9.15 Depletion Deduction

Properties subject to depletion deductions are mines, oil and gas wells, timber, and exhaustible natural deposits.

Two methods of computing depletion are: (1) cost depletion and (2) percentage depletion. If you are allowed to compute under either method, you must use the one that produces the larger deduction. In most cases, this will be percentage depletion. For timber, you must use cost depletion.

Cost depletion.

The cost depletion of minerals is computed as follows: (1) divide the total number of units (such as tons or barrels) remaining in the deposit to be mined into the adjusted basis of the property; and (2) multiply the unit rate found in Step 1 by the number of units for which payment is received during the taxable year if you are on the cash basis, or by the number of units sold if you are on the accrual basis.

Adjusted basis is the original cost of the property, less depletion allowed, whether computed under the percentage or cost depletion method. It does not include nonmineral property such as mining equipment. Adjusted basis may not be less than zero.

Timber depletion is based on the cost of timber (or other basis in the owner’s hands) and does not include any part of the cost of land. Depletion takes place when standing timber is cut. Depletion must be computed by the cost method, not by the percentage method. However, instead of claiming the cost depletion method, you may elect to treat the cutting of timber as a sale subject to capital gain or loss treatment. For further details, see IRS Publication 535.

Percentage depletion.

Percentage depletion is based on a certain percentage rate applied to annual gross income derived from the resource. In determining gross income for percentage depletion, do not include any lease bonuses, advance royalties, or any other amount payable without regard to production. A deduction for percentage depletion is allowed even if the basis of the property is already fully recovered by prior depletion deductions. The percentage to be applied depends upon the mineral involved; the range is from 5% up to 22%. For example, the maximum 22% depletion deduction applies to sulphur, uranium, and U.S. deposits of lead, zinc, nickel, mica, and asbestos. A 15% depletion percentage applies to U.S. deposits of gold, silver, copper, iron ore, and shale.

Taxable income limit.

For properties other than oil and gas, the percentage depletion deduction may not exceed 50% of taxable income from the property computed without the depletion deduction. In computing the 50% limitation, a net operating loss deduction is not deducted from gross income. A 100% taxable income limit applies to oil and gas properties (9.16).

Oil and gas property.

Percentage depletion for oil and gas wells was repealed as of January 1, 1975, except for the following exemptions: (1) small independent producers and royalty owners and (2) for gas well production (9.16).