What Is the Depletion Rate for Oil and Gas Wells?

The federal percentage depletion rate for oil and gas wells is 15% of gross income from the property, available to independent producers and royalty owners who stay within the production limits set by Section 613A of the Internal Revenue Code. Taxpayers who don’t qualify for percentage depletion, or whose cost depletion produces a bigger write-off in a given year, use cost depletion instead. Every year, you compute both methods and claim whichever is larger.¹

How the 15% Percentage Depletion Rate Works

Percentage depletion is calculated on revenue, not investment. You take 15% of the gross income from the property for the tax year, and that’s your deduction. The rate comes from Section 613A(c), which carves out an exception to the general rule in Section 613(d) that otherwise bars percentage depletion for oil and gas wells.²³

Because the deduction runs off revenue, it can and often does exceed what you originally paid for the property over the life of the well. A royalty owner who paid $200,000 for mineral rights that generate $80,000 a year in gross income deducts $12,000 annually. After about 17 years the cumulative deductions surpass the purchase price, and the deduction keeps flowing as long as the well produces income.

When you compute gross income for this purpose, subtract any rents or royalties paid to others on the property. A working interest owner who pays a 20% landowner royalty on $100,000 of production has gross income of $80,000 and a percentage depletion deduction of $12,000.

When the Rate Rises Above 15%

Congress built in a bonus for marginal properties, meaning wells that average 15 barrel equivalents or less per day per well (stripper wells) or properties where substantially all production is heavy oil. For these, the rate can climb up to a maximum of 25%.²

The formula adds one percentage point to the base 15% for each whole dollar by which $20 exceeds the IRS reference price for crude oil from the prior calendar year. When crude prices sit above $20, the enhancement is zero and the rate stays at 15%. The IRS reference price for 2024 was $74.48 per barrel, so no enhancement applied for the 2025 tax year.⁴ With crude prices remaining well above $20, the enhanced rate is unlikely to kick in for 2026 either.

Cost Depletion: The Other Method

Cost depletion is available to every taxpayer with an economic interest in a mineral property, including integrated oil companies that can’t use percentage depletion. You start with the adjusted basis of your property, which is what you paid for the lease or mineral rights plus any capitalized development costs.¹

Divide that basis by the total estimated recoverable units in the reservoir (barrels of oil or thousands of cubic feet of gas) to get a per-unit cost. Multiply by the units you actually sold during the year, and you have the deduction. Pay $500,000 for a property estimated at 100,000 barrels, sell 8,000 barrels in a year, and you deduct $40,000.

There’s a hard stop. Once cumulative cost depletion reduces the property’s adjusted basis to zero, cost depletion ends. You’ve recovered your investment, and nothing more can be deducted under this method.⁵

Who Qualifies for the 15% Rate

Section 613A restricts percentage depletion to independent producers and royalty owners. Three requirements decide eligibility.

Production Cap

Your average daily production eligible for percentage depletion is capped at 1,000 barrels of crude oil. For natural gas, each 6,000 cubic feet counts as one barrel equivalent, so the gas ceiling is 6 million cubic feet per day. If you produce both, you can elect to allocate some of the 1,000-barrel allowance to gas, but doing so reduces the oil allowance barrel for barrel.² Production above the cap can still generate cost depletion.

Retailer Exclusion

If you or a related person sells oil, gas, or refined products through retail outlets, you lose percentage depletion, unless combined gross receipts from all those outlets stay at or below $5 million for the tax year.² A small producer who also runs a handful of gas stations can still qualify.

Refiner Exclusion

If you or related persons operate refineries with average daily runs above 75,000 barrels, you’re out.² This threshold is the line between independent producers and the major integrated oil companies.

Income Limits on the Deduction

Two separate caps restrict how much percentage depletion you can actually claim. Both can bite.

100% of Taxable Income From the Property

Your percentage depletion from any single property cannot exceed 100% of the taxable income from that property, figured before the depletion deduction and before any Section 199A qualified business income deduction.³ For minerals like gold or copper the cap is 50%, but Congress gave oil and gas the more generous 100% threshold. In practice this only bites when a well has high gross income but low net income after operating expenses.

65% of Your Overall Taxable Income

Even if each property clears its individual test, your total percentage depletion across all oil and gas properties cannot exceed 65% of your overall taxable income for the year, computed without the depletion deduction, any Section 199A deduction, or any net operating loss or capital loss carrybacks.²

If the 65% cap reduces your deduction, the disallowed amount carries forward to the following tax year and is treated as an allowable percentage depletion deduction then, subject to the 65% test again.²

Why Percentage Depletion Usually Wins Over Time

Cost depletion stops when adjusted basis hits zero. Percentage depletion has no such floor. As long as the property produces gross income and you meet the qualification tests, the 15% deduction keeps running indefinitely.⁵

That’s what makes the annual comparison lopsided in the long run. Early in a property’s life, when adjusted basis is still high and production is heavy, cost depletion can produce the larger number. Once enough deductions have drawn the basis down, percentage depletion almost always wins, and eventually becomes the only option. Run both calculations every year and claim the larger.¹

The AMT Carveout

Normally, when percentage depletion exceeds a property’s adjusted basis, the excess counts as a tax preference item for the Alternative Minimum Tax. Congress carved out an exception: depletion computed under Section 613A(c), the independent producer and royalty owner provision, is exempt from that AMT preference.⁶ For most independent producers, the ongoing deduction above zero basis won’t create AMT problems.

Buying a Well That’s Already Producing

Buyers sometimes worry that acquiring a well already in production disqualifies them from percentage depletion. That concern is outdated. Before 1990, the tax code did bar percentage depletion on transferred proven properties. Congress repealed that restriction for transfers after October 11, 1990.⁷

Under current rules, a buyer of a proven property can claim percentage depletion on production regardless of whether the seller was eligible. Even if the seller was an integrated refiner who couldn’t use it, a buyer who qualifies as an independent producer or royalty owner gets the full 15%. The buyer also establishes a new adjusted basis equal to the purchase price for cost depletion.

Where to Report the Deduction

Where depletion lands on your return depends on how you hold the property. Individual royalty owners and working interest owners who aren’t operating a trade or business report depletion on Schedule E of Form 1040. Sole proprietors running an oil and gas business report on Schedule C.⁸ Partnerships file Form 1065 and pass the deduction through to partners on Schedule K-1.

Keep the paperwork that supports the numbers. That means the original lease or purchase agreement establishing your adjusted basis, certified reserve estimates for cost depletion, and monthly production statements from the operator showing volumes sold and gross income. The IRS can request engineering data and production logs to verify that reported depletion matches actual output.

1
eCFR. 26 CFR 1.611-1 – Allowance of Deduction for Depletion
2
Office of the Law Revision Counsel. 26 U.S. Code 613A – Limitations on Percentage Depletion in Case of Oil and Gas Wells
3
Office of the Law Revision Counsel. 26 U.S. Code 613 – Percentage Depletion Allowance
4
Internal Revenue Service. Internal Revenue Bulletin 2025-20
5
eCFR. 26 CFR 1.612-1 – Basis for Allowance of Cost Depletion
6
Office of the Law Revision Counsel. 26 U.S. Code 57 – Items of Tax Preference
7
eCFR. 26 CFR 1.613A-3 – Exemption for Independent Producers and Royalty Owners
8
Internal Revenue Service. Instructions for Schedule E (Form 1040)