Depletion – The Larger of Cost or Percentage!

We had a reader ask the following question:

“Hi, I just inherited a Kansas wheat farm with an oil well on it. I assume that I still get the 15% percentage depletion on the oil royalty. My question is do you know if I can “value” the oil and then take a larger cost depletion deduction from the royalty income? “

Many farmers in the Midwest and other areas of the United States may have situations similar to this reader.  Many of our clients are now making more money from their oil and gas income than from farming. 

One method of reducing this income is the use of depletion.  Cost depletion is similar to depreciation and is based upon the amount of units sold during the year compared to the estimated total units still available to be sold.  For example, assume a farmer inherits a piece of farm land with an oil well on it.  A qualified survey of the oil well is performed and it is estimated there is 30,000 barrels of oil still to be pumped from the ground.  During 2011, the farmer pumps 1,000 barrels of oil.  The value of the oil in the ground at the time of the inheritance was estimated at $300,000 or $10 per barrel, therefore, the cost depletion deduction for 2011 is $10,000 (1,000 barrels times $10).

Another method of depletion is the use of percentage depletion.  This method takes the gross income derived from oil sales and times it by a percentage (in most cases 15%).  The farmer is allowed to use either percentage or cost depletion each year and is entitled to the greater of each.  This can be cost one year and percentage the next.  In our same example, lets assume the farmer collects $50,000 from the sale of their oil for the year.  Percentage depletion based upon 15% would equal a deduction of $7,500.  Since cost depletion of $10,000 is higher than percentage depletion, the farmer would deduct cost depletion in this year.  However, lets assume the farmer received $100,000 from the sale of their oil.  In this case, percentage depletion of $15,000 would be higher than cost depletion and the farmer could use percentage depletion.

One drawback of depletion is that the farmer must reduce the basis in their oil and gas property by the amount of depletion taken. 

As you can see, these calculations can get complicated and there are various other rules on percentage depletion that can limit the amount of this deduction.  If you have an oil and gas well on your farmland, you should review this with a tax advisor that understands this type of taxation.

But, the bottom line is you can take cost depletion based on the cost allocated to the oil reserves if cost depletion is greater than percentage depletion.