To calculate depletion expense using the cost method, subtract the property’s residual value from its depletable base, divide by the total estimated recoverable units, and multiply by the units extracted during the period. That gives you the depletion attached to the resource for that period. For federal tax on most mineral and oil and gas properties, you run a second calculation — percentage depletion, a statutory percentage of gross income from the property — and take whichever number is larger.
Build the Depletable Base First
Every depletion calculation starts with one dollar figure: the total investment in the resource property. The tax code ties this to the property’s adjusted basis under 26 U.S.C. § 1011.1Office of the Law Revision Counsel. 26 USC 612 – Basis for Cost Depletion
What goes into that base:
- Acquisition cost — the price paid for the land or extraction rights, plus title search and survey fees.
- Exploration costs incurred before extraction begins.
- Development costs such as drilling wells, digging mine shafts, and building access roads.
- Estimated restoration costs. Under GAAP (ASC 410-20), these are recorded as an asset retirement obligation at fair value, generally using a present-value technique with a credit-adjusted risk-free discount rate.
From that total, subtract the residual value of the land after all resources are gone, the adjusted basis of any portion used for something other than mineral production, and any amounts recoverable through depreciation or other deductions.2Internal Revenue Service. Publication 535 (2022), Business Expenses What’s left is your depletable base.
The other input is an estimate of total recoverable units, usually supplied by a geologist or mining engineer and expressed in barrels, tons, board feet, or a similar measure. Include units that are developed, in sight, or blocked out, plus probable reserves supported by good evidence.2Internal Revenue Service. Publication 535 (2022), Business Expenses The whole depletion schedule flows from this number, so its accuracy matters.
Run the Cost Depletion Calculation
Cost depletion is two steps.
Step 1 — Per-unit rate: (Depletable base − Residual value) ÷ Total estimated recoverable units.
Step 2 — Period expense: Rate per unit × Units extracted during the period.
A worked example: a mining company has a depletable base of $5,000,000, no meaningful residual land value, and geologists estimate 2,500,000 tons of ore. The rate is $2 per ton. If the company extracts 100,000 tons in a quarter, quarterly depletion is $200,000. The rate stays fixed until new development costs are added to the base or the reserve estimate changes.
Depletion on Units Extracted vs. Units Sold
Depletion attaches to every unit the moment it comes out of the ground, but it only hits the income statement when those units are sold. If a coal company mines 50,000 tons and sells 40,000, only the depletion on the 40,000 tons flows to cost of goods sold. The depletion on the remaining 10,000 tons stays in inventory on the balance sheet until sold in a later period.
How you count “units sold” depends on your accounting method. Cash-basis taxpayers count units for which they received payment during the tax year, regardless of when the sale itself occurred. Accrual-basis taxpayers use their inventory methods.2Internal Revenue Service. Publication 535 (2022), Business Expenses
Journal Entries for Depletion
When units are extracted, debit Inventory (or Work in Process) for the total depletion on the units taken out, and credit Accumulated Depletion — a contra-asset account that sits under the natural resource on the balance sheet and reduces its carrying value.
When those units are sold, debit Cost of Goods Sold (Depletion Expense) for the depletion on the sold units and credit Inventory for the same amount. Net income drops by that amount.
On the balance sheet, Accumulated Depletion is subtracted from the gross carrying value of the resource property. A mineral property recorded at $5,000,000 with $1,200,000 of accumulated depletion shows a net book value of $3,800,000.
Percentage Depletion: The Tax Alternative
Percentage depletion works differently. It ignores your investment in the property and takes a fixed statutory percentage of the gross income the property generates for the year. Some of the rates from the tax code:
- 22% — sulfur and uranium
- 15% — gold, silver, copper, and other metal mines
- 10% — coal and asbestos
- 5% — gravel, sand, peat, and common clay
The full rate schedule covers dozens of minerals.3eCFR. 26 CFR 1.613-2 – Percentage Depletion Rates Soil, sod, water, and minerals extracted from seawater or other inexhaustible sources cannot use percentage depletion at all.4Office of the Law Revision Counsel. 26 USC 613 – Percentage Depletion
The deduction is capped at 50% of taxable income from the property, calculated before the depletion deduction itself. For oil and gas properties, the cap is raised to 100% of taxable income from the property.4Office of the Law Revision Counsel. 26 USC 613 – Percentage Depletion
Oil and Gas Rules
Major integrated oil companies generally cannot use percentage depletion. Independent producers and royalty owners can, at a 15% rate, and only on production up to 1,000 barrels of oil per day or the gas equivalent. The total percentage depletion deduction for oil and gas also cannot exceed 65% of the taxpayer’s overall taxable income for the year.5Office of the Law Revision Counsel. 26 USC 613A – Limitations on Percentage Depletion in Case of Oil and Gas Wells
Timber Uses Cost Depletion Only
Standing timber cannot use percentage depletion. Cost depletion is the only option, and reserves are measured in board feet, cords, or similar units.2Internal Revenue Service. Publication 535 (2022), Business Expenses6eCFR. 26 CFR 1.611-3 – Rules Applicable to Timber
Pick the Larger Deduction Each Year
For mineral properties other than timber, you must generally use whichever method — cost or percentage — produces the larger deduction.2Internal Revenue Service. Publication 535 (2022), Business Expenses This isn’t a one-time election. You compare the two methods each year and take the bigger number.
When commodity prices are high and gross income from the property is large, percentage depletion often wins because it tracks revenue rather than historical cost. In leaner years, or when percentage depletion runs into the taxable-income cap, cost depletion can produce the better result.
One structural difference matters over the long run. Cost depletion stops once the depletable base is fully recovered. Percentage depletion keeps going as long as the property produces income and you meet the statutory tests, so it can eventually exceed your total investment in the property.
Revise the Rate When Reserves Change
Reserve estimates rarely hold. Further drilling reveals more ore, or less. The tax code handles this by revising the estimate and basing all future depletion allowances on the new number; the basis for depletion itself does not change.7Office of the Law Revision Counsel. 26 USC 611 – Allowance of Deduction for Depletion Under GAAP, a reserve revision is a change in accounting estimate applied prospectively. You adjust the rate going forward without restating prior periods.
The revised rate uses the remaining depletable base divided by the revised remaining units. Suppose a company originally estimated 1,000,000 barrels and has extracted 300,000 at $4 per barrel, consuming $1,200,000 of a $4,000,000 base. Geologists now estimate 900,000 barrels remain instead of 700,000. The new rate is ($4,000,000 − $1,200,000) ÷ 900,000 = $3.11 per barrel going forward.
Recapture When You Sell the Property
Selling a depleted property triggers recapture under Section 1254. If you sell at a gain, part of that gain is treated as ordinary income rather than capital gain. The ordinary-income amount equals the lesser of your total Section 1254 costs (which include depletion deductions that reduced your adjusted basis) or the gain itself.8eCFR. 26 CFR 1.1254-1 – Treatment of Gain from Disposition of Natural Resource Recapture Property The IRS is taking back the tax benefit of prior depletion by taxing that slice of the sale at ordinary rates.
Recapture applies even where the gain would otherwise be deferred. On an installment sale, the ordinary-income portion comes first: each payment is treated as recapture gain until the full recapture amount is reported, and only then does remaining gain qualify for capital gains treatment.8eCFR. 26 CFR 1.1254-1 – Treatment of Gain from Disposition of Natural Resource Recapture Property Abandoning a property or letting a mineral interest expire by its own terms does not trigger recapture.