Depletion: Turn production into annual deductions that can outlast basis

Depletion converts oil and gas production into yearly tax relief. Two methods apply in the U.S. tax code: cost depletion and percentage depletion. Compute both each year and claim the larger allowable amount for each property. This page follows the house style for clarity and investor use.

Place depletion inside your tax stack for steady relief

Depletion sits alongside two other drivers. IDCs often create large Year 1 deductions. Tangible drilling costs create multi‑year depreciation. Depletion then reduces taxable production income every year the well flows. Used together, these provisions pull value forward and smooth taxes over time.

Choose the method that yields the larger deduction each year

Cost depletion: recover basis with unit‑of‑production math

What it is. A basis‑driven method that recovers your investment over the reserves you will produce.
Formula. Cost depletion = (Units sold this year ÷ Total recoverable units) × Adjusted basis.
What you need. Reserve engineering support, a clean basis roll‑forward, and property‑level production and sales.
Constraint. You cannot deduct more than total basis. When basis reaches zero, cost depletion stops even if the well continues to produce.

Percentage depletion: 15 percent of gross income for eligible owners

What it is. A statutory deduction equal to 15 percent of gross income from the property for eligible independent producers and royalty owners. It can continue even after basis is fully recovered.
Who qualifies. Independent producers and royalty owners generally qualify. Many integrated companies rely on cost depletion instead.

Who qualifies and the limits you must model

• Production cap. Allowance applies up to an average domestic production of 1,000 barrels per day of oil or 6,000 Mcf per day of gas per taxpayer.
• Property net‑income limit. Percentage depletion cannot exceed 100 percent of that property’s taxable income. It cannot create or deepen a loss on the property.
• Overall income cap. Total percentage depletion cannot exceed 65 percent of the taxpayer’s taxable income. Any excess may be carried forward.

See the math on $100,000 to plan decisions

Assumptions
Basis: $100,000. Recoverable reserves: 100,000 barrels. Production this year: 5,000 barrels. Average price: $50 per barrel. Gross income: $250,000. Property net income: $200,000.

Cost depletion
Cost per barrel = $100,000 ÷ 100,000 = $1.00.
Deduction = 5,000 × $1.00 = $5,000.
Remaining basis: $95,000.

Percentage depletion
15 percent × $250,000 = $37,500.
Property limit check: $37,500 is below $200,000 so allowed.
65 percent overall cap: assume not binding.

Result
Percentage depletion of $37,500 beats cost depletion of $5,000 this year. Next year may differ as volumes, prices, and basis change. Compute both annually and document the choice.

Practical trade‑offs you should expect

Recordkeeping versus simplicity

Cost depletion mirrors reservoir drawdown but requires defended reserves and basis schedules. Percentage depletion is simpler to compute but bound by caps.

Price and volume swings

Revenue volatility can flip which method wins in any year. Model both with updated production and pricing.

Eligibility cliffs and caps

Falling outside Section 613A eligibility removes percentage depletion. The property net‑income limit can reduce the deduction to zero in high‑cost years even when gross revenue looks healthy. Track the 1,000‑barrel and 6,000‑Mcf thresholds if you add wells mid‑year.

Pass‑through complexity

In partnerships, depletion is determined at the owner level. Two partners in the same well can have different allowable deductions based on their circumstances. Grouping properties does not fix a loss on one lease for percentage‑depletion tests.

Actions to capture and defend your deduction

1. Model both methods every year. Refresh reserves, basis, and revenue by property. File the larger allowable amount and keep workpapers.
2. Track property‑level income monthly. The property limit requires accurate net income by property.
3. Coordinate with IDCs and depreciation. Time IDC elections and placed‑in‑service dates so early deductions and depletion complement each other.
4. Monitor the 65 percent cap and carryovers. Record disallowed amounts for use in future profitable years.
5. Document reserves. Maintain engineering reports and updates that match production history.
6. Keep basis clean. Capture all additions and prior depletion in a rolling schedule tied to AFEs and accounting entries.
7. Plan for ownership changes. Sales or reassignments affect basis and who claims depletion. Update files promptly.

Be filing ready with this year‑end checklist

• Property list with interest type for each lease
• Basis roll‑forward that reflects additions and prior depletion
• Reserve engineering support and any revisions during the year
• Monthly production, pricing, and revenue tie‑outs by property
• Lease operating statements to compute property net income
• K‑1 support for pass‑throughs, including any simulated depletion
• Eligibility memo that tests independent status and the daily production cap
• Carryover tracker for any 65 percent cap disallowances

Depletion FAQs for quick clarity

Can percentage depletion exceed my basis

Yes. Percentage depletion can continue after basis is fully recovered, subject to the production, property, and overall caps.

Who can use percentage depletion

Independent producers and royalty owners generally qualify. Many integrated companies cannot use percentage depletion for oil and gas and rely on cost depletion.

What happens if the property shows a loss

The property net‑income limit can reduce percentage depletion to zero for that property in that year. Cost depletion may still apply if basis remains.

How does depletion interact with IDCs and TDCs

IDCs and equipment depreciation reduce taxable income on their timelines. Depletion then applies annually to production income. Use all three where eligible and maintain property‑level records.

Outlook: plan annually and watch policy

Debate around depletion surfaces from time to time. The 15 percent rate and Section 613A limits have been stable for years, yet rules can change. Plan annually, document well, and remain flexible.

Conclusion: compute both and choose well

One rule wins each year. Compute cost and percentage depletion for every property and claim the larger allowable deduction with clean support. This discipline can compound value on long‑lived wells while keeping filings defensible. Written in house style for investor clarity.

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