Depletion Allowance

[billcw98]

Several years ago, I inherited a portion of the mineral rights to an oil well. I did not have to invest any money and I receive a royalty check every month based on the amount of oil that is pumped/purchased. I also do not incur any expenses to receive this check. Although I have read the TT help and an outside article (furnished by the company that sends me the checks), I am still not certain I am entitled to the depletion deduction. Here is the excerpt from that article: 

In other words, the depletion allowance is an oil and gas deduction from gross income that is allowed, reflecting the depletion of mineral deposits. The cost depletion deduction applied is based on the fact that investors should be incentivized to engage in high-risk investments such as oil and natural gas production.

In the United States, anyone can claim the oil depletion allowance if they hold an economic interest in a mineral deposit, for example, natural gas reserves. The depletion deductions follow a principle that states the asset represents a capital investment, a wasting asset. As a result, depreciation can be considered an offset – or a capital loss – against asset-generated income.

I have used TT in the preceding years and have never claimed it, but now am not so sure whether or not I should have. 

Thank you in advance for any help/insights!

[Mike9241]

A depletion deduction is allowed when a taxpayer has an economic interest in mineral property. 

there are two ways to compute depletion - you can take the larger one. 

1) percentage depletion  - is based on a % of gross revenues the % varies with the type of mineral

2) cost depletion which is computed as follows "unrecovered depletable costs"  dividend by the number of "estimated recoverable reserves (in units) at the beginning of the year times the units sold during the year   

percentage depletion is not subject to recapture if property sold but cost depletion may be even if you didn't take it. seek professional guidance. 

[PaulaM]

Yes, as an owner (in addition to mineral producers) of the mineral interest you are entitled to a depletion deduction of 15%. The IRS allows for a recovery for that depletion of a mineral resource.

In addition to the depletion, you are allowed deductions for taxes and other production costs based on the oil extraction. The drilling company typically shows these amount on your royalty statement. Royalties are reported in their gross amount, but you likely received an amount net of these costs so look over the statements carefully to deduct the differences. 

Lastly, if you owned the property in addition to the mineral rights you could deduct the property taxes associated with the property (assuming its vacant land).  Check with your state also. Some may offer additional depletion allowances and if they do, you would deduct under the state return.

[billcw98]

Thank you for the information! It did help further clarify my understanding of the depletion allowance. 

Because I have not invested any money to purchase any fixed assets (nor have I invested any money at all to operate/maintain this well/capital asset), it is my understanding that I would not be entitled to claim this deduction. Am I interpreting this correctly? 

[JulieS]

No, that's not right. In the case of oil and gas resources, the allowance for depletion may be computed on a cost or percentage depletion basis, whichever results in a greater allowance for depletion for the tax year. 

Percentage depletion allows the deduction of a statutory percentage of gross income from property, and bears no relationship to cost or other basis. 

In fact, an allowance calculated under percentage depletion is deductible even when the taxpayer's adjusted basis in the property is zero, provided that the taxpayer has gross income from the property.

[billcw98]

Got it! Thank you very much. I have the complete picture.

[tpclark]

Where is this entered?  Thank you.

[PaulaM]

The 15% depletion allowance is automatically calculated in the Royalty section when you indicate that you have Oil & Gas Income. If your state allows additional depletion, it is often a manual calculation that is entered on the state return. @tpclark 

[tpclark]

The income was reported via K1.  I saw another post where I would need to create a separate entry to record the depletion deduction.

[billcw98]

Where on Schedule E do I find the 15% depletion amount listed? Although the royalty income amount is listed, I do not see where the 15% depletion amount. Also, when I go to the two year schedule comparison, there is no amount of income listed for this year or last? Am I looking at the wrong sheet/schedule?

[DianeW777]

It depends. You have a couple of options.

1. If you do not see an entry for depletion you can add another Schedule E to record only the depletion since the royalty comes from a K-1. 
2. Or you can simply reduce the K-1 royalties by 15% depletion expense 
3. Or you can remove the royalty from the K-1, enter it in Schedule E and add your depletion expense at the same time

• Gross royalty x 15% = depletion
• Gross royalty - depletion - taxable amount of royalty

Search (upper right) > Type schedule e > Click the Jump to... link > Enter your royalty property (either step 1 or 3)

@tpclark 

@billcw98