Depletion is an accounting concept used most often in mining, timber, petroleum, or other similar industries. The depletion deduction allows an owner or operator to account for the reduction of a product's reserves. Depletion is similar to depreciation in that, it is a cost recovery system for accounting and tax reporting. For tax purposes, there are two types of depletion; cost depletion and percentage depletion.
For mineral property, you generally must use the method that gives you the larger deduction. For standing timber, you must use cost depletion.
According to the IRS Newswire, over 50 percent of oil and gas extraction businesses use cost depletion to figure their depletion deduction. Mineral property includes oil and gas wells, mines, and other natural deposits (including geothermal deposits). For this purpose, the term “property” means each separate interest businesses own in each mineral deposit in each separate tract or parcel of land. Businesses can treat two or more separate interests as one property or as separate properties.
Types of depletion
Depletion, for United States tax purposes, (and accounting purposes) is a method of recording the gradual expense or use of natural resources over time. Depletion is the using up of natural resources by mining, quarrying, drilling, or felling.
- Percentage depletion To figure percentage depletion, you multiply a certain percentage, specified for each mineral, by your gross income from the property during the tax year. The rates to be used and other conditions and qualifications for oil and gas wells are discussed later under Independent Producers and Royalty Owners and under Natural Gas Wells. Rates and other rules for percentage depletion of other specific minerals are found later in Mines and Geothermal Deposits.
- Cost depletion Cost depletion is an accounting method by which costs of natural resources are allocated to depletion over the period that make up the life of the asset. Cost depletion is computed by (1) estimating the total quantity of mineral or other resources acquired and (2) assigning a proportionate amount of the total resource cost to the quantity extracted in the period. For example, Big Texas Oil, Co. discovers a large reserve of oil. The company has estimated the oil well will produce 200,000 barrels of oil. The company invests $100,000 to extract the oil, and they extract 10,000 barrels the first year. Therefore, the depletion deduction is $5,000 ($100,000 X 10,000/200,000).
- Cost Depletion for Federal Tax Purposes (USA) is as follows:
Cost Depletion - Deduction for Basis in the Mineral Property in Relation to the Production and Sale of Minerals
Cost Depletion for tax purposes may be completely different than for accounting purposes.
Cost Depletion = S/(R+S) × AB or AB/(R+S) × S = Cost Depletion
S = Units sold in the current year
R = Reserves on hand at the end of the current year
AB = Adjusted basis of the property at the end of the current year
CD = Cost Depletion
Cost Depletion = S/R+S × AB, OR AB/R+S × S = Cost Depletion
Notes for above Cost Depletion for Tax:
a. Adjusted basis is basis at end of year adjusted for prior years's depletion either cost or percentage. This automatically allows for adjustments to the basis during the taxable year.
b. By using the units remaining at the end of the year, adjustment automatically allows for revised estimates of the reserves.
c. Depletion is based upon sales and not production. Units are considered sold in the year the proceeds are taxable under the taxpayer's accounting method.
d. Reserves generally include proven developed reserves and "probable" or "prospective" reserves where there is reasonable evidence to have believed that such quantities existed at that time.
Example of Cost Depletion:
Producer X has capitalized costs on Property A of $40,000, originally consisting of the lease bonus, capitalized exploration costs, and some capitalized carrying costs. The lease has been producing for several years and during this time, X has claimed $10,000 of allowable depletion. In 2009, X's share of production sold was 40,000 barrels and an engineer's report indicated that 160,000 barrels could be recovered after December 31, 2009.
The calculation of cost depletion for this lease is as follows:
Again the formula Cost depletion = S/(R+S) × AB or AB/(R+S) × S
CD = 40,000/(40,000 + 160,000) × ($40,000 − $10,000)
= 40,000/200,000 × $30,000 = $6,000
- Shulman, Peter A., “The Making of a Tax Break: The Oil Depletion Allowance, Scientific Taxation, and Natural Resources Policy in the Early Twentieth Century,” Journal of Policy History (2011), 23#3 pp 281–322.