What Is Percentage Depletion?
Percentage depletion is a tax deduction for depreciation allowable for businesses involved in extracting fossil fuels, minerals, and other nonrenewable resources from the earth.
Key Takeaways
- The depletion allowance has made oil and gas at the wellhead one of the most tax-advantaged investments available.
- The deduction is intended to incentivize domestic energy production.
- The depreciation rates allowable vary for different resources.
Percentage depletion assigns a set percentage of depletion to the gross income derived from extracting these nonrenewable resources. The deduction is intended as an incentive for drillers and investors to develop domestic mineral and energy production.
How Percentage Depletion Works
The rules of oil and gas accounting require that the costs incurred to find, develop, and obtain minerals and oil- and gas-producing properties must be capitalized.
Percentage depletion allows for an income tax deduction for these capitalized costs, reflecting the declining production of reserves over time. The percentage depletion is a measure of the amount of depletion associated with the extraction of nonrenewable resources. It is an allowance that independent producers and royalty owners can apply to the taxable gross income of a productive well’s property.
The Benefit to Investors
Oil and gas investments at the wellhead have become one of the most tax-advantaged investments available in the U.S. today due to the depletion allowance. Approximately 15% of gross income from oil and gas is tax-free for small investors and independent oil and gas producers.
There is no dollar limit to the total amount of depletion that can be deducted from income from qualified nonrenewable resources. However, percentage depletion can only be taken from a property that has net income (or profits).
If a property recognizes a net loss for any given tax year, percentage depletion cannot be deducted.
Percentage depletion is limited to 50% of net income, less exploration costs.
There is no dollar limit to the deduction from income from qualified nonrenewable resources.
The allowable statutory percentage depletion deduction is the lesser of net income or 15% of gross income. If net income is less than 15% of gross income, the deduction is limited to 100% of net income.
Depreciation Rates Vary
Percentage depletion is a capital cost recovery method that is allowed for nearly all natural resources except timber.
The IRS sets different depletion rates for different resources. Some of the rates are as follows:
- Oil and gas, 15% percent
- Sand, gravel, and crushed stone, 5%
- Borax, granite, limestone, marble, mollusk shells, potash, slate, soapstone and carbon dioxide produced from a well, 14%
- Sulfur and uranium, 23%
- Gold, silver, copper, iron ore, and certain oil shale from U.S. deposits, 15%
The percentage depletion formula requires that gross income be multiplied by the appropriate percentage.
Alternate Method
The IRS provides another method of determining depletion: cost depletion. Cost depletion is easier to calculate and involves producers writing off the real cost of their investments based on the fraction of resources extracted.
Since the percentage depletion deduction is a flat rate, the resulting tax break often exceeds the cost depletion deduction, thus acting as a sizable subsidy to qualifying energy companies.
