Depletion allows owners of natural resources to recover the cost of assets as those resources are extracted from the ground, much like depreciation allows businesses to recover the cost of equipment as it wears out over time. Mineral interest owners generally calculate depletion in one of two ways, and the method used can have a meaningful impact on a producer’s tax liability.
Cost depletion allows property owners to recover their initial investment as the resource is produced. It is calculated by allocating the property’s basis over the estimated recoverable units of the resource and multiplying that amount by the units extracted during the year. Over the life of the property, total cost depletion cannot exceed the owner’s initial investment in the resource.
Taxpayers may also be eligible to claim percentage depletion on annual production. Under this method, a statutory percentage established by Congress in the Internal Revenue Code is applied to the property’s gross income to determine the annual deduction. Rates vary by resource; for example, the rate is 15% for oil and natural gas, 10% for coal, and 5% for gravel and limestone. Several limitations may restrict the amount of percentage depletion a taxpayer can claim. Unlike cost depletion, percentage depletion may continue even after the property’s tax basis has been fully recovered, provided the property continues to generate income.
Each year, taxpayers may claim the greater of cost depletion or percentage depletion. Cost depletion is based on the quantity of the resource extracted, while percentage depletion is based on income from the property. Cost depletion may be claimed whether the property generates income or a loss, but percentage depletion generally cannot be claimed when the property is in a loss position. Because percentage depletion is not limited to the taxpayer’s initial investment, it can often produce a larger deduction.
For working and royalty interest owners, depletion deductions can provide meaningful annual tax benefits. Understanding how each method works can help taxpayers identify opportunities to maximize their deductions. If you have questions about depletion, please contact a member of the Schneider Downs Energy and Resources Industry Group.
