To figure the property's basis for depletion, subtract all the following from the property's 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.

The total recoverable units is the sum of the following.

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.

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 for which depletion deductions were allowed or allowable in earlier years.

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.

When figuring your percentage depletion, subtract from your gross income from the property the following amounts.

A bonus payment includes amounts you paid as a lessee to satisfy a production payment retained by the lessor.

Use the following fraction to figure the part of the bonus you must subtract.

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.

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.

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

For tax years beginning after 1997 and before 2004, 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.

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.

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.

You cannot claim percentage depletion if both the following apply.

For the purpose of determining if this rule applies, do not count the following.

To determine if you and another person are related persons, see Related person under Refiners who cannot claim percentage depletion, earlier.

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 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. For a definition of the term “interest in proven oil or gas property,” see section 1.613A–7(p) of the regulations.

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 (defined later) 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.

Figure your average daily production by dividing your total domestic production for the tax year by the number of days in your tax year.

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 first 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. Then multiply the total production from the property by your percentage participation to figure your share of the production.

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 (1,000 barrels) by the number of barrels you use to figure your depletable natural gas quantity. If you have production from marginal wells, see section 613A(c)(6) of the Internal Revenue Code to figure your depletable oil or natural gas quantity.

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.

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%.”

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.

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.

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.

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.

For tax years beginning after 1997 and before 2004, 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.

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.

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 line 20 of 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 instructions for Schedule E explain where to report this income or loss and whether you need to file either of the following forms.

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 65 percent-of-taxable-income limit and the depletable oil or natural gas quantity. 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.

An electing large partnership does not figure the depletion allowance of its partners that are disqualified persons. Disqualified persons must figure it themselves, as explained earlier.

All the following are disqualified persons.

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.

Qualified natural gas from geopressured brine is eligible for a percentage depletion rate of 10%. This is natural gas that is both the following.

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 percentage depletion rates for the more common minerals.

You can find a complete list of minerals and their percentage depletion rates in section 613(b) of the Internal Revenue Code.

The percentage depletion deduction of a corporation for iron ore and coal (including lignite) is reduced by 20% of:

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.

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.

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.

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.

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:

You cannot take a depletion deduction for coal (including lignite) or iron ore mined in the United States if both the following apply.

Treat any gain on the disposition as a capital gain.

This rule does not apply if you dispose of the coal or iron ore to one of the following persons.

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. Percentage depletion on a geothermal deposit cannot be more than 50% of your taxable income from the property.

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.

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.

In the case of mines, wells, and other natural deposits other than gas, oil, or geothermal property, you may use the percentage rates discussed earlier. Any bonus or advanced royalty payments are generally part of the gross income from the property to which the rates are applied in making the calculation. However, in the case of independent producers and royalty owners of oil and gas property, bonuses and advance royalty payments are not a part of gross income.

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.

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.

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

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.

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

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

Claim your depletion allowance as a deduction in the year of sale or other disposition of the products cut from the timber, unless you choose to treat the cutting of timber as a sale or exchange. 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.

You can choose, under certain circumstances, to treat the cutting of timber held for more than 1 year as a sale or exchange. You must make the choice on your income tax return for the tax year to which it applies. If you make this choice, subtract the adjusted basis for depletion from the fair market value of the timber on the first day of the tax year in which you cut it to figure the gain or loss on the cutting. You generally report the gain as long-term capital gain. The fair market value then becomes your basis for figuring your ordinary gain or loss on the sale or other disposition of the products cut from the timber. For more information, see Timber in chapter 2 of Publication 544, Sales and Other Dispositions of Assets.

Attach Form T (Timber), Forest Activities Schedule, to your income tax return if you are claiming a deduction for timber depletion or choosing to treat the cutting of timber as a sale or exchange.