The IRS code allows for percentage or cost depletion allowances to help owners account for the depletion of reserves during the production and sale of oil and gas.

What is Depletion Allowance?

Depletion allowance is a deduction from gross income that reflects the reduction of mineral deposits. This deduction encourages investment in oil and gas production by providing a tax incentive for the cost depletion of reserves.

Who Can Claim a Depletion Allowance?

Individuals or entities with an economic interest in a mineral deposit, such as natural gas reserves, can claim the oil depletion allowance. This interest exists if:

• The party has invested in mineral deposits.
• The party is legally entitled to income from the mineral extraction as a return on their capital investment.

Do Rates Vary?

The IRS sets different depletion rates for various natural resources. Some examples include:

• Oil and gas: 15%
• Borax, limestone, granite, mollusk shells, marble, slate, potash, carbon dioxide from wells, and soapstone: 14%
• Gravel, sand, and crushed stone: 5%
• Iron, copper, gold ore, silver, and specific oil shale deposits: 15%

Benefits of Depletion Allowance

The depletion allowance makes investing in oil and gas wells a highly tax-favored option in the United States. Independent oil and gas producers and small investors can enjoy tax-free income of approximately 15% of their gross income from oil and gas operations.

There is no limit on the total amount that can be deducted for non-renewable resource depletion. However, percentage depletion can only be applied to oil and gas properties that generate net income. If a property incurs a net loss in a tax year, percentage depletion cannot be applied, and it is typically capped at 50% of net income.

Methods for Calculating Depletion Allowance

Two methods are used to calculate the oil depletion allowance: cost depletion and percentage depletion. If net income is less than 15% of gross income, the percentage depletion deduction is limited to 100% of net income.

Conclusion

Under U.S. tax law, anyone with an economic interest in a mineral deposit can benefit from the oil depletion allowance. This significant subsidy provides a tax-advantaged investment opportunity for investors in the United States. The allowance varies for different natural resources, and royalty owners in oil and gas operations enjoy a taxable income limit