income from all sources. For instance, if a taxpayer has a total taxable income of $200,000 and a potential percentage depletion deduction of $150,000, the deduction would be limited to $130,000 ($200,000 65%). Any amount disallowed by this limit can be carried forward and deducted in a future tax year.

Choosing and Applying the Correct Method

After calculating the potential deduction under both cost and percentage depletion, a taxpayer must choose which method to use. For each individual property, the taxpayer must use the method that results in the greater deduction for that year. This comparison must be performed annually for every property.

The outcome of this comparison can vary. For example, a new well with high initial development costs might have a large adjusted basis, making cost depletion higher in the early years of production. Conversely, an older well that has been producing for many years may have a very low or zero adjusted basis, making cost depletion minimal.

In such cases, percentage depletion offers an advantage. A benefit of the percentage depletion method is that the deduction can continue to be claimed even after the property’s entire cost basis has been recovered. As long as the well is producing income, a deduction based on a percentage of that income may be available, subject to its limitations.

Reporting and Tax Implications

Reporting

The location for reporting the depletion deduction on a tax return depends on the type of interest held. Royalty owners report their royalty income and the corresponding depletion deduction on Schedule E of Form 1040. Working interest owners, who are operating a trade or business, report their revenues, expenses, and depletion deduction on Schedule C. While no specific IRS form is required for the calculation, taxpayers must maintain detailed records to substantiate their claims.

Depletion Recapture

Upon the sale of an oil and gas property, a portion of the gain may be subject to recapture under Internal Revenue Code Section 1254. This means a portion of the gain is treated as ordinary income rather than capital gain. The amount recaptured is the lesser of the gain on the sale or the sum of depletion deductions that reduced the property’s basis plus any intangible drilling and development costs that were deducted. This rule prevents taxpayers from benefiting from ordinary deductions and then receiving preferential capital gains treatment on the entire gain at disposition.

Alternative Minimum Tax (AMT)

The choice of depletion method can have consequences for the Alternative Minimum Tax (AMT). While the amount by which percentage depletion exceeds the property’s cost basis can be a tax preference item, this rule does not apply to independent producers and royalty owners. For these taxpayers, this is not a factor in their AMT calculation.