Key Takeaways
- Learn how depletion deductions help recover your investment in oil and gas wells.
- Understand the difference between cost and percentage depletion and when each applies.
- See how simple examples show which method can yield greater tax savings.
Do you invest in oil and gas, or are you planning to? Depletion deductions are the tax benefit that can help you recover part of your investment as resources are extracted.
This guide explains the two primary depletion methods used to do this: cost depletion and percentage depletion; who qualifies, and how they impact your taxes.
What Is Depletion in Oil & Gas Taxation?
Depletion is an IRS-approved tax deduction that recognizes the gradual exhaustion of natural resources as they’re produced and sold. It allows you to recover the capital invested in developing oil and gas reserves over time.
Think of it as the natural resource equivalent of depreciation. While depreciation applies to tangible assets like rigs and equipment, and intangible drilling costs (IDCs) cover exploration and development expenses; depletion specifically applies to the value of the resource itself.
Depletion spreads your investment across the units you extract, so your taxable income more accurately reflects the resource’s decline. You can calculate it in two ways.
Cost Depletion: How It Works and Who Can Claim It
Cost depletion measures how much of your original investment is used up as you produce and sell oil or gas from a property. It’s tied directly to what you paid for the property and the quantity of resources you expect to recover.
How It Works
The calculation follows a simple formula:
- (Adjusted basis [the total amount you’ve invested in the property] ÷ total recoverable units [the total quantity of oil or gas expected to be produced]) × units sold = annual cost depletion deduction.
This gives you a clear picture of how much of your original investment you can deduct each year, based on how much you’ve actually produced and sold.
How to Apply It
- Determine your adjusted basis. This is the amount of your investment that’s still unrecovered for tax purposes. Start with what you paid for the property, add any drilling or development costs, and subtract any prior depletion you’ve already claimed.
- Estimate the total recoverable units. This is the total amount of oil or gas the property is expected to produce over its lifetime. These figures usually come from engineering or geological reserve reports prepared by qualified professionals.
- Divide your adjusted basis by the total recoverable units. That’s the total number of barrels of oil or cubic feet of gas the property is expected to produce over its lifetime. This gives you a clear picture of how much of your original investment you can deduct each year, based on the oil or gas you’ve actually produced and sold.
- Multiply your cost per unit by the number of barrels or cubic feet sold during the year to calculate your annual cost depletion deduction.
Who Can Claim It
You can claim cost depletion if you earn money from the oil or gas that’s produced – either because you own the rights to extract and sell it (a working interest) or you receive royalty income from production (a royalty interest).
Limitations
- The total deduction cannot exceed the amount you’ve invested in the property – known as your adjusted basis.
- Once that investment has been fully recovered, cost depletion ends, even if production continues.
- Cost depletion usually provides the greatest benefit in the early years of production, when your investment is still high and the reserves are steadily being drawn down.
Percentage Depletion: A Flexible Tax Deduction for Oil & Gas
Unlike cost depletion, percentage depletion isn’t tied to how much you paid for the property, it’s based on production revenue. This method lets you deduct a fixed percentage of the gross income from a producing property, regardless of your original investment or remaining basis.
That’s a good thing because it can continue generating deductions even after you’ve fully recovered your initial investment.
How It works
- The IRS assigns specific depletion rates to different natural resources. For most oil and gas wells, the standard rate is 15% of the property’s gross income for the year.
- Formula: Gross income (the total revenue from the property before expenses) × depletion rate (typically 15% for oil and gas) = annual percentage depletion deduction
Who Can Claim It
Percentage depletion is generally available to independent producers and royalty owners. Large, integrated oil companies that refine or retail petroleum products are not eligible for this deduction.
Limitations
A major advantage of percentage depletion is that it can continue even after the property’s cost basis has been fully recovered, providing ongoing tax benefits over time. But there are limitations to keep in mind:
- The deduction cannot exceed 100% of the property’s taxable income for the year.
- It’s also subject to the small producer exemption, which restricts eligibility based on production levels. To qualify, a producer must not produce more than 1,000 barrels of oil (or 6 million cubic feet of gas) per day, averaged across all properties. Exceeding that threshold disqualifies the taxpayer from claiming percentage depletion for that year.
Cost vs. Percentage Depletion: Which One Saves More?
Both methods aim to help you recover your investment, but the results can vary significantly depending on production, basis, and income levels.
Let’s say you have an oil well with a $500,000 investment (basis) that earns $200,000 in gross income for the year. The total recoverable reserves are 100,000 barrels, and you sell 20,000 barrels this year.
- Cost depletion: ($500,000 ÷ 100,000) × 20,000 = $100,000 deduction
- Percentage depletion: $200,000 × 15% = $30,000 deduction
In this case, cost depletion gives you a higher deduction because your remaining investment in the property is still large. Over time, as that basis is used up, percentage depletion could provide a greater ongoing benefit.
In practice, investors often calculate both methods each year to determine which provides the higher deduction. This helps optimize cash flow, manage taxable income, and extend the benefits of depletion over the life of the well. It’s advisable to consult with a CPA when choosing your method to ensure it aligns with both your short-term needs and long-term strategy.
IRS Compliance: How to Claim and Report Depletion Deductions
Whether you use cost depletion or percentage depletion, accurate reporting and documentation are essential. The IRS allows taxpayers to calculate both methods if eligible and claim the larger deduction, as long as they maintain clear records to support each calculation.
- Ensure accurate reporting:
- Royalty owners generally report income and deductions (including depletion) on Schedule E (Form 1040).
- Working interest owners report on Schedule C (Form 1040) since their income is subject to self-employment tax.
2. Document all transactions
- Keep detailed reserve estimates, production records, and supporting reports (such as engineering or geological evaluations) to justify your depletion calculations and basis.
3. Make timeous estimated tax payments
- Because tax isn’t usually withheld from royalty or production payments, you may need to make quarterly estimated payments to avoid underpayment penalties.
At Fusion CPA, we help oil and gas investors stay compliant, optimize deductions, and plan strategically for future production years.
Want to reduce your taxable income and plan smarter for your next production year? Book your depletion strategy session before year-end. Schedule a Discovery Call today!
Frequently Asked Questions
- Can I claim both cost and percentage depletion in the same year?
You can calculate both each year if you qualify, but you can only claim the larger deduction of the two for each property.
- What records should I keep for depletion deductions?
Keep detailed records of your property basis, production volumes, reserve estimates, and income per property. The IRS requires proof of how you calculated the deduction.
- Do I have to be an oil company to claim depletion?
No. Royalty owners and independent producers can claim depletion if they own an economic interest in the property. Large, integrated oil companies cannot claim percentage depletion.
____________________________________________________
This blog does not provide legal, accounting, tax, or other professional advice. We base articles on current or proposed tax rules at the time of writing. We do not update older posts for tax rule changes. Our team disclaims all liability regarding actions taken or not taken based on the contents of this blog. The same goes for the use or interpretation of this information. This website does not provide all-inclusive information, and you should not rely on it as such.