Tax Benefits for Oil and Gas Well Owners

Table of Contents
Oil and Gas Depletion
What’s New for 2012
Introduction
Who Can Claim Depletion?
Mineral Property?
Cost Depletion
Percentage Depletion
Oil and Gas Wells
Lessor’s Gross Income

What’s New for 2012

A working interest in an Oil & Gas well can generate several tax benefits and lower your tax liability on your 2011 income tax return. Marginal production of oil and gas. With soaring gas prices in recent years, many oil and gas wells have positive cash flow. The IRS allows a depletion deduction for the oil and gas produced from the well. The depletion deduction can be computed either by amortizing the cost of the well (units of production method) or on percentage depletion method—usually, 15% percent of the gross income.

Historically, the IRS limited the depletion deduction to 100% of taxable income. However, the 100% taxable income limitation on percentage depletion for the marginal production of oil and natural gas also applies to tax years beginning in 2010 and 2011.

Introduction

Depletion is the using up of natural resources by mining, quarrying, drilling, or felling. The depletion deduction allows an owner or operator to account for the reduction of a product’s reserves.

There are two ways of figuring depletion: cost depletion and percentage depletion. For mineral property, you generally must use the method that gives you the larger deduction.

Who Can Claim Depletion?

If you have an economic interest in mineral property, you can take a deduction for depletion. More than one person can have an economic interest in the same mineral deposit.

You have an economic interest if both the following apply.

You have acquired by investment any interest in mineral deposits.
You have a legal right to income from the extraction of the mineral to which you must look for a return of your capital investment.
A contractual relationship that allows you an economic or monetary advantage from products of the mineral deposit is not, in itself, an economic interest. A production payment carved out of, or retained on the sale of, mineral property is not an economic interest.

Individuals, corporations, estates, and trusts who claim depletion deductions may be liable for alternative minimum tax.

Mineral Property

Mineral property includes oil and gas wells. For this purpose, the term “property” means each separate interest you own in each mineral deposit in each separate tract or parcel of land. You can treat two or more separate interests as one property or as separate properties. See section 614 of the Internal Revenue Code and the related regulations for rules on how to treat separate mineral interests.

There are two ways of figuring depletion on mineral property.

Cost Depletion.
Percentage Depletion.
Generally, you must use the method that gives you the larger deduction. However, unless you are an independent producer or royalty owner, you generally cannot use percentage depletion for oil and gas wells.

Cost Depletion

To figure cost depletion you must first determine the following.

The property’s basis for depletion.
The total recoverable units of mineral in the property’s natural deposit.
The number of units of mineral sold during the tax year.
Basis for depletion. To figure the property’s basis for depletion, subtract all the following from the property’s adjusted basis.
Amounts recoverable through:
Depreciation deductions,
Deferred expenses (including deferred exploration and development costs), and
Deductions other than depletion.
The residual value of land and improvements at the end of operations.
The cost or value of land acquired for purposes other than mineral production.
Adjusted basis. The adjusted basis of your property is your original cost or other basis, plus certain additions and improvements, and minus certain deductions such as depletion allowed or allowable and casualty losses. Your adjusted basis can never be less than zero. See Publication 551, Basis of Assets, for more information on adjusted basis.
Total recoverable units. The total recoverable units is the sum of the following.

The number of units of mineral remaining at the end of the year (including units recovered but not sold).
The number of units of mineral sold during the tax year (determined under your method of accounting, as explained next).
You must estimate or determine recoverable units (tons, pounds, ounces, barrels, thousands of cubic feet, or other measure) of mineral products using the current industry method and the most accurate and reliable information you can obtain.
Number of units sold. You determine the number of units sold during the tax year based on your method of accounting. Use the following table to make this determination.