We had a reader ask the following question:
"Hi, I just inherited a Kansas wheat farm with an oil well on it. I assume that I still get the 15% percentage depletion on the oil royalty. My question is do you know if I can "value" the oil and then take a larger cost depletion deduction from the royalty income?"
Many farmers in the Midwest and other areas of the U.S. may have situations similar to this reader's. Many of our clients are now making more money from their oil and gas income than from farming.
One method of reducing this income is the use of depletion. Cost depletion is similar to depreciation and is based upon the amount of units sold during the year compared to the estimated total units still available to be sold. For example, assume a farmer inherits a piece of farmland with an oil well on it. A qualified survey of the oil well is performed and it is estimated there are 30,000 barrels of oil still to be pumped from the ground. During 2011, the farmer pumps 1,000 barrels of oil. The value of the oil in the ground at the time of the inheritance was estimated at $300,000 or $10 per barrel, therefore the cost depletion deduction for 2011 is $10,000 (1,000 barrels times $10).
Another method of depletion is the use of percentage depletion. This method takes the gross income derived from oil sales and multiplies it by a percentage (in most cases, 15%). The farmer is allowed to use either percentage or cost depletion each year and is entitled to the greater of each. This can be cost one year and percentage the next. In our example, let's assume the farmer collects $50,000 from the sale of his oil for the year. Percentage depletion based upon 15% would equal a deduction of $7,500. Since cost depletion of $10,000 is higher than percentage depletion, the farmer would deduct cost depletion in this year. However, let's assume the farmer received $100,000 from the sale of his oil. In this case, percentage depletion of $15,000 would be higher than cost depletion and the farmer could use percentage depletion.
One drawback of depletion is that the farmer must reduce the basis in his oil and gas property by the amount of cost depletion taken. The excess of percentage depletion over cost is not used to reduce the basis.
As you can see, these calculations can get complicated, and there are various other rules on percentage depletion that can limit the amount of this deduction. If you have an oil and gas well on your farmland, you should review your situation with a tax adviser who understands this type of taxation.
But the bottom line is that you can take cost depletion based on the cost allocated to the oil reserves if cost depletion is greater than percentage depletion.