The IRs says you can claim depletion if you have an economic interest in a mineral property, but two conditions have to be met. I understand the first condition, but what does the second mean? (Emphasis is mine.)
"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. In the case of leased property, the depletion deduction is divided between the lessor and the lessee.
You have an economic interest if both the following apply.
You have acquired by investment any interest in mineral deposits or standing timber.
You have a legal right to income from the extraction of the mineral or 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."
The language of the rules is complex but, generally speaking, if the owner of a mineral and/or royalty interest receives royalty payments on production, then the owner likely qualifies for a depletion deduction.
There are two types of depletion deductions available for oil & gas income: percentage depletion and cost depletion. Percentage depletion is a flat 15%, whereas cost depletion is a much more complicated calculation which depends on the owner’s cost basis in the property among other factors. If the owner has significant basis in the property, then cost depletion could provide a larger deduction than percentage depletion. Cost depletion can also be used to offset lease bonus income in certain situations. Both types of depletion can be a valuable deduction for oil & gas interest owners. You can read more about this topic in one of my posts here.
The depletion rules are complex and this is a general overview for informational purposes only. Consult a qualified professional regarding the application of these rules to any specific situation.
Thank you, Patrick, for responding and referring me to your other post. How does a person qualify for both - does purchasing mineral rights count as a capital investment?
Generally speaking, purchasing a mineral interest would be a capital investment - but there are other scenarios, such as receiving an interest by gift or inheritance, which could also fulfill the conditions. The interest owner could claim depletion using whichever one of the depletion methods provides the higher deduction. Unfortunately I can’t address specific situations or provide advice in this public forum.
The information is for general informational purposes only. This should not be substituted for legal advice and should not be taken as legal advice for any individual case or situation. This information is not intended to create, and receipt or reading does not constitute, an attorney-client relationship.