Table of Contents
Marginal production of oil and gas. For tax years beginning after December 31, 2007, the temporary suspension of the taxable income limit on percentage depletion from the marginal production of oil and natural gas is scheduled to expire. See Percentage Depletion.
Depletion is the using up of natural resources by mining, quarrying, drilling, or felling. The depletion deduction allows an owner or operator to account for the reduction of a product's reserves.
There are two ways of figuring depletion: cost depletion and percentage depletion. For mineral property, you generally must use the method that gives you the larger deduction. For standing timber, you must use cost depletion.
If you have an economic interest in mineral property or standing timber, you can take a deduction for depletion. More than one person can have an economic interest in the same mineral deposit or timber.
You have an economic interest if both the following apply.
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You have acquired by investment any interest in mineral deposits or standing timber.
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You have a legal right to income from the extraction of the mineral or cutting of the timber to which you must look for a return of your capital investment.
A contractual relationship that allows you an economic or monetary advantage from products of the mineral deposit or standing timber is not, in itself, an economic interest. A production payment carved out of, or retained on the sale of, mineral property is not an economic interest.
Individuals, corporations, estates, and trusts who claim depletion deductions may be liable for alternative minimum tax.
Mineral property includes oil and gas wells, mines, and other natural deposits (including geothermal deposits). For this purpose, the term “property” means each separate interest you own in each mineral deposit in each separate tract or parcel of land. You can treat two or more separate interests as one property or as separate properties. See section 614 of the Internal Revenue Code and the related regulations for rules on how to treat separate mineral interests.
There are two ways of figuring depletion on mineral property.
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Cost depletion.
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Percentage depletion.
Generally, you must use the method that gives you the larger deduction. However, unless you are an independent producer or royalty owner, you generally cannot use percentage depletion for oil and gas wells. See Oil and Gas Wells, later.
To figure cost depletion you must first determine the following.
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The property's basis for depletion.
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The total recoverable units of mineral in the property's natural deposit.
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The number of units of mineral sold during the tax year.
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Amounts recoverable through:
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Depreciation deductions,
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Deferred expenses (including deferred exploration and development costs), and
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Deductions other than depletion.
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The residual value of land and improvements at the end of operations.
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The cost or value of land acquired for purposes other than mineral production.
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The number of units of mineral remaining at the end of the year (including units recovered but not sold).
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The number of units of mineral sold during the tax year (determined under your method of accounting, as explained next).
IF you
use ... |
THEN the units sold during the year are ... |
The cash method of accounting | The units sold for which you receive payment during the tax year (regardless of the year of sale). |
An accrual method of accounting | The units sold based on your inventories and method of accounting for inventory. |
Step | Action | Result |
1 |
Divide your property's
basis for depletion by total recoverable units. |
Rate per unit. |
2 |
Multiply the rate per
unit by units sold during the tax year. |
Cost depletion deduction. |
Note.
You must keep accounts for the depletion of each property and adjust these accounts each year for units sold and depletion claimed.
To figure percentage depletion, you multiply a certain percentage, specified for each mineral, by your gross income from the property during the tax year.
The rates to be used and other conditions and qualifications for oil and gas wells are discussed later under Independent Producers and Royalty Owners and under Natural Gas Wells. Rates and other rules for percentage depletion of other specific minerals are found later in Mines and Geothermal Deposits.
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Any rents or royalties you paid or incurred for the property.
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The part of any bonus you paid for a lease on the property allocable to the product sold (or that otherwise gives rise to gross income) for the tax year.
No. of units sold in the tax year Recoverable units from the property |
× | Bonus Payments |
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Operating expenses.
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Certain selling expenses.
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Administrative and financial overhead.
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Depreciation.
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Intangible drilling and development costs.
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Exploration and development expenditures.
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Do not deduct any net operating loss deduction from the gross income from the property.
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Corporations do not deduct charitable contributions from the gross income from the property.
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If, during the year, you dispose of an item of section 1245 property that was used in connection with mineral property, reduce any allowable deduction for mining expenses by the part of any gain you must report as ordinary income that is allocable to the mineral property. See section 1.613-5(b)(1) of the regulations for information on how to figure the ordinary gain allocable to the property.
You cannot claim percentage depletion for an oil or gas well unless at least one of the following applies.
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You are either an independent producer or a royalty owner.
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The well produces natural gas that is either sold under a fixed contract or produced from geopressured brine.
If you are an independent producer or royalty owner, see Independent Producers and Royalty Owners, next.
For information on the depletion deduction for wells that produce natural gas that is either sold under a fixed contract or produced from geopressured brine, see Natural Gas Wells, later.
If you are an independent producer or royalty owner, you figure percentage depletion using a rate of 15% of the gross income from the property based on your average daily production of domestic crude oil or domestic natural gas up to your depletable oil or natural gas quantity. However, certain refiners, as explained next, and certain retailers and transferees of proven oil and gas properties, as explained later, cannot claim percentage depletion. For information on figuring the deduction, see Figuring percentage depletion, later.
For example, a corporation, partnership, estate, or trust and anyone who holds a significant ownership interest in it are related persons. A partnership and a trust are related persons if one person holds a significant ownership interest in each of them.
For purposes of the related person rules, significant ownership interest means direct or indirect ownership of 5% or more in any one of the following.
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The value of the outstanding stock of a corporation.
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The interest in the profits or capital of a partnership.
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The beneficial interests in an estate or trust.
Any interest owned by or for a corporation, partnership, trust, or estate is considered to be owned directly both by itself and proportionately by its shareholders, partners, or beneficiaries.
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You sell oil or natural gas or their by-products directly or through a related person in any of the following situations.
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Through a retail outlet operated by you or a related person.
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To any person who is required under an agreement with you or a related person to use a trademark, trade name, or service mark or name owned by you or a related person in marketing or distributing oil, natural gas, or their by-products.
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To any person given authority under an agreement with you or a related person to occupy any retail outlet owned, leased, or controlled by you or a related person.
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The combined gross receipts from sales (not counting resales) of oil, natural gas, or their by-products by all retail outlets taken into account in (1) are more than $5 million for the tax year.
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Bulk sales (sales in very large quantities) of oil or natural gas to commercial or industrial users.
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Bulk sales of aviation fuels to the Department of Defense.
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Sales of oil or natural gas or their by-products outside the United States if none of your domestic production or that of a related person is exported during the tax year or the prior tax year.
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You do not have a significant ownership interest in the retailer.
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You sell your production to persons who are not related to either you or the retailer.
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The retailer does not buy oil or natural gas from your customers or persons related to your customers.
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There are no arrangements for the retailer to acquire oil or natural gas you produced for resale or made available for purchase by the retailer.
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Neither you nor the retailer knows of or controls the final disposition of the oil or natural gas you sold or the original source of the petroleum products the retailer acquired for resale.
Example.
John Oak owns oil property in which Paul Elm owns a 20% net profits interest. During the year, the property produced 10,000 barrels of oil, which John sold for $200,000. John had expenses of $90,000 attributable to the property. The property generated a net profit of $110,000 ($200,000 - $90,000). Paul received income of $22,000 ($110,000 × .20) for his net profits interest.
Paul determined his percentage participation to be 11% by dividing $22,000 (the income he received) by $200,000 (the gross revenue from the property). Paul determined his share of the oil production to be 1,100 barrels (10,000 barrels × 11%).
Example.
You have both oil and natural gas production. To figure your depletable natural gas quantity, you choose to apply 360 barrels of your 1000-barrel depletable oil quantity. Your depletable natural gas quantity is 2.16 million cubic feet of gas (360 × 6000). You must reduce your depletable oil quantity to 640 barrels (1000 - 360).
If you have production from marginal wells, see section 613A(c)(6) of the Internal Revenue Code to figure your depletable oil or natural gas quantity.
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Corporations, trusts, and estates if 50% or more of the beneficial interest is owned by the same or related persons (considering only persons that own at least 5% of the beneficial interest).
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You and your spouse and minor children.
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Figure your average daily production of oil or natural gas for the year.
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Figure your depletable oil or natural gas quantity for the year.
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Figure depletion for all oil or natural gas produced from the property using a percentage depletion rate of 15%.
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Multiply the result figured in (3) by a fraction, the numerator of which is the result figured in (2) and the denominator of which is the result figured in (1). This is your depletion allowance for that property for the year.
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100% of your taxable income from the property figured without the deduction for depletion and the deduction for domestic production activities under section 199 of the Internal Revenue Code. For a definition of taxable income from the property, see Taxable income limit, earlier, under Mineral Property.
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65% of your taxable income from all sources, figured without the depletion allowance, the deduction for domestic production activities, any net operating loss carryback, and any capital loss carryback.
Note.
For tax years beginning before January 1, 2008, depletion on the marginal production of oil or natural gas is not limited to your taxable income from the property figured without the depletion deduction. For information on marginal production, see section 613A(c)(6) of the Internal Revenue Code.
Generally, each partner or shareholder, and not the partnership or S corporation, figures the depletion allowance separately. (However, see Electing large partnerships must figure depletion allowance, later.) Each partner or shareholder must decide whether to use cost or percentage depletion. If a partner or shareholder uses percentage depletion, he or she must apply the 65%-of-taxable-income limit using his or her taxable income from all sources.
Each partner or shareholder must separately keep records of his or her share of the adjusted basis in each oil and gas property of the partnership or S corporation. The partner or shareholder must reduce his or her adjusted basis by the depletion allowed or allowable on the property each year. The partner or shareholder must use that reduced adjusted basis to figure cost depletion or his or her gain or loss if the partnership or S corporation disposes of the property.
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Form 6198, At-Risk Limitations.
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Form 8582, Passive Activity Loss Limitations.
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The partnership had 100 or more partners in the preceding year.
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The partnership chooses to be an electing large partnership.
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Refiners who cannot claim percentage depletion (discussed under Independent Producers and Royalty Owners, earlier).
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Retailers who cannot claim percentage depletion (discussed under Independent Producers and Royalty Owners, earlier).
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Any partner whose average daily production of domestic crude oil and natural gas is more than 500 barrels during the tax year in which the partnership tax year ends. Average daily production is discussed earlier.
You can use percentage depletion for a well that produces natural gas either sold under a fixed contract or produced from geopressured brine.
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Produced from a well you began to drill after September 1978 and before 1984.
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Determined in accordance with section 503 of the Natural Gas Policy Act of 1978 to be produced from geopressured brine.
Certain mines, wells, and other natural deposits, including geothermal deposits, qualify for percentage depletion.
DEPOSITS | RATE |
Sulphur, uranium, and, if from deposits in the United States, asbestos, lead ore, zinc ore, nickel ore, and mica | 22% |
Gold, silver, copper, iron ore, and certain oil shale, if from deposits in the United States | 15% |
Borax, granite, limestone, marble, mollusk shells, potash, slate, soapstone, and carbon dioxide produced from a well | 14% |
Coal, lignite, and sodium chloride | 10% |
Clay and shale used or sold for use in making sewer pipe or bricks or used or sold for use as sintered or burned lightweight aggregates | 7½% |
Clay used or sold for use in making drainage and roofing tile, flower pots, and kindred products, and gravel, sand, and stone (other than stone used or sold for use by a mine owner or operator as dimension or ornamental stone) | 5% |
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The percentage depletion deduction for the tax year (figured without regard to this reduction), minus
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The adjusted basis of the property at the close of the tax year (figured without the depletion deduction for the tax year).
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Extracting ores or minerals from the ground.
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Applying certain treatment processes.
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Transporting ores or minerals (generally, not more than 50 miles) from the point of extraction to the plants or mills in which the treatment processes are applied.
Internal Revenue Service
Associate Chief Counsel
Passthroughs and Special Industries
CC:PSI:FO
1111 Constitution Ave., N.W., IR-5300
Washington, DC 20224
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You disposed of it after holding it for more than 1 year.
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You disposed of it under a contract under which you retain an economic interest in the coal or iron ore.
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A related person (as listed in chapter 2 of Publication 544).
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A person owned or controlled by the same interests that own or control you.
A lessor's gross income from the property that qualifies for percentage depletion usually is the total of the royalties received from the lease. However, for oil, gas, or geothermal property, gross income does not include lease bonuses, advanced royalties, or other amounts payable without regard to production from the property.
You can figure timber depletion only by the cost method. Percentage depletion does not apply to timber. Base your depletion on your cost or other basis in the timber. Your cost does not include the cost of land or any amounts recoverable through depreciation.
Depletion takes place when you cut standing timber. You can figure your depletion deduction when the quantity of cut timber is first accurately measured in the process of exploitation.
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Determine your cost or adjusted basis of the timber on hand at the beginning of the year. Adjusted basis is defined under Cost Depletion in the discussion on Mineral Property.
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Add to the amount determined in (1) the cost of any timber units acquired during the year and any additions to capital.
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Figure the number of timber units to take into account by adding the number of timber units acquired during the year to the number of timber units on hand in the account at the beginning of the year and then adding (or subtracting) any correction to the estimate of the number of timber units remaining in the account.
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Divide the result of (2) by the result of (3). This is your depletion unit.
Example.
You bought a timber tract for $160,000 and the land was worth as much as the timber. Your basis for the timber is $80,000. Based on an estimated one million board feet (1,000 MBF) of standing timber, you figure your depletion unit to be $80 per MBF ($80,000 ÷ 1,000). If you cut 500 MBF of timber, your depletion allowance would be $40,000 (500 MBF × $80).
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