What Is a Depletion Allowance and How Does It Work?

A depletion allowance is a federal income tax deduction that lets the owner of an economic interest in a natural resource — oil, gas, minerals, geothermal deposits, or timber — recover that investment as the resource is extracted and sold. Because a deposit shrinks with every barrel, ton, or board foot removed, the tax code treats it much like depreciation on equipment. Two methods exist: cost depletion, which spreads your basis over the units produced, and percentage depletion, which deducts a fixed share of the gross income the property generates each year.

What Resources Qualify

The deduction is authorized for mines, oil and gas wells, other natural deposits including geothermal deposits, and timber.¹ “Mines” is read broadly and reaches deposits of waste or residue from which ores or minerals can be recovered, alongside traditional metal and coal mines. Qualifying minerals range from gravel and sand up through sulfur, uranium, gold, silver, copper, lithium, and dozens of other metals and non-metals listed in the statutory rate schedule.² Standing timber qualifies too, though it is calculated and reported separately from mineral deposits. Geothermal deposits in the United States sit on the mineral side and carry a 15 percent rate.³

Some natural materials are specifically excluded. Soil, sod, dirt, and turf don’t qualify. Neither do water or mosses. Minerals drawn from inexhaustible sources such as sea water or the air are also outside the definition.⁴

Who Can Claim a Depletion Deduction

Handling, transporting, or processing a natural resource doesn’t get you the deduction. Treasury regulations require you to hold an “economic interest” in the deposit itself. That means you made a capital investment in the mineral in place or the standing timber, and you look to income from severance of that resource to return your investment.⁵

A contract to buy or process the extracted product doesn’t create a depletable interest, however valuable it is. A refinery that buys crude at a set price from a well operator has no depletion claim on that well.⁵ More than one party can hold an economic interest in the same property, though. A landowner who leases mineral rights and the operator who drills the well may each claim a share of depletion based on their agreement. Royalty interests, overriding royalties, and net profits interests are also recognized economic interests.⁶

How Cost Depletion Works

Cost depletion resembles straight-line depreciation applied to a resource. Your adjusted basis in the property — generally what you paid for the mineral interest, less amounts recoverable through depreciation and other deductions — is spread across the total recoverable units in the deposit.⁷

The math has two steps. First, divide the property’s basis for depletion by the total recoverable units remaining, which includes units already recovered but not yet sold plus units sold during the year. That gives you a per-unit depletion rate. Then multiply that rate by the number of units you actually sold during the tax year. The product is your cost depletion for the year.

If development work or ongoing operations reveal that the deposit holds more or fewer recoverable units than you first estimated, you revise the estimate going forward. Deductions already taken are not adjusted retroactively.¹ Cost depletion ends once you have fully recovered your basis in the property. For standing timber, cost depletion is the only method available.

How Percentage Depletion Works

Percentage depletion ignores your actual investment and instead deducts a set percentage of the gross income from the property each year. The rate depends on the mineral.² The main tiers are:

22 percent for sulfur, uranium, and a list of strategic minerals from U.S. deposits including lead, lithium, nickel, tin, tungsten, and zinc.
15 percent for gold, silver, copper, iron ore, and oil shale from U.S. deposits.
14 percent for certain other metal mines not covered by the 22 or 15 percent tiers.
10 percent for coal, lignite, and sodium chloride.
5 percent for gravel, sand, peat, pumice, and common stone.

The key difference from cost depletion is that percentage depletion is not capped at your original investment. Because it is figured on gross income rather than basis, the deduction can keep going year after year even after your basis has fallen to zero, as long as the property produces income. Over the life of a productive property, that feature can make percentage depletion significantly more valuable.

Two caps limit the deduction. For most properties, percentage depletion cannot exceed 50 percent of the taxable income from the property, computed before the depletion deduction itself and without any Section 199A deduction. For oil and gas properties, that per-property cap is 100 percent of taxable income from the property.²

Choosing Between the Two Methods

You are required to run both calculations each year and take whichever produces the larger deduction.⁸ Early in a property’s life, when basis is high and income modest, cost depletion often wins. Once basis has been substantially recovered but the resource keeps producing, percentage depletion typically pulls ahead — and it can continue past the point where cost depletion would have stopped.

Special Rules for Oil and Gas

Oil and gas are governed by their own provision, Section 613A, rather than the general percentage depletion rules.² The 15 percent rate for oil and gas is available only to independent producers and royalty owners, and only up to a daily production limit of 1,000 barrels of crude oil, or an equivalent volume of natural gas figured at 6,000 cubic feet per barrel of the remaining depletable oil quantity.⁹ Production above the threshold must be depleted using the cost method.

Two groups are shut out of the independent producer exemption entirely. Retailers — anyone selling oil, gas, or derived products through a retail outlet, directly or through a related person — cannot use it. Neither can large refiners, meaning any taxpayer whose average daily refinery runs, including those of related persons, exceed 75,000 barrels during the tax year.⁹ Together, those two exclusions keep major integrated oil companies out of percentage depletion on oil and gas.

Oil and gas percentage depletion also carries a taxpayer-level cap. The total deduction for the year cannot exceed 65 percent of taxable income, computed without regard to the oil and gas depletion deduction itself, any Section 199A deduction, any net operating loss carryback, or any capital loss carryback. Anything disallowed under the 65 percent cap carries forward to the next tax year, where it is treated as allowable depletion subject to the same limit.¹⁰

How Depletion Affects Your Basis and Later Sale

Every depletion deduction reduces your adjusted basis in the property. Section 1016 requires the basis reduction for the amount of depletion “allowed or allowable,” which means that if you failed to claim the deduction in a prior year, basis still comes down as if you had.¹¹ Basis cannot go below zero.

This shows up when you sell. Lower basis means larger taxable gain. If percentage depletion has driven your basis to zero, and often it will on a long-producing property, the entire sale price can be gain.

Where the Deduction Is Reported

The form depends on how you hold the property. An individual royalty owner reports royalty income and depletion on Schedule E of Form 1040 — income on line 4, depletion on line 18.¹² A self-employed operator running the extraction business reports on Schedule C. Partnerships file Form 1065, but for oil and gas the partnership does not take the depletion itself; instead, it passes the information partners need on Schedule K-1, box 20, code T, so each partner runs the calculation individually. Timber depletion requires Form T (Timber), Forest Activities Schedule, attached to the return.¹³

1
Office of the Law Revision Counsel. 26 USC 611 – Allowance of Deduction for Depletion
2
Office of the Law Revision Counsel. 26 USC 613 – Percentage Depletion
3
Office of the Law Revision Counsel. 26 USC Subtitle A, Chapter 1, Subchapter I, Part I – Deductions
4
eCFR. 26 CFR 1.613-2 – Percentage Depletion Rates
5
eCFR. 26 CFR 1.611-1 – Allowance of Deduction for Depletion
6
Internal Revenue Service. National Office Technical Advice Memorandum
7
Office of the Law Revision Counsel. 26 USC 612 – Basis for Cost Depletion
8
Internal Revenue Service. Tips on Reporting Natural Resource Income
9
Office of the Law Revision Counsel. 26 USC 613A – Limitations on Percentage Depletion in Case of Oil and Gas Wells
10
Office of the Law Revision Counsel. 26 USC 613A – Limitations on Percentage Depletion in Case of Oil and Gas Wells
11
Office of the Law Revision Counsel. 26 USC 1016 – Adjustments to Basis
12
Internal Revenue Service. Instructions for Schedule E (Form 1040)
13
Internal Revenue Service. Instructions for Form 1065