Demystifying Depletion: What Investors Should Know

Investors in oil and gas properties should ensure that they do not overlook a significant tax deduction for these capital intensive and risky projects. They can deduct a portion of the property’s income to help recover some of the capitalized costs to develop the oil resource and to account for the reduction of the property’s value or basis as a result of the oil production.

This “depletion deduction” can be a key tax benefit for partners and shareholders of pass-through entities that invest in oil and gas properties. Although determining depletion can be complex, owners of oil and gas properties should understand this deduction and how it impacts their taxable income.

Depletion Calculations

The tax code provides two methods for calculating depletion: percentage depletion and cost depletion. Investors should calculate depletion using both methods and deduct the greater amount.

Percentage depletion

Percentage depletion allows oil and gas investors to deduct the lesser of 15% of gross income or net income from each well on a yearly basis. Low-producing marginal wells are allowed to deduct more than 15%. Gross income is generally the sales of the resource produced from the well reduced by gathering and marketing costs, while net income is generally the well’s gross income reduced by taxes, lease operating expenses, depreciation, intangible drilling costs (IDC) and overhead.

Investors use current year revenues and expenses on a per-well basis when calculating depletion. The deduction is limited to 1,000 barrels of oil per day. Since percentage depletion depends on current year production rather than on basis, it is possible to generate depletion in excess of basis. Taxpayers cannot take the deduction, however, if the well has a net loss in the tax year. New wells typically have minimal or no percentage depletion during their first year of production.

Cost depletion

Cost depletion allows oil and gas investors to deduct the actual exploration and development costs of the oil from the property’s basis. The depletion deduction is limited to the amount of net basis, which is the gross basis reduced by any accumulated depletion taken previously.

Similar to a depreciation calculation, the depletion of basis is calculated using a unit-of-production method. For example, assume a company’s reserve report determines that there are 10 barrels of oil under the ground at the beginning of the year. If the company extracted three of those barrels during the current year, the cost depletion rate would be 30%. If the company’s leasehold cost was $1,000, the cost depletion would be $300.

Depletion is a Partner and Shareholder Deduction

While passthrough entities often report the depletion deduction to partners and shareholders on line 20T of their Schedule K-1, the entity does not take the deduction. Instead, partners or shareholders take the depletion deduction on their individual tax returns.

The depletion reported on the Schedule K-1 is often called “simulated depletion,” as it does not necessarily reflect what the partner or shareholder will report on their return. Partners or shareholders may report a different depletion amount for various reasons, including the limits on percentage depletion under IRC Section 613A, capitalization of IDC that amortized from current and previously reported IDC, the lack of net income, and the 1,000-barrel-a-day limit.

Weaver can assist you in navigating the shifting complexities of the oil and gas landscape. Contact us today to learn more about all the ways we can help.

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