Oil Royalties – Income Tax on Depletion vs. Depreciation
March 23, 2016
Each year when tax time rolls around, anyone who has income that has been earned from oil royalties must claim that money, just like any other earned income. Similarly, there are also certain deductions that royalty owners can use, based on the fact that oil production reduces over time as the supply in a well is depleted. Depletion deductions are essentially depreciation deductions, except they are for oil and mineral extraction operations. To file an accurate income tax return, it is important to understand some things about depreciation, depletion, and filing taxes claiming oil royalties.
Depletion vs. Depreciation
Although they are similar, depletion and depreciation are technically different when it comes to deducting expenses for oil royalties. Depreciation occurs with physical things, while depletion that would include a continual reduction in the amount of oil produced from a well occurs to any type of depletable product. Based on this concept, those claiming income from oil royalties can use a depletion deduction to account for the reduced production of any of their wells.
Who Can Use the Depletion Deduction?
To claim a depletion deduction on income earned on oil royalties, the IRS states that these three qualifications must be met:
- The landowner must have ownership interest in the mineral being extracted.
- The landowner must have legal right to income from the extraction of that mineral.
- The deduction is applicable only to the oil or gas that is sold and producing reportable income. Therefore, it does not apply to any oil bonus income, only royalty income itself.
Depletion Deduction for Oil Royalties
There are two methods of filing depletion deductions for oil royalties:
- Cost Depletion Method - Cost depletion is based on the cost of the owner’s interest in their land and mineral rights as well as the value placed on such minerals. The cost of the reduction in production is determined by a specific calculation. As long as this amount is less than the value of the entire calculated worth of the minerals, it can be deducted as depletion.
- Percentage Depletion Method - As long as properties are producing less than 75,000 barrels of oil a day, the percentage deduction method may also be used by those claiming income from oil royalties. This method permits a deduction of 15 percent of the total amount of royalties earned from sold oil, not including bonus income.
Based on these two methods, anyone claiming income from oil royalties can deduct the gradual reduction in production of their wells as a standard depletion deduction. The IRS instructs those who are claiming income from oil royalties and using the associated depletion deductions to use whichever method gives them the largest deduction.
For more information on depletion tax deductions, it is important to contact an experienced mineral royalties company to provide the necessary assistance!
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