Depletion

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.

Who Can Claim Depletion

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

You have an economic interest if both the following apply.

1. You have acquired by investment any interest in mineral deposits or standing timber.
2. You have a legal right to income from the extraction of the mineral or the cutting of the timber, 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 or standing timber 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.

The term "mineral 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.

The term "timber property" means your economic interest in standing timber in each tract or block representing a separate timber account.

Figuring Depletion

There are two ways of figuring depletion.

• Cost depletion.
• Percentage depletion.

For mineral property, you generally must use the method that gives you the larger deduction. For standing timber, you must use cost depletion.

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.

You must estimate or determine recoverable units (tons, barrels, board feet, or other measure) using the current industry method and the most accurate and reliable information you can obtain.

Basis for depletion and recoverable units are explained in chapter 10 of Publication 535.

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.

The number of units sold during the tax year does not include any units for which depletion deductions were allowed or allowable in earlier years.

Figuring the cost depletion deduction. Once you have figured your property's basis for depletion, the total recoverable units, and the number of units sold during the tax year, you can figure your cost depletion deduction by taking the following steps.

Cost depletion for ground water in Ogallala Formation. Farmers who extract ground water from the Ogallala Formation for irrigation are allowed cost depletion. Cost depletion is allowed when it can be demonstrated the ground water is being depleted and the rate of recharge is so low that, once extracted, the water is lost to the taxpayer and immediately succeeding generations.

To figure your cost depletion deduction, use the guidance provided in Revenue Procedure 66-11 in Cumulative Bulletin 1966-1.

For tax years ending before December 13, 1982, those extracting ground water for irrigation farming from the Ogallala Formation in areas outside the Southern High Plains were not required to reduce their basis in ground water by any allowable cost depletion not claimed.

Timber depletion. Depletion takes place when you cut standing timber (including Christmas trees). You can figure your depletion deduction when the quantity of cut timber is first accurately measured in the process of exploitation.

To figure timber depletion, you multiply the number of units of standing timber cut by your depletion unit.

Timber units. When you acquire timber property, you must make an estimate of the quantity of marketable timber that exists on the property. You measure the timber using board feet, log scale, cords, or other units. If you later determine that you have more or less units of timber, you must adjust the original estimate.

Depletion units. You figure your depletion unit each year by taking the following steps.

1. Determine your cost or the adjusted basis of the timber on hand at the beginning of the year.
2. Add to the amount determined in (1) the cost of any units acquired during the year and any additions to capital.
3. Figure the number of units to take into account by adding the units acquired during the year to the units on hand in the account at the beginning of the year and then adding (or subtracting) any correction to the estimate of the units remaining in the account.
4. Divide the result of (2) by the result of (3). This is your depletion unit.

When to claim timber depletion. Claim your depletion allowance as a deduction in the year of sale or other disposition of the products cut from the timber, unless you elect to treat the cutting of timber as a sale or exchange as explained in chapter 10. Include allowable depletion for timber products not sold during the tax year the timber is cut as a cost item in the closing inventory of timber products for the year. The inventory is your basis for determining gain or loss in the tax year you sell the timber products.

Form T. Attach Form T to your income tax return if you are claiming a deduction for timber depletion or electing to treat the cutting of timber as a sale or exchange.

Example. Sam Brown bought a farm that included standing timber. This year Sam determined that the standing timber could produce 300,000 units when cut. At that time, the adjusted basis of the standing timber was $24,000. Sam then cut and sold 27,000 units. Sam did not elect to treat the cutting of the timber as a sale or exchange. Sam's depletion for each unit for the year is $.08 ($24,000 × 300,000). His deduction for depletion is $2,160 (27,000 × $.08). If Sam had cut 27,000 units but sold only 20,000 units during the year, his depletion for each unit would have remained at $.08. However, his depletion deduction would have been $1,600 (20,000 × $.08) for this year and he would have included the balance of $560 (7,000 × $.08) in the closing inventory for the year.

Percentage Depletion

You can use percentage depletion on certain mines, wells, and other natural deposits. You cannot use the percentage method to figure depletion for standing timber, soil, sod, dirt, or turf.

To figure percentage depletion, you multiply a certain percentage, specified for each mineral, by your gross income from the property during the year. See Mines and other natural deposits in chapter 10 of Publication 535 for a list of the percentages.

Taxable income limit. The percentage depletion deduction cannot be more than 50% (100% for oil and gas property) of your taxable income from the property figured without the depletion deduction. For tax years beginning after 1997 and before 2002, the 100-percent taxable income limit does not apply to percentage depletion on the marginal production of oil or natural gas. For information on marginal production, see section 613A(c)(6) of the Internal Revenue Code.

The following rules apply when figuring your taxable income from the property for purposes of the taxable income limit.

• Do not deduct any net operating loss deduction from the gross income from the property.
• Corporations do not deduct charitable contributions from the gross income from the property.
• If, during the year, you disposed of an item of section 1245 property used in connection with the mineral property, reduce any allowable deduction for mining expenses by the part of any gain you must report as ordinary income that is allocable to the mineral property. See section 1.613-5(b)(1) of the regulations for information on how to figure the ordinary gain allocable to the property.

More Information

For more information on depletion, see chapter 10 in Publication 535.

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