How to Handle Oil and Gas Depletion on a K-1

The tax code provides a deduction for oil and gas depletion to account for the reduction of mineral assets as they are extracted and sold. For individuals who are partners in a partnership or shareholders in an S corporation, the entity itself does not claim this deduction. Instead, the entity passes the necessary information to the owners on a Schedule K-1. The individual owner is then responsible for using this information to calculate and claim the depletion deduction on their personal tax return.

Understanding the K-1 Information for Depletion

The first step for a partner or S corporation shareholder is to locate and understand the depletion-related information provided on their Schedule K-1. For partners receiving a K-1 from Form 1065, this data is found in Box 20 with a code of “T”. For S corporation shareholders receiving a K-1 from Form 1120-S, the relevant information is in Box 17 with a code of “R”. These boxes do not contain the final deduction amount but rather the components needed for you to calculate it.

The statement accompanying the K-1 provides several data points for each oil and gas property. You will find your share of the gross income from the property for the percentage depletion calculation. The statement will also list your share of expenses attributable to the property for determining the property’s taxable income. Other details, such as information about your share of the property’s adjusted basis and the total quantity of oil or gas sold, are also provided for the cost depletion calculation.

The partnership or S corporation has already done the work of allocating these property-specific figures to each owner based on their ownership percentage. Your role is not to re-calculate these allocations but to use the provided numbers to determine your allowable deduction.

Calculating Your Depletion Deduction

You must calculate your depletion deduction using two distinct methods: cost depletion and percentage depletion. The law requires you to compute the deduction under both methods for each property and then claim the larger of the two amounts on your tax return.

Cost depletion recovers the actual capital investment, or basis, in the mineral property over its productive life. The calculation involves dividing your adjusted basis in the property by the total estimated number of recoverable units (barrels of oil or cubic feet of gas) to find a per-unit rate. This rate is then multiplied by the number of units sold during the year to arrive at the cost depletion deduction.

Percentage depletion is calculated based on the property’s income, not its cost. For most independent producers and royalty owners, the deduction is calculated by multiplying the gross income from the property by a statutory rate of 15%. For example, if your share of gross income from a well is $10,000, your tentative percentage depletion would be $1,500. This method is often more favorable, especially for properties with a low cost basis, as the total deductions can exceed your original investment.

Limitations on the Percentage Depletion Deduction

The percentage depletion deduction is subject to limitations that can reduce the amount you can claim. The first is that the deduction for any given property cannot exceed 100% of the taxable income from that specific property. This taxable income is figured by taking the gross income from the property and subtracting all related expenses, but before subtracting the depletion deduction itself. If a property generates a net loss for the year, no percentage depletion is allowed for that property.

A second limitation restricts the total percentage depletion deduction from all your oil and gas properties to 65% of your overall taxable income from all sources. This calculation is made after all other deductions have been taken but before considering the depletion deduction. If your calculated depletion exceeds this 65% threshold, the excess amount is carried forward to be deducted in future years.

Percentage depletion is available only to independent producers and royalty owners under what is known as the “small producer exemption.” This exemption is limited to taxpayers with an average daily production that does not exceed 1,000 barrels of oil or 6,000,000 cubic feet of natural gas. Large integrated oil companies are not eligible for this tax benefit.

Reporting the Deduction and Adjusting Your Basis

Report the deduction on your tax return and adjust your basis in the property. The total allowable depletion deduction from all your oil and gas interests is reported on Schedule E (Form 1040), Supplemental Income and Loss. This deduction reduces the amount of rental and royalty income subject to tax.

Each year, you must reduce your adjusted basis in the property by the amount of the depletion deduction you take. The adjusted basis is used to calculate the gain or loss if you sell your interest in the property in the future. A lower basis will result in a larger taxable gain upon sale.

While cost depletion cannot be claimed once your basis has been reduced to zero, percentage depletion can continue to be claimed even after your basis is fully recovered. This means you can continue to receive a tax deduction based on the property’s income as long as it remains productive and you meet the other requirements.