What Is Depletion on Taxes: Cost vs. Percentage Methods and Limits

Depletion on taxes is a federal deduction that lets owners of natural resources—oil and gas wells, mines, and timber tracts—recover their investment as the resource is extracted and sold. Authorized under Internal Revenue Code Section 611, it works on the same idea as depreciation, but it applies to assets that are physically used up rather than assets that wear out.¹ Two calculation methods exist, cost depletion and percentage depletion, and for most properties the IRS requires you to use whichever produces the larger deduction in a given year.²

Qualifying resources are broad. Oil, natural gas, geothermal deposits, coal, gold, copper, stone, gravel, clay, timber, and dozens of other minerals all count.

Who Can Claim Depletion

You must hold what the tax law calls an “economic interest” in the mineral property or standing timber. Per IRS Publication 535, two conditions have to be true at once: you acquired the interest through an investment, and you have a legal right to income from the extraction that represents the return of that investment.² More than one person can hold an economic interest in the same deposit, and when property is leased the deduction gets split between the lessor and the lessee.¹

Someone who only processes or transports minerals bought from others does not have an economic interest and cannot claim the deduction. Neither can employees of a mining or drilling company; they have wages, not an ownership stake in the deposit.

How Cost Depletion Works

Cost depletion is available for every type of depletable resource, and it is the only method allowed for timber.² The math resembles unit-of-production depreciation. You figure a per-unit cost for the resource, then multiply by the units you actually sold.

Three numbers drive the calculation:

Adjusted basis. What you paid for the property (including acquisition costs), minus depletion claimed in prior years. Basis for cost depletion excludes amounts recoverable through depreciation or other deductions, and it excludes the residual value of the land after extraction ends.³
Total recoverable units. The estimated quantity of the resource remaining in the deposit. If new geological data changes the estimate, you can revise this number going forward without amending prior returns.¹
Units sold during the year. Actual production converted to revenue.

Divide adjusted basis by total recoverable units to get a per-unit rate, then multiply by units sold. Say a property has a $1,000,000 adjusted basis and an estimated 500,000 barrels of recoverable oil. The rate is $2.00 per barrel. Selling 50,000 barrels this year produces a $100,000 deduction and drops the adjusted basis to $900,000 going into next year.

The built-in ceiling is straightforward. Once total depletion deductions equal your original basis, the deduction stops. Cost depletion cannot take basis below zero.

How Percentage Depletion Works

Percentage depletion takes a completely different approach. Instead of tracking what you paid for the property, you multiply a statutory percentage by the gross income from the property each year. The important consequence: total deductions over the life of the property can exceed your original investment. The method is available for minerals, oil, and gas, but not for timber.²

The Statutory Rates

Congress set different rates for different resources in IRC Section 613(b).⁴ The high end sits at 22 percent for sulfur, uranium, and a list of strategic minerals from U.S. deposits including lead, zinc, nickel, tin, tungsten, cobalt, and chromite. Gold, silver, copper, iron ore from U.S. deposits, and oil shale get 15 percent. Other metal mines, rock asphalt, and certain refractory clays get 14 percent. Coal, lignite, sodium chloride, and perlite get 10 percent. Clay and shale used to make bricks or sewer pipe get 7.5 percent. Gravel, sand, pumice, peat, common stone, and most construction-grade materials get 5 percent.

A catch-all category at 14 percent covers minerals not specifically listed, such as limestone, marble, granite, phosphate rock, and potash. That rate drops to 5 percent if the mineral is sold for low-value uses like road fill or concrete aggregate.⁴

Oil and Gas Follow Their Own Rules

Oil and gas percentage depletion is governed by IRC Section 613A rather than the general table. Only independent producers and royalty owners qualify. Integrated companies that refine more than 75,000 barrels per day or sell through their own retail outlets are excluded. For those who qualify, the rate is 15 percent of gross income from the property, limited to average daily production of 1,000 barrels of oil. You can elect to convert some of that oil allowance to natural gas at 6,000 cubic feet per barrel, which works out to a maximum of 6 million cubic feet per day if you apply the whole allowance to gas.⁵

Two Caps to Watch

Percentage depletion has two separate ceilings, and both can bite.

The first is a property-level cap. For most minerals, percentage depletion cannot exceed 50 percent of taxable income from that specific property, figured before the depletion deduction. Oil and gas properties get a more generous 100 percent of the property’s taxable income.⁴ Either way, a property producing a net loss for the year generates no percentage depletion. There has to be positive income for the percentage to bite into.

The second cap applies only to oil and gas. Total percentage depletion for the year cannot exceed 65 percent of your overall taxable income from all sources, computed without regard to the depletion deduction itself, any Section 199A qualified business income deduction, and certain carrybacks. Any amount disallowed by this cap carries forward to the next tax year, where it faces the same 65 percent test again.⁵

Which Method You Actually Use

For mineral, oil, and gas properties, you calculate both methods each year and claim whichever is larger. This is not a choice; the IRS requires the larger amount.² In practice, percentage depletion usually wins on productive properties because it’s tied to revenue instead of a shrinking cost basis. In lean years, when production is low or prices fall, cost depletion can produce the bigger number.

Timber owners don’t have the choice. Percentage depletion isn’t available, so cost depletion is the only option.²

Where To Report It On Your Return

Sole proprietors report depletion as a business expense on Line 12 of Schedule C (Form 1040).⁶
Royalty owners who receive payments under a mineral lease rather than operating the property themselves report on Schedule E (Form 1040).⁷
Partnerships and S corporations pass depletion information to owners on Schedule K-1. The owner then finishes the calculation on the individual return, because depletion is computed at the partner or shareholder level.
Timber owners claiming a depletion deduction, electing to treat cutting as a sale under Section 631(a), or selling timber outright under Section 631(b) must file Form T (Timber), Forest Activities Schedule, with the return.⁸

What Happens When You Sell The Property

Selling mineral rights or oil and gas property is not a clean exit from the depletion system. Under Section 1254, any gain on the sale is treated as ordinary income to the extent of your prior “Section 1254 costs,” which include depletion deductions that reduced the property’s adjusted basis.⁹ The recapture amount equals the lesser of your accumulated Section 1254 costs or the gain on the sale. Recapture applies even in transactions that would otherwise qualify for nonrecognition treatment.

Gain beyond the recapture amount generally qualifies for capital gains treatment. If you held the property more than a year, the excess is taxed at long-term capital gains rates. High-income sellers should also factor in the 3.8 percent net investment income tax, which can apply to both the capital gain portion and, in some cases, royalty income received in prior years.

Depletion And The Alternative Minimum Tax

Percentage depletion creates an AMT preference item under IRC Section 57(a)(1), but the rule is narrower than many people expect. The preference amount is the excess of the depletion deduction allowed for the year over the adjusted basis of the property at year-end, figured before that year’s depletion. The preference does not apply to oil and gas depletion claimed by independent producers and royalty owners under Section 613A(c), which covers most small operators.¹⁰ For other minerals where percentage depletion has already driven basis to zero, each additional dollar of percentage depletion becomes a preference item that increases AMT exposure. The preference is reported on Form 6251.

1
Office of the Law Revision Counsel. 26 USC 611 Allowance of Deduction for Depletion
2
Internal Revenue Service. Publication 535 – Business Expenses
3
eCFR. 26 CFR 1.612-1 – Basis for Allowance of Cost Depletion
4
Office of the Law Revision Counsel. 26 USC 613 Percentage Depletion
5
Office of the Law Revision Counsel. 26 USC 613A Limitations on Percentage Depletion in Case of Oil and Gas Wells
6
Internal Revenue Service. Schedule C (Form 1040) – Profit or Loss From Business
7
Internal Revenue Service. Instructions for Schedule C (Form 1040)
8
Internal Revenue Service. About Form T (Timber), Forest Activities Schedule
9
eCFR. 26 CFR 1.1254-1 – Treatment of Gain From Disposition of Natural Resource Recapture Property
10
Office of the Law Revision Counsel. 26 USC 57 Items of Tax Preference