What is an Oil and Gas Depletion Allowance for Mineral Rights Owners?

If you own mineral rights or oil and gas royalties, then you may be lucky enough to have a large income stream each month for the extraction and sale of precious minerals. When it comes time to pay taxes on your earnings, there are a number of deductions designed to help you keep as much of your earnings as possible. In this article, we are going to focus on fully explaining oil and gas Depletion Allowances as it relates to mineral rights and royalties.

Depletion Allowance Definition

Depletion can be defined as “using up a natural resource through drilling, mining, etc.” The IRS allows for a mineral rights owner to account for the reduction in mineral production through an oil and gas depletion allowance. This allows mineral rights and oil and gas royalty owners to recover the cost from initially high capital investment.

The Two Types of Depletion Allowance for Oil and Gas Royalties

There are two main types of oil and gas depletion allowance: cost and percentage. Mineral rights owners will generally choose whichever method will lead to the highest possible tax deduction.

Cost Depletion Allowance

In a cost depletion allowance, an estimate is made as to what percentage of the valuable reserves can still be recovered from an active property’s subsurface. The taxpayer will take this percentage and apply that to the original cost of their capital investment.

Percentage Depletion Allowance

A percentage depletion allowance is slightly different. Instead of applying a percentage of the estimated remaining minerals to the original investment cost, percentage depletion allowances use a flat rate of 15% of the reserves gross income. If the gross income is high, this allows for percentage depletion users to recover costs that exceed the cost of the original investment.

In percentage depletion, there is a limit on the amount of taxable income as it applies to oil and gas royalty owners. Currently, It is either 65% of your property income, or 100% of your overall income, whichever is smaller without deductions or allowances for depletion.