Oil and Gas Tax in a Nutshell – Part 2

In my previous post, I gave an overview of oil and gas tax, including percentage depletion. In this article, I will discuss cost depletion.

Cost depletion is important because your clients will not always qualify for percentage depletion. If they do qualify for percentage depletion, they are allowed to take the greater of cost, or percentage depletion, on a property-by-property basis.

According to IRS Pub 535, Business Expenses, “Depletion is the using up of natural resources by mining, drilling, quarrying stone or cutting timber. The depletion deduction allows an owner or operator to account for the reduction of a product’s reserves.”

Oil and gas rules say that you generally capitalize these oil and gas property costs:

• Acquire – costs to gain rights to the property.
• Explore – costs to look for reserves.
• Develop – costs to access proven reserves and set up for extraction of them.

These costs are commonly called capitalized leasehold costs, and are recovered through a depletion deduction on the tax return. Cost depletion is calculated from the capitalized costs, and is taken as the oil or gas is extracted from the property (production).

How to calculate: The portion of the capitalized costs that can be taken as cost depletion is determined by:

 Current units sold

————————————————-  X  Tax basis for depletion before current depletion

Current units sold + Ending reserves

Intuit® ProConnect™ Lacerte® will automatically do the calculation for you.

Editor’s note: For more information, read “Basic Tax Reporting of Oil- and Gas-Related Activities” on the Intuit ProConnect Tax Pro Center as well as the IRS Oil and Gas Handbook.