Landowners who have active oil and gas extraction on their property may be able to reduce their income tax liability for their royalty payments by using what the Internal Revenue Service (IRS) refers to as the "depletion deduction."
What is the Depletion Deduction?
The IRS defines depletion as "the using up of natural resources by mining, quarrying, drilling, or felling." Recognizing that oil, gas, and other minerals are used up or depleted as they are extracted, the IRS allows for a reasonable income tax deduction based on depletion of the mineral resource.
Who is Eligible?
Three factors determine whether a landowner qualifies for the depletion deduction. First, the landowner must have an ownership interest in the mineral property. Second, the landowner must have a legal right to income from the oil and gas extraction. Third, the deduction is allowed only when oil or gas is actually sold and income is reportable. Therefore, this deduction is not an applicable deduction against lease bonus payments but is for royalty payments.
Which Method to Use?
The IRS requires a landowner to compare two methods when determining the depletion deduction, and to use the method which provides the largest deduction.
Cost depletion method
This method is tied to the landowner's basis in the property. The cost basis of a property is usually determined upon its acquisition (by purchase, inheritance, gift). The basis usually includes the value of the land and its associated capital assets such as timber, equipment, buildings, and oil/gas. When establishing the basis, the landowner splits the value of the property at acquisition among these different capital assets.
In Ohio, it is not common for landowners to allocate part of the basis to the oil and gas reserves. Because of this, most landowners will not be able to use the cost depletion method. However, they can use percentage depletion deduction which will be described more in detail later in this fact sheet.
The following information is necessary for determining cost depletion:
1. The property's basis for depletion, determined by subtracting all of the following from the adjusted basis of the property:
• Amounts recovered through depreciation deductions, deferred expenses, and deductions other than depletions.
• The residual value of land and improvements at the end of operations.
• The cost or value of land acquired for purposes other than mineral production.
2. The total recoverable units of mineral in the property's natural deposit.
3. The number of units of minerals sold during the tax year.
The adjusted basis of property is the original cost or other basis, plus certain additions and improvements, and minus certain deductions such as depletion allowed and casualty losses. The adjusted basis can never be less than zero.
The total recoverable units is the sum of the number of units of minerals remaining at the end of the year plus the number of units of minerals sold during the tax year. The landowner is required to estimate or determine the recoverable units of mineral product using the current industry method and the most accurate and reliable information available. There is a provision which allows land owners to select an elective safe harbor to determine the recoverable units. For details see Procedure-2004-19 of IRS Bulletin 2004-10.
The number of units sold during the tax year is based on the accounting method used. For those using the cash method of accounting, the units sold during the year are the units sold for which payment was received. For those using the accrual accounting method, the units sold during the year are the units sold based on inventories and method of accounting for inventory. The number of units sold during the tax year does not include any for which depletion deductions were allowed or allowable in earlier years.
A landowner calculates the cost depletion deduction as follows:
- Step 1: Divide the property's basis for depletion by the total recoverable units, which results in a rate per unit.
- Step 2: Multiply the rate per unit by the units sold during the tax year to arrive at the cost depletion deduction.
Example of cost depletion:
Landowner Buxton recently inherited 400 acres of property from his father. Upon his father's death, the value of the land received a stepped-up basis to its fair market value of $4,000 per acre. The total value of the land is $1,600,000. Due to recent increase of oil and gas drilling in Ohio, he allocated a portion of the land's basis to the mineral rights. He establishes a basis in the mineral rights to be $80,000. Through a geological survey, it was determined there is 4,000 million cubic feet (MMcf) of natural gas reserves. In the first year, the well produced 400 MMcf.
The first step to calculate the cost depletion is to calculate the value for each depletion unit. This is calculated by dividing the adjusted basis of the reserves by the total reserve units. In this example, Mr. Buxton would divide $80,000 by 4,000 MMcf which equals $20 per MMcf or $0.02/Mcf. In the first year, 400 MMcf of gas were sold. For this amount the cost depletion value is (400 MMcf * $20/MMcf) is $8,000. Since this is less than his cost basis of $80,000, he can deduct $8,000 for his cost depletion on Schedule E. His adjusted basis for the next tax year will be $72,000, eligible for cost depletion.
Percentage depletion method
This method uses a specified percentage (15% for natural gas) of the landowner's gross income from the property, limited to the lesser of 15% of the landowner's taxable income from the property or 65% of the landowner's taxable income from all sources. A landowner cannot use percentage depletion unless the landowner is a producer or royalty owner and their well produces natural gas that is either sold under a fixed contract or produced from geopressurized brine.
For purposes of percentage depletion, gross income from the property (in the case of oil and gas wells) is the amount you receive from the sale of the oil or gas in the immediate vicinity of the well. Gross income from the property does not include lease bonuses, advance royalties, or other amounts payable without regard to production from the property. It should be noted that a landowner can carry over to the following year any amount they cannot deduct because of the 65% of taxable income limit. The carried over amount is added to the depletion allowance (before applying any limits) for the next year.
Examples of percentage depletion:
Example 1: Farmer Jefferson receives royalty income of $12,000, which is the only income received from his real estate. He has a taxable income from all other sources of $50,000. To calculate his percentage depletion, Farmer Jefferson first multiplies the royalty income of $12,000 by the specified percentage of 15%, which equals $1,800. He then determines if his deduction will be limited by the 65% taxable rule. In this example, he takes his taxable income of $50,000 multiplied by 65% which equals $32,500. Because $1,800 is smaller than $32,500, his deletion would not be limited. His depletion deduction would be $1,800 and placed on line 18 of Schedule E.
Example 2: Jennifer Estes receives royalty income of $50,000, which is the only income received from her real estate. She has a taxable income from all sources of $125,000. To calculate her percentage depletion, Jennifer first multiplies the royalty income of $50,000 by the specified percentage of 15%, which equals $7,500. She then sees if this amount is limited by the 65% income rule. To do this, she multiplies her taxable income of $125,000 by 65% which equals $81,250. Since $7,500 is smaller than her $81,250 limit, she can deduct the entire $7,500 on line 18 on Schedule E.
The Importance of Professional Assistance
The depletion deduction is an important yet complex tax liability tool. We strongly encourage all landowners to seek the advice of an accountant, attorney, or other tax professional familiar with oil and gas laws and IRS tax codes.
Conclusion
The depletion deduction is something all eligible landowners should explore as a way of reducing their tax liability for gas royalty payments. Most landowners will use the percentage depletion method for calculating the depletion deduction because they lack an established basis in the mineral portion of their property and thus cannot use the cost depletion method.
This fact sheet is not a comprehensive review of the IRS Depletion Deduction allowance. The entire document is available online at irs.gov/publications/p535/ch09.html.
References
- Jacobsen, Michael. Tax Treatment of Natural Gas. 2011. State College, Pennsylvania. Accessible at: extension.psu.edu/tax-treatment-of-natural-gas.
- U.S. Department of the Treasury, Internal Revenue Service. 2011. Business Expenses (IRS Publication 535). Washington, DC: U.S. Government Printing Office. irs.gov/publications/p535/ch09.html
Thank you to the following for reviewing this publication: Barry Ward, Director of the OSU Income Tax Schools and Peggy Kirk Hall, Director, OSU Extension Agricultural & Resource Law Program