Depletion Allowance

The depletion allowance is a federal tax provision that recognizes mineral reserves as a wasting asset and allows the owner to deduct a portion of royalty income each year to account for that gradual exhaustion. It is roughly analogous to depreciation for physical assets, but with a structure specific to oil, gas, and other extractive industries.

There are two methods of calculating depletion: cost depletion and percentage depletion. Mineral owners generally use percentage depletion, which is simpler and often more advantageous, while large producers use cost depletion, which is required above certain volume thresholds.

Percentage depletion: 15 percent of gross royalty income from oil and gas wells (subject to several limits) can be deducted each year. The 15 percent is set by statute and applies regardless of the actual reserves remaining. There is a limit: the deduction cannot exceed 100 percent of the property’s net taxable income before the depletion deduction, and there is an overall cap of 65 percent of the taxpayer’s taxable income from all sources.

The practical effect is meaningful: roughly fifteen percent of gross royalty income comes off the top before income tax is calculated. For ongoing royalty income, particularly in higher tax brackets, this is a noticeable reduction in effective tax rate compared to most other forms of passive income.

A few important wrinkles:

Percentage depletion is available to most individual mineral owners and small-to-mid producers. It is restricted for oil and gas integrated producers (the major oil companies) and capped at certain production volumes. Most mineral owners, especially inheritors of family interests, fall well within the eligibility window.

Cost depletion, the alternative method, is based on the actual basis the owner has in the property and the percentage of reserves produced each year. For inherited mineral rights, the basis is typically the fair market value at the date of death (the “stepped-up basis”), which can be significant. Cost depletion is often less advantageous than percentage depletion for active wells, but mineral owners have the option to use whichever method produces the higher deduction in any given year.

The depletion allowance does not require any action from the mineral owner beyond claiming it on their tax return. A competent CPA or tax preparer with oil and gas experience handles the calculation. Most royalty payments arrive with a 1099-MISC form that the taxpayer reports as ordinary income, and the depletion allowance reduces that income on Schedule E.

The deduction has been a feature of US tax law since the 1920s and has survived numerous attempted repeals, though specific rates and limits have changed over time. The figures and rules above reflect long-standing tax law, but tax law does change, and any specific application to your situation should be confirmed with a CPA or tax preparer who has oil and gas experience. Timberline is not a tax advisor and nothing here is tax advice.