Understanding Royalty Taxes – Part 2 Depletion Allowance!
April 19, 2019
There are many taxes that apply to the production of natural resources and the sale of oil and gas royalties that you should be aware of if you generate any income this way.
Fortunately, there are also some tax deductions like the depletion allowance that apply to the selling of oil and gas royalties.
The depletion allowance can save you money if you sell your gas and oil royalties and take the right tax deduction.
What is a Depletion Allowance?
The depletion allowance is a tax deduction that can be claimed against income earned by selling oil and gas royalties.
It is a deduction that recognizes the depletion of a natural resource and that as oil and gas are produced over the life of a well, the supply will slowly reduce until the well is no longer productive.
As depletion is comparable to the depreciation that affects some tangible property, this tax deduction partially offsets the costs of production that can end up eating into profits when wells begin to deplete.
Who Can Claim a Depletion Allowance Tax Deduction?
Anyone who has a financial interest in a mineral property can claim a depletion allowance, including those who are simply selling their oil and gas royalties as that income still reflects a portion of the cost of production.
How Is The Depletion Allowance Applied to Earned Income?
There are two ways in which a depletion allowance can be claimed as a tax deduction against the costs of a slowly depleting well:
===>> Percentage Depletion - The claimable percentage depletion allowance taken by most owners of oil and gas royalties is 15% of the gross taxable income earned from the property.
It is a fixed amount and an easy calculation that can be applied by the individual owner on their income tax return.
Before assuming a percentage depletion, it is a good idea for owners to consider whether they actually qualify for a much larger deduction by claiming a cost depletion allowance.
===>> Cost Depletion - A cost depletion allowance is a variable amount calculated using a formula that considers the amount of well production, value of the product, and importantly the estimated amount of product still left in the ground.
Based on this formula, calculating cost depletion involves multiple parties including engineers, mineral appraisers, and other specialists who can help determine the value of what the deposit can still produce.
While it’s financially beneficial to take whichever one is going to give you the largest deduction, calculating cost depletion can be complex and should be done with the assistance of a royalties expert.
Conversely, as complicated as the calculation may be, it’s worthwhile when it can result in a higher deduction that could be as much as 50% or more from royalty income.
Get the Right Depletion Allowance With a Royalties Expert
Selling oil and gas royalties can be as complicated as it is fruitful.
Although there are many taxes that apply to the income you make when you sell your gas and oil royalties, there are also important deductions and incentives you can take advantage of to keep more of that income.
When calculating your depletion deduction, don’t just assume percentage depletion is right for you; work with a royalties expert who can help you decide whether cost depletion is the favorable option for a larger deduction.
Find out more about what the 1031 Exchange for Mineral Rights is and how it can save you taxes on your royalty income in Understanding Royalty Taxes – Part 3 1031 Exchange for Mineral Rights of this informative 6-part series or if you missed the first in the series about Oil Severance taxes, click the title to read that one!
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