The IRS code provides the percentage or cost depletion allowance as a means for owners to account for the depletion of reserves during the production and sale of oil and gas.
This depletion allowance is a deduction from gross income and reflects the reduction of mineral deposits. It is designed to encourage investors to engage in investments such as oil and gas production by applying the cost depletion deduction.
In the United States, individuals who hold an economic interest in a mineral deposit, such as natural gas reserves, can claim the oil depletion allowance. Depletion deductions stem from the principle or concept that the asset is both a capital investment and a wasting asset. Because of this, depreciation can serve as a means of offsetting or treating a capital loss against the income generated by the asset.
The allowance has attracted significant interest due to the close relationship between the oil industry and the government. Moreover, the percentage depletion method enables claimants to write off more than the entire capital cost of the asset.
Who is Eligible to Claim a Depletion Allowance?
A deduction for depletion can be taken by a party who demonstrates an economic interest in a mineral property. Economic interest exists when the following conditions are met:
- The party has invested in an interest in mineral deposits.
- The party has a legal entitlement to income from the mineral extraction, which serves as a return on their capital investment.
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Do Rates Vary?
The IRS establishes depletion rates for different natural resources, which can vary. Here are some examples of the prevailing rates:
- Oil and gas -15%
- Borax, limestone, granite, mollusk shells, marble, slate, potash, carbon dioxide from wells, and soapstone – 14%
- Gravel, sand, and crushed stone – 5%
- Iron, copper, gold, ore, silver, and specific oil shale deposits – 15%
Benefit of Depletion Allowance
Due to the depletion allowance, investing in oil and gas wells has become one of the most tax-favored options in the United States. As a result, independent oil and gas producers and small investors can enjoy a tax-free income of approximately 15 percent of their gross income from oil and gas operations.
The depletion deduction for non-renewable resources has no limit on the total amount that can be deducted from income. However, percentage depletion can only be applied to oil and gas properties that generate net income. Percentage depletion cannot be applied if a property incurs a net loss in a specific tax year. The usual practice is to cap percentage depletion at 50 percent of the net income.
Two methods can be used to compute for the oil depletion allowance: cost depletion and percentage depletion. If net income is less than 15 percent of gross income, a percentage depletion deduction is limited to 100 percent of net income.
Conclusion
Under U.S. tax law, anyone with an economic interest in a mineral deposit can benefit from the oil depletion allowance. This allowance is a significant subsidy for corporations.
The oil depletion allowance provides a tax-advantaged investment opportunity for investors in the United States. However, the allowance varies for different natural resources, and it is worth noting that royalty owners in oil and gas operations enjoy a taxable income limit.
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Sources:
“Overview of the Mining Industry,” U.S. Department of Treasury, https://www.irs.gov/pub/irs-utl/mining_industry_overview_november_2006.pdf
“Percentage Depletion: Meaning, Overview, Benefits,” Investopedia, https://www.investopedia.com/terms/p/percentage-depletion.asp
“Depletion Allowance,” Investing Answers, https://investinganswers.com/dictionary/d/depletion-allowance
“Allowance of deduction for depletion,” Cornell Law School, https://www.law.cornell.edu/cfr/text/26/1.611-1
“Percentage Depletion: Meaning, Overview, Benefits,” Investopedia, https://www.investopedia.com/terms/p/percentage-depletion.asp
“Using the Depletion Deduction to Minimize Oil and Gas Tax Liability,” Ohio State University Extension, https://ohioline.osu.edu/factsheet/SOGD-TAX3