Publication 535 |
2001 Tax Year |
Mineral Property
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.
Mineral property includes oil and gas wells, mines, and other
natural deposits (including geothermal deposits).
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. See Oil and Gas Wells, later.
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.
IF you use ... |
THEN the units sold during the year are ... |
The cash method of accounting, |
The units sold for which you receive payment during the tax year (regardless of the year of sale). |
An accrual method of accounting, |
The units sold based on your inventories. |
The number of units sold during the tax year does not include any
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.
Step |
Action |
Result |
1 |
Divide your property's
basis for depletion by
total recoverable units. |
Rate per unit. |
2 |
Multiply the rate per
unit by units sold
during the tax year. |
Cost depletion
deduction. |
Percentage Depletion
To figure percentage depletion, you multiply a certain percentage,
specified for each mineral, by your gross income from the property
during the tax year.
Gross income.
When figuring your percentage depletion, subtract from your gross
income from the property the following amounts.
- Any rents or royalties you paid or incurred for the
property.
- The part of any bonus you paid for a lease on the property
allocable to the product sold (or that otherwise gives rise to gross
income) for the tax year.
A bonus payment includes a bonus for either a mineral lease or
an oil and gas lease.
Use the following fraction to figure the part of the bonus you must
subtract.
Number of units sold in the tax year ------------------------------------------------------
Recoverable units from the property |
× |
Bonus
Payments |
For oil and gas wells and geothermal deposits, gross income from
the property is defined later under Oil and Gas Wells. For
property other than a geothermal deposit or an oil and gas well, gross
income from the property is defined later under Mines and
Geothermal Deposits.
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.
Taxable income from the property means gross income from the
property minus all allowable deductions (excluding any deduction for
depletion) attributable to mining processes, including mining
transportation. These deductible items include the following.
- Operating expenses.
- Certain selling expenses.
- Administrative and financial overhead.
- Depreciation.
- Intangible drilling and development costs.
- Exploration and development expenditures.
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 dispose of an item of section 1245
property that was used in connection with 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.
For tax years beginning after 1997 and before 2002, percentage
depletion on the marginal production of oil or natural gas is not
limited to taxable income from the property figured without the
depletion deduction.
Oil and Gas Wells
Generally, only independent producers and royalty owners can claim
percentage depletion for any oil or gas well. However, if you are
not an independent producer or royalty owner, you may be
able to claim percentage depletion for the following items.
- Natural gas sold under a fixed contract.
- Natural gas from geopressured brine.
For information on the depletion deduction for these items, see
Natural Gas Wells, later.
Independent Producers and Royalty Owners
If you are an independent producer or royalty owner, you figure
percentage depletion using a rate of 15% of the gross income from the
property based on your average daily production of domestic crude oil
or domestic natural gas up to your depletable oil or natural gas
quantity. However, certain refiners and retailers, as explained next,
and certain transferees of proven oil and gas properties, as explained
later, cannot claim percentage depletion. For information on figuring
the deduction, see Figuring percentage depletion, later.
Refiners who cannot claim percentage depletion.
You cannot claim percentage depletion if you or a related person
refine crude oil and you and the related person refined more than
50,000 barrels on any day during the tax year.
Related person.
You and another person are related persons if either of you holds a
significant ownership interest in the other person or if a third
person holds a significant ownership interest in both of you.
For example, a corporation, partnership, estate, or trust and
anyone who holds a significant ownership interest in it are related
persons. A partnership and a trust are related persons if one person
holds a significant ownership interest in each of them.
For purposes of the related person rules, significant ownership
interest means direct or indirect ownership of 5% or more in any one
of the following.
- The value of the outstanding stock of a corporation.
- The interest in the profits or capital of a
partnership.
- The beneficial interests in an estate or trust.
Any interest owned by or for a corporation, partnership, trust, or
estate is considered to be owned directly both by itself and
proportionately by its shareholders, partners, or beneficiaries.
Retailers who cannot claim percentage depletion.
You cannot claim percentage depletion if both the following apply.
- You sell oil or natural gas or their by-products directly or
through a related person in any of the following situations.
- Through a retail outlet operated by you or a related
person.
- To any person who is required under an agreement with you or
a related person to use a trademark, trade name, or service mark or
name owned by you or a related person in marketing or distributing
oil, natural gas, or their by-products.
- To any person given authority under an agreement with you or
a related person to occupy any retail outlet owned, leased, or
controlled by you or a related person.
- The combined gross receipts from sales (not counting
resales) of oil, natural gas, or their by-products by all retail
outlets taken into account in (1) are more than $5 million for the tax
year.
For the purpose of determining if this rule applies, do not count
the following.
- Bulk sales (sales in very large quantities) of oil or
natural gas to commercial or industrial users.
- Bulk sales of aviation fuels to the Department of
Defense.
- Sales of oil or natural gas or their by-products outside the
United States if none of your domestic production or that of a related
person is exported during the tax year or the prior tax year.
Sales through a related person.
You are considered to be selling through a related person if any
sale by the related person produces gross income from which you may
benefit because of your direct or indirect ownership interest in the
person.
You are not considered to be selling through a related
person who is a retailer if all the following apply.
- You do not have a significant ownership interest in the
retailer.
- You sell your production to persons who are not related to
either you or the retailer.
- The retailer does not buy oil or natural gas from your
customers or persons related to your customers.
- There are no arrangements for the retailer to acquire oil or
natural gas you produced for resale or made available for purchase by
the retailer.
- Neither you nor the retailer knows of or controls the final
disposition of the oil or natural gas you sold or the original source
of the petroleum products the retailer acquired for resale.
Transfers.
You cannot claim percentage depletion if you received your interest
in a proven oil or gas property by transfer after 1974 and before
October 12, 1990. For a definition of the term "transfer," see
section 1.613A-7(n) of the regulations.
Figuring percentage depletion.
Generally, as an independent producer or royalty owner, you figure
your percentage depletion by computing your average daily production
of domestic oil or gas and comparing it to your depletable oil or gas
quantity. If your average daily production does not exceed your
depletable oil or gas quantity, you figure your percentage depletion
by multiplying the gross income from the oil or gas property by 15%.
If your average daily production of domestic oil or gas exceeds your
depletable oil or gas quantity, you must make an allocation as
explained later under Average daily production exceeds depletable
quantities.
In addition, there is a limit on the percentage depletion
deduction. See Taxable income limit, later.
Average daily production.
Figure your average daily production by dividing your total
domestic production for the tax year by the number of days in your tax
year.
Partial interest.
If you have a partial interest in the production from a property,
figure your share of the production by multiplying total production
from the property by your percentage of interest in the revenues from
the property.
You have a partial interest in the production from a property if
you have a net profits interest in the property. To figure the share
of production for your net profits interest, you must determine your
percentage participation (as measured by the net profits) in the gross
revenue from the property. To figure this percentage, you divide the
income you receive for your net profits interest by the gross revenue
from the property.
Example.
John Oak owns oil property in which Paul Elm owns a 20% net profits
interest. During the year, the property produced 10,000 barrels of
oil, which John sold for $200,000. John had expenses of $90,000
attributable to the property. The property generated a net profit of
$110,000 ($200,000 - $90,000). Paul received income of $22,000
($110,000 × .20) for his net profits interest.
Paul determined his percentage participation to be 11% by dividing
$22,000 (the income he received) by $200,000 (the gross revenue from
the property). Paul determined his share of the oil production to be
1,100 barrels (10,000 barrels × 11%).
Depletable oil or natural gas quantity.
Generally, your depletable oil quantity is 1,000 barrels. Your
depletable natural gas quantity is 6,000 cubic feet multiplied by the
number of barrels of your depletable oil quantity that you choose to
apply. If you claim depletion on both oil and natural gas, you must
reduce your depletable oil quantity by the number of barrels you use
to figure your depletable natural gas quantity. If you are involved in
marginal production, see section 613A(c) of the Internal Revenue Code
to figure your depletable oil or natural gas quantity.
Example.
You have both oil and natural gas production. To figure your
depletable natural gas quantity, you choose to apply 360 barrels of
your depletable oil quantity. Your depletable natural gas quantity is
2.16 million cubic feet of gas (360 × 6000). You must reduce
your depletable oil quantity to 640 barrels (1000 - 360).
You must allocate the depletable oil or gas quantity among the
following related persons in proportion to each entity's or family
member's production of domestic oil or gas for the year.
- Corporations, trusts, and estates if 50% or more of the
beneficial interest is owned by the same or related persons
(considering only persons that own at least 5% of the beneficial
interest).
- You and your spouse and minor children.
For purposes of this allocation, a related person is anyone
mentioned under Related persons in chapter 12 except that
item (1) in that discussion includes only an individual, his or her
spouse, and minor children.
Members of the same controlled group of corporations are treated as
one taxpayer when figuring the depletable oil or natural gas quantity.
They share the depletable quantity. Under this rule, a controlled
group of corporations is defined in section 1563(a) of the Internal
Revenue Code, except that the stock ownership requirement in that
definition is "more than 50%" rather than "at least 80%."
Gross income from the property.
For purposes of percentage depletion, gross income from the
property (in the case of oil and gas wells) is the amount you receive
from the sale of the oil or gas in the immediate vicinity of the well.
If you do not sell the oil or gas on the property, but manufacture or
convert it into a refined product before sale or transport it before
sale, the gross income from the property is the representative market
or field price (RMFP) of the oil or gas, before conversion or
transportation.
If you sold gas after you removed it from the premises for a price
that is lower than the RMFP, determine gross income from the property
for percentage depletion purposes without regard to the RMFP.
Gross income from the property does not include lease bonuses,
advance royalties, or other amounts payable without regard to
production from the property.
Average daily production exceeds depletable quantities.
If your average daily production for the year is more than your
depletable oil or natural gas quantity, figure your allowance for
depletion for each domestic oil or natural gas property as
follows.
- Figure your average daily production of oil or natural gas
for the year.
- Figure your depletable oil or natural gas quantity for the
year.
- Figure depletion for all oil or natural gas produced from
the property using a percentage depletion rate of 15%.
- Multiply the result figured in (3) by a fraction, the
numerator of which is the result figured in (2) and the denominator of
which is the result figured in (1). This is your depletion allowance
for that property for the year.
Taxable income limit.
If you are an independent producer or royalty owner of oil and gas,
your deduction for percentage depletion is limited to the smaller of
the following.
- Your taxable income from the property figured without the
deduction for depletion. For a definition of taxable income from the
property, see Taxable income limit, earlier, under
Mineral Property.
- 65% of your taxable income from all sources, figured without
the depletion allowance, any net operating loss carryback, and any
capital loss carryback.
You can carry over to the following year any amount you cannot
deduct because of the 65%-of-taxable-income limit. Add it to your
depletion allowance (before applying any limits) for the following
year.
Temporary suspension of taxable income limit for marginal
production.
For tax years beginning after 1997 and before 2002, percentage
depletion on the marginal production of oil or natural gas is not
limited to taxable income from the property figured without the
depletion deduction. For information on marginal production, see
section 613A(c)(6) of the Internal Revenue Code.
Partnerships and S Corporations
Generally, each partner or shareholder, and not the partnership or
S corporation, figures the depletion allowance separately. (However,
see Electing large partnerships must figure depletion allowance,
later.) Each partner or shareholder must decide whether to use cost or
percentage depletion. If a partner or shareholder uses percentage
depletion, he or she must apply the 65%-of-taxable-income limit using
his or her taxable income from all sources.
Partner's or shareholder's adjusted basis.
The partnership or S corporation must allocate to each partner or
shareholder his or her share of the adjusted basis of each oil or gas
property held by the partnership or S corporation. The partnership or
S corporation makes the allocation as of the date it acquires the oil
or gas property.
Each partner's share of the adjusted basis of the oil or gas
property generally is figured according to that partner's interest in
partnership capital. However, in some cases, it is figured according
to the partner's interest in partnership income.
The partnership or S corporation adjusts the partner's or
shareholder's share of the adjusted basis of the oil and gas property
for any capital expenditures made for the property and for any change
in partnership or S corporation interests.
Each partner or shareholder must separately keep records of his or
her share of the adjusted basis in each oil and gas property of the
partnership or S corporation. The partner or shareholder must reduce
his or her adjusted basis by the depletion he or she takes on the
property each year. The partner or shareholder must use that reduced
adjusted basis to figure cost depletion or his or her gain or loss if
the partnership or S corporation disposes of the property.
Reporting the deduction.
Information that you, as a partner or shareholder, use to figure
your depletion deduction on oil and gas properties is reported by the
partnership or S corporation on line 25 of Schedule K-1 (Form 1065) or
on line 23 of Schedule K-1 (Form 1120S). Deduct oil and gas depletion
for your partnership or S corporation interest on Schedule E (Form
1040). The depletion deducted on Schedule E is included in figuring
income or loss from rental real estate or royalty properties. The line
instructions for Schedule E explain where to report this income or
loss and whether you need to file either of the following forms.
- Form 6198, At-Risk Limitations.
- Form 8582, Passive Activity Loss
Limitations.
Electing large partnerships must figure depletion allowance.
For partnership tax years beginning after 1997, an electing large
partnership, rather than each partner, generally must figure the
depletion allowance. The partnership figures the depletion allowance
without taking into account the limits on the amount of production and
taxable income. Also, the adjusted basis of a partner's interest in
the partnership is not affected by the depletion allowance.
An electing large partnership is one that meets both the following
requirements.
- The partnership had 100 or more partners in the preceding
year.
- The partnership chooses to be an electing large
partnership.
Disqualified partners.
An electing large partnership does not figure the depletion
allowance of its disqualified partners. The disqualified partners must
figure it themselves, as explained earlier.
All the following are disqualified partners.
- Refiners who cannot claim percentage depletion (discussed
under Independent Producers and Royalty Owners,
earlier).
- Retailers who cannot claim percentage depletion (discussed
under Independent Producers and Royalty Owners,
earlier).
- Any partner whose average daily production of domestic crude
oil and natural gas is more than 500 barrels during the tax year in
which the partnership tax year ends. Average daily production is
discussed earlier.
Natural Gas Wells
You can use percentage depletion for natural gas sold under a fixed
contract or produced from geopressured brine.
Natural gas sold under a fixed contract.
Natural gas sold under a fixed contract qualifies for a percentage
depletion rate of 22%. This is domestic natural gas sold by the
producer under a contract that does not provide for a price increase
to reflect any increase in the seller's tax liability because of the
repeal of percentage depletion for gas. The contract must have been in
effect from February 1, 1975, until the date of sale of the gas. Price
increases after February 1, 1975, are presumed to take the increase in
tax liability into account unless demonstrated otherwise by clear and
convincing evidence.
Natural gas from geopressured brine.
Qualified natural gas from geopressured brine is eligible for a
percentage depletion rate of 10%. This is natural gas that is both the
following.
- Produced from a well you began to drill after September 1978
and before 1984.
- Determined in accordance with section 503 of the Natural Gas
Policy Act of 1978 to be produced from geopressured brine.
Mines and
Geothermal Deposits
Certain mines, wells, and other natural deposits, including
geothermal deposits, qualify for percentage depletion.
Mines and other natural deposits.
For a natural deposit, the percentage of your gross income from the
property that you can deduct as depletion depends on the type of
deposit.
The following is a list of the depletion percentages for the more
common minerals.
DEPOSITS |
PERCENT |
Sulphur, uranium, and, if from deposits
in the United States, asbestos, lead ore, zinc ore, nickel ore, and
mica |
22 |
Gold, silver, copper, iron ore, and
certain oil shale, if from deposits in the United States |
15 |
Borax, granite, limestone, marble,
mollusk shells, potash, slate, soapstone, and carbon dioxide produced
from a well |
14 |
Coal, lignite, and sodium chloride |
10 |
Clay and shale used or sold for use in
making sewer pipe or bricks or used or sold for use as sintered or
burned lightweight aggregates |
7 1/2 |
Clay used or sold for use in making
drainage and roofing tile, flower pots, and kindred products, and
gravel, sand, and stone (other than stone used or sold for use by a
mine owner or operator as dimension or ornamental stone) |
5 |
You can find a complete list of minerals and their percentage
depletion rates in section 613(b) of the Internal Revenue Code.
Corporate deduction for iron ore and coal.
The percentage depletion deduction of a corporation for iron ore
and coal (including lignite) is reduced by 20% of:
- The percentage depletion deduction for the tax year (figured
without regard to this reduction), minus
- The adjusted basis of the property at the close of the tax
year (figured without the depletion deduction for the tax year).
Gross income from the property.
For property other than a geothermal deposit or an oil or gas well,
gross income from the property means the gross income from mining.
Mining includes all the following.
- Extracting ores or minerals from the ground.
- Applying certain treatment processes.
- Transporting ores or minerals (generally, not more than 50
miles) from the point of extraction to the plants or mills in which
the treatment processes are applied.
Excise tax.
Gross income from mining includes the separately stated excise tax
received by a mine operator from the sale of coal to compensate the
operator for the excise tax the mine operator must pay to finance
black lung benefits.
Extraction.
Extracting ores or minerals from the ground includes extraction by
mine owners or operators of ores or minerals from the waste or residue
of prior mining. This does not apply to extraction from waste or
residue of prior mining by the purchaser of the waste or residue or
the purchaser of the rights to extract ores or minerals from the waste
or residue.
Treatment processes.
The processes included as mining depend on the ore or mineral
mined. To qualify as mining, the treatment processes must be applied
by the mine owner or operator. For a listing of treatment processes
considered as mining, see section 613(c)(4) of the Internal Revenue
Code and the related regulations.
Transportation of more than 50 miles.
If the IRS finds that the ore or mineral must be transported more
than 50 miles to plants or mills to be treated because of physical and
other requirements, the additional authorized transportation is
considered mining and included in the computation of gross income from
mining.
|
If you wish to include transportation of more than 50 miles in the
computation of gross income from mining, file an application in
duplicate with the IRS. Include on the application the facts
concerning the physical and other requirements which prevented the
construction and operation of the plant within 50 miles of the point
of extraction. Send this application to:
Internal Revenue Service
Washington, DC 20224
Attention: Assistant Chief Counsel, Passthroughs and Special
Industries |
Disposal of coal or iron ore.
You cannot take a depletion deduction for coal (including lignite)
or iron ore mined in the United States if both the following apply.
- You disposed of it after holding it for more than 1
year.
- You disposed of it under a contract under which you retain
an economic interest in the coal or iron ore.
Treat any gain on the disposition as a capital gain.
Disposal to related person.
This rule does not apply if you dispose of the coal or iron ore to
one of the following persons.
- A related person (as listed in chapter 12).
- A person owned or controlled by the same interests that own
or control you.
Geothermal deposits.
Geothermal deposits located in the United States or its possessions
qualify for a percentage depletion rate of 15%. A geothermal deposit
is a geothermal reservoir of natural heat stored in rocks or in a
watery liquid or vapor. For percentage depletion purposes, a
geothermal deposit is not considered a gas well.
Figure gross income from the property for a geothermal steam well
in the same way as for oil and gas wells. See Gross income from
the property, earlier, under Oil and Gas Wells.
Lessor's Gross Income
A lessor's gross income from the property that qualifies for
percentage depletion usually is the total of the royalties received
from the lease. However, for oil, gas, or geothermal property, gross
income does not include lease bonuses, advanced royalties, or other
amounts payable without regard to production from the property.
Bonuses and advanced royalties.
Bonuses and advanced royalties are payments a lessee makes before
production to a lessor for the grant of rights in a lease or for
minerals, gas, or oil to be extracted from leased property. If you are
the lessor, your income from bonuses and advanced royalties received
is subject to an allowance for depletion.
Figuring cost or percentage depletion.
To figure cost depletion on a bonus, multiply your adjusted basis
in the property by a fraction, the numerator of which is the bonus and
the denominator of which is the total bonus and royalties expected to
be received. To figure cost depletion on advanced royalties, use the
computation explained earlier under Cost Depletion,
treating the number of units for which the advanced royalty is
received as the number of units sold.
To figure percentage depletion (for other than gas, oil, or
geothermal property), any bonus or advanced royalty payments are part
of your gross income from the property.
Terminating the lease.
If you receive a bonus on a lease that expires, terminates, or is
abandoned before you derive any income from the extraction of mineral,
include in income for the year of expiration, termination, or
abandonment, the depletion deduction you took. Also increase your
adjusted basis in the property to restore the depletion deduction you
previously subtracted.
For advanced royalties, include in income for the year of lease
termination, the depletion claimed on minerals for which the advanced
royalties were paid if the minerals were not produced before
termination. Increase your adjusted basis in the property by the
amount you include in income.
Delay rentals.
These are payments for deferring development of the property. Since
delay rentals are ordinary rent, they are ordinary income that is not
subject to depletion. These rentals can be avoided by either
abandoning the lease, beginning development operations, or obtaining
production.
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