Depletion
The deduction for depletion allows an owner or operator to compensate for the reduction in a product's resources. Examples of property that are subject to depletion deductions are oil and gas wells, mines, exhaustible natural deposits and timber. The two methods of computing depletion are discussed below. The taxpayer must use the method that produces the largest deduction.  

Computing Depletion:

  1. Percentage Depletion
  2. Cost Depletion
Percentage Depletion
The percentage to be used depends on the mineral involved, and the range is 5 to 22%.
The percentage rate is then applied to the annual gross income derived from the resource.

Limits: Percentage depletion deduction may not exceed 50% of taxable income (oil and gas is the exception)

Oil and gas percentage depletion for small independent producers are allowed to deduct percentage depletion at a 15% rate for domestic oil and gas production, which is subject to taxable income limits.

Cost Depletion
Costs of natural resources are allocated to depletion over the period that makes up the life of the asset. Two requirements: a) estimate the total units of the mineral to be extracted; b) assign proportionate amount of the resource cost to the quantity extracted in the period (timber must use cost depletion).

Calculation:

Investment to extract (x) [first year extraction in units/total estimated extraction in units]

Example:
Joe Riggs Oil Company invests $500,000 in a petroleum drilling operation where they estimate to extract 900,000 barrels of oil. In the first year, 100,000 barrels are extracted. Calculate the depletion deduction.

Depletion = $500,000 x [100,000 / 900,000] = $55,555

Sample Questions 1 - 7

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