Cost Depletion: A Valuable Tax Deduction for Royalty Owners
Owners of mineral and royalty interests may be interested to learn that the Internal Revenue Code "IRC" allows a deduction known as “depletion” for oil & gas income. The depletion deduction could significantly reduce a royalty owner's income tax bill. Since a mineral interest runs out eventually (because the production 'depletes' the reserves in the ground), the IRC allows the taxpayer to claim a deduction for the decreased value of the property caused by production of minerals. The rationale behind this deduction is that, as an owner receives income from a producing mineral interest, the value of that interest diminishes (because there is less oil left after each unit produced). Therefore, the IRC essentially treats this income as a “loss" of the mineral property itself. The loss in the mineral interest’s value during production can offset the income from production. The objective of this article is to inform recipients of oil & gas income about their potential eligibility for depletion.
Cost Depletion vs. Percentage Depletion: There are two different types of depletion calculations: cost depletion and percentage depletion. Many recipients of royalty income from oil and gas already claim percentage depletion, which reduces taxable income by 15% of gross taxable income from the property. However, the more complex and potentially more valuable deduction is known as cost depletion. Unlike percentage depletion, cost depletion is not a fixed percentage but rather a formula based on the value of the property and the ratio of annual production to remaining reserves. A "property" is defined as a mineral formation in a tract or parcel of land and could include multiple wells when they are in the same reservoir on a contiguous parcel. The correct depletion method to use is determined separately for each property. Cost depletion can, in certain circumstances, generate deductions far greater than the 15% allowed by percentage depletion, thereby significantly reducing the amount of Federal income tax due.
The process to set up cost depletion involves the coordination of petroleum engineers, appraisers and CPAs. Due to this complexity, some taxpayers mistakenly claim percentage depletion by default when in fact they should have claimed cost depletion in order to benefit from a larger deduction. In those situations taxpayers may be able to amend several prior years’ tax returns to claim significant tax refunds. Determining which depletion method to use can be difficult, particularly for professionals unfamiliar with oil & gas.
Qualifying for Cost Depletion: The first issue in determining eligibility for cost depletion is whether the taxpayer can establish a significant basis in the property. The basis, or fair market value, is calculated based on the circumstances when the property was purchased or when it was inherited and valued for estate purposes. If the current owner acquired the mineral interest before minerals were known to have value (based on leasing, production, or nearby activity), then the basis may be very low and cost depletion would not be beneficial. If the taxpayer does have a significant basis attributable to the mineral interest, then the next requirement is to establish the amount of recoverable reserves in the property (how many barrels of oil are in the ground). Once the taxpayer has established a basis and recoverable reserves for the property, the cost depletion deduction is calculated as follows:
( units produced during tax year ÷ total reserve units ) X basis in property = deduction amount
Example Calculation: In 2017 a taxpayer received a royalty of $50,000, which represented the sale of 1,000 barrels of oil on Property A. A petroleum engineer calculated that the taxpayer’s interest in Property A would produce 10,000 total barrels of oil based on reservoir engineering principles. The taxpayer's basis in Property A is $300,000 because this was the fair market value on the date that the property was acquired. The taxpayer’s calculation is:
(1,000 ÷ 10,000) x $300,000 = $30,000
In this example, the taxpayer has a cost depletion deduction of $30,000. Thus, the cost depletion calculation results in a 60% deduction against income whereas percentage depletion would have provided a deduction of only 15%. The property basis and reserve figures are updated each year to reflect the amounts claimed in the previous year. Once the taxpayer claims total deductions equal to their basis in the property, the taxpayer can then switch to percentage depletion for as long as the property continues to generate income.
Conclusion: The above example illustrates a simplified overview from a royalty owner’s perspective. I have omitted certain details for the sake of clarity since the regulations themselves are lengthy and highly technical. If you have questions regarding your eligibility for depletion, Contact Us for a consultation.