Tax Depletion / Tax Basis / Capital Gains

[jdwhite2]

I’m a tax accountant in Houston, TX and wanted to share some general information regarding the federal rules regarding tax depletion, tax basis, and capital gains since it looked like member questions pop up frequently on the forum. This post is not intended to be tax, legal, or accounting advice.

Tax Depletion

The deduction for tax depletion (“depletion allowance”) is calculated as the higher of cost depletion or percentage depletion (a/k/a “statutory depletion”) for a depletable property for the taxable year:

1. Cost Depletion – IRC § 611

Cost depletion is calculated as follows:

Adjusted Basis of Property at End of Year × (Units Sold During the Year ÷ (Units Remaining at End of Year + Units Sold During the Year)) = Cost Depletion

2. Percentage Depletion – IRC § 613A

Percentage depletion is calculated as follows:

Gross Income from Property × Statutory Depletion Percentage = Percentage Depletion

Note #1: The statutory depletion percentage for oil and gas is currently 15% - IRC § 613A(c)(B)

Note #2: An “economic interest” is required in a depletable property in order to claim a depletion deduction – IRC § 1.611-1(b)

Note #3: Percentage depletion is subject to three statutory limitations:

1. Depletable property net income limitation – IRC § 613(a)

The deduction for percentage depletion for a depletable property for the taxable year may not exceed the taxable income from the depletable property (i.e. you can’t deduct more percentage depletion from a depletable property than you have net income [before depletion] from the property).

2. 65% of taxable income limitation – IRC § 613A(d)

The total deductions for percentage depletion for all depletable properties for the taxable year may not exceed 65% of the taxpayer’s adjusted taxable income. Any disallowed percentage depletion under IRC § 613A(d) is carried forward to next year.

3. Depletable quantity limitation (a/k/a “barrel limitation”) – IRC § 613A(c)

The deduction for percentage depletion may only be claimed on so much of the taxpayer’s average daily production as does not exceed the taxpayer’s depletable oil quantity. Generally, the depletable oil quantity is 1,000 barrels per day (or 6,000 MCF per day).

Note #4: Percentage depletion is not available on lease bonuses, advance royalties, or other amounts payable “without regard to production from the property” – IRC § 613A(d)(5)

Note #5: Percentage depletion is not available on non-domestic production – IRC § 613A(e)(3)

And here are some additional thoughts on tax depletion for you to consider:

1. The calculation for depletion is multi-part and complex and may (especially with cost depletion) require information you can’t readily obtain if your oil and gas production comes from a non-operated working interest or a royalty interest.

2. As you may’ve noticed from the two depletion formulas above, cost depletion is only available when you have remaining undepleted tax basis in a depletable property at the end of the year whereas percentage depletion is available whether or not you have any remaining undepleted tax basis. This means that (as long as you clear all the other limitation hurdles) you can continue to claim percentage depletion as long as the property has production.

3. It’s very important for you to properly calculate your depletion deduction each year if you have remaining undepleted basis since “allowed” (i.e. amount you deducted) or “allowable” (i.e. amount you should’ve deducted but didn’t) depletion reduces your tax basis.

Tax Basis

Interests in oil and gas properties are most often acquired through either purchases, gifts, or bequests:

1. Acquired by Purchase – IRC § 1012

Your initial tax basis in the interests you purchased is the amount you paid for them.

2. Acquired by Gift – IRC § 1014

Your initial tax basis in the interests you received by gift is the tax basis of the person(s) who gifted them to you on the date of the gift (a/k/a “carryover basis”).

3. Acquired by Bequest – IRC § 1015

Your initial tax basis in the interests you received by bequest (or otherwise inherited) is their fair market value as of the decedent’s date of death (or, if so elected, the fair market value on the six-month anniversary of the decedent’s date of death) (a/k/a “stepped-up basis”).

4. Adjustments to Basis – IRC § 1016

The tax basis in the interests you acquired must be reduced each year (though never below zero) by the deductions for cost depletion and/or percentage depletion you’ve taken (or should’ve taken).

And here are some additional thoughts on tax basis for you to consider:

1. This is easily the most problematic tax area for mineral interest owners due to the complex recordkeeping and/or market valuation analysis required.

2. If you purchased, were gifted, or inherited land (i.e. instead of just mineral interests), you’ll want to consider how your initial tax basis needs to be allocated between the land/land improvements, the timber, the crops, and the mineral interests acquired.

Capital Gains

The sale of interests in oil and gas properties often results in capital gains. Capital gains and losses are calculated as follows:

Amount Realized - Adjusted Basis = Capital Gain or Loss

Note #1: The “installment method”, at a taxpayer’s election, generally allows capital gain to be spread ratably over the years in which the sales proceeds are received – IRC § 453

Note #2: Capital gains may be deferred if the seller reinvests the sales proceeds into a similar property and meets all the other statutory requirements (a/k/a “like-kind exchange”) – IRC § 1031

Note #3: Gain amounts attributable to deductions allowed (or allowable) when arriving at adjusted basis may have to be recharacterized as ordinary income instead of capital gain (a/k/a “ordinary income recapture”) – IRC § 1254

Note #4: Net short-term capital gains (from the sale or exchange of a capital asset held for not more than 1 year) are taxable at ordinary income tax rates versus the preferential capital gain rates – IRC § 1

Note #5: The holding period (for determining short-term versus long-term capital gain) for property acquired through gift generally begins on the date the donor originally acquired the property – IRC § 1223(2)

Note #6: The holding period (for determining short-term versus long-term capital gain) for property acquired through bequest (or otherwise inherited) is generally considered to be more than 1 year (i.e. long-term) – IRC § 1223(9)(B)

And here are some additional thoughts on capital gains for you to consider:

1. Your holding period is very important for you to know before entering into a sale of your mineral interests since it can have an outsized impact on the amount of tax you’ll pay.

2. To the extent you’ve taken cost depletion and/or percentage depletion that’s reduced your adjusted basis in your mineral interests, you could be subject to ordinary income tax rates on that portion of your gain on sale. However, percentage depletion taken in excess of basis does not increase your gain on sale (i.e. that’s why they sometimes refer to percentage depletion [derisively] as a “free deduction”).

3. In cases where you’ve received your mineral interests through gift or bequest (as well as in cases where you’ve purchased or received land versus just mineral interests), you should strongly consider engaging an attorney, accountant, and/or valuation specialist to help you with the values and/or allocations.

Hope this has been helpful. Hope y’all have a great weekend.

[mjliddell]

Great info! I’m passing this along to my accountant. But I still have one simple question. Requirements mention one must have an economic interest …I’ve read about depletion being limited to investors. My question is, can an individual that inherits mineral rights claim depletion if all other criteria is met, or just those purchasing mineral rights for investment purposes?

[jdwhite2]

Yes sir. An inherited royalty interest in a mineral deposit should qualify as an “economic interest” under IRC § 1.614-1(a)(2):

“(2) The term interest means an economic interest in a mineral deposit. See paragraph (b) of § 1.611–1. The term includes working or operating interests, royalties, overriding royalties, net profits interests, and, to the extent not treated as loans under section 636, production payments.”

Please (as always) consult with your advisor regarding your personal tax situation.

[mjliddell]

Thank you! That clarifies that for me perfectly. My mineral interest are located in northern Utah. I reside in southern Utah where accountants are less familiar with mineral rights than they are in northern Utah where there’s more production and has been for many years… So any information I can gather to forward onto my tax accountant will help him out and I appreciate it as well! I’m trying to get better educated in all aspects of the mineral rights environment. My tax accountant is a brilliant young man and willing to dive into this and learn. Thank you again. I appreciate your help and sharing valuable information!

[jdwhite2]

No problem. I’m glad you found the information helpful. I’ve been working in oil and gas tax for ten plus years and I’m still learning stuff so it’s very complex (but also very rewarding).

I wanted to add another tidbit regarding what is (in my experience) a common misconception regarding recordkeeping. Generally, you should keep records for 3 years from the date you filed your tax return. However, if the records are related to the tax basis in a property you own (e.g. mineral interests, real estate, stocks, bonds, partnership interests, etc.), you should generally keep the records until three years after you’ve sold (or otherwise disposed of) the property. And you likely won’t be able to rely on your tax accountant to keep your older records for you since our guidelines generally only call for us to retain records for 7 years.

[Clay_Belcher]

This is such a great and succinct listing on these topics, thank you for this post. As you alluded, nobody should ever take info like this as some type of set of hard and fast rules for obvious reasons, but it’s especially helpful to have descriptions like these from a tax accountant. I wanted to ask you, my mother is in a situation where she’s considering selling some inherited mineral interests that have never produced but we’re concerned how we would ever be able to determine a tax basis since she inherited them in the 1960’s and hasn’t leased them at any point between now and then. They were left off of the appraisal of the estate’s inventory when it went through probate back then so we don’t know where to even begin to come up with a 1965 value for them. Do you know of any common or preferred way to determine a tax basis for inherited minerals in a situation like this?

[jdwhite2]

Thank you for the kind words. I’m afraid market valuation analysis is out of my wheelhouse, but I can point you to the definition of “fair market value” under IRC § 20.2031-1(b):

“The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. The fair market value of a particular item of property includible in the decedent’s gross estate is not to be determined by a forced sale price. Nor is the fair market value of an item of property to be determined by the sale price of the item in a market other than that in which such item is most commonly sold to the public, taking into account the location of the item wherever appropriate.”

Sorry I can’t be of more help. You might consider creating a new topic to see if there’s someone else on the forum who can be of assistance with market valuation analyses.