Percentage Depletion vs. Cost Depletion Explained

If you receive royalty income from mineral rights, the IRS allows you to deduct a portion of that income each year through depletion. Depletion accounts for the fact that the mineral resource is being used up. There are two methods: percentage depletion and cost depletion. You're required to use whichever gives you the larger deduction each year.

This is not tax advice. Consult a tax professional for your specific situation. But understanding the basics will help you have a better conversation with your CPA.

Percentage Depletion

Percentage depletion is the simpler method. You deduct a fixed percentage of your gross royalty income, regardless of what you originally paid for the minerals.

For oil and gas, the percentage is 15% of gross income for independent producers and royalty owners. There are limits:

• The deduction cannot exceed 100% of the net income from the property (after operating expenses and other deductions)
• Your total percentage depletion across all properties cannot exceed 65% of your overall taxable income (before the depletion deduction)
• It's only available to independent producers and royalty owners, not major integrated oil companies
• There's a production limit of 1,000 barrels of oil per day (or 6,000 MCF of gas), which is well above what most individual owners produce

For most small mineral rights holders, percentage depletion is straightforward: take 15% of your gross royalty income, subject to the net income limitation.

Cost Depletion

Cost depletion is based on your actual cost basis in the minerals. The formula is:

(Your adjusted basis / Total estimated recoverable units) x Units sold during the year = Cost depletion

Your basis is what you paid for the minerals, or if you inherited them, the fair market value at the date of the prior owner's death (stepped-up basis). Recoverable units are the estimated total barrels of oil or MCF of gas remaining in the ground.

Cost depletion requires you to know:

• Your original cost basis (or inherited fair market value)
• How much depletion you've already claimed in previous years (this reduces your adjusted basis)
• An estimate of remaining recoverable reserves

Once your adjusted basis reaches zero, you can no longer take cost depletion. This is one of the key differences from percentage depletion, which can continue as long as there's income.

Which One Is Better

For most individual royalty owners, percentage depletion produces a larger deduction because:

• It doesn't require knowing the recoverable reserves
• It doesn't run out when your basis hits zero
• It's a simple percentage of income with no complex calculation
• Many inherited interests have a relatively low stepped-up basis compared to the income they produce

However, in the early years of a high-value interest (especially one you purchased at a high price), cost depletion may be larger. You calculate both each year and use whichever is greater.

What You Need to Track

Regardless of which method you use, keep records of:

• Your original basis (purchase price or fair market value at date of inheritance)
• Cumulative depletion taken in all prior years
• Gross income from each property each year
• Net income from each property (gross minus expenses)

Your CPA will need these numbers to calculate both methods and determine which is larger. If you can't produce them, you may lose the deduction entirely.

A Common Mistake

Some mineral owners forget to claim depletion at all, especially if they prepare their own returns. Depletion is not automatic. It's a deduction you have to calculate and claim on Schedule E (or Schedule C if you have a working interest). If you've been receiving royalty income and haven't been claiming depletion, talk to a tax professional about whether you can amend prior returns.

The Bottom Line

Depletion is one of the most valuable tax benefits available to mineral rights owners. Percentage depletion at 15% effectively means the first 15% of your gross royalty income is tax-free (subject to limitations). That's worth getting right, and it's worth keeping the records to support it.

MinRight tracks gross and net income per property, which gives you the numbers your CPA needs for the depletion calculation. For inherited interests, make sure you've established your stepped-up basis and keep it updated as you claim depletion each year. For the bigger tax picture, see our post on reporting royalty income on Schedule E and why you should keep records for seven years.