Do You Depreciate or Deplete Oil Royalties for Taxes?
Image: Shutterstock
When landowners first receive royalty checks from an oil or gas lease, it feels like free money. But soon after the excitement, reality sets in that the Internal Revenue Service (IRS) will want its share. Many new royalty owners assume that they can depreciate these payments, similar to writing off equipment or real estate. The truth is, you do not depreciate royalties. Instead, the IRS allows something called depletion, a special deduction that reflects the gradual exhaustion of natural resources.
This distinction matters. Understanding how depletion works and how to claim it can save you thousands on taxes if you own mineral rights, or receive oil and gas royalty income.
Here’s Why Depletion Exists
Oil and gas reserves are not infinite. Every barrel or cubic foot pumped from the ground is one less that remains. Unlike a piece of machinery that loses value through wear and tear, oil wells lose value because their resources are being extracted. Recognizing this, the IRS provides the depletion allowance. It lets royalty and working interest owners recover part of their investment by deducting the diminishing value of what’s underground.
Think of it as the natural resources version of depreciation, except in this case, the deduction accounts for what is no longer in the ground rather than the decline of an artificial asset.
Two Ways to Calculate Depletion
There are two primary methods, and the right one depends on the type of ownership and the records you keep.
Cost depletion is based on your actual investment in the property. You estimate the total reserves in the well and deduct a portion each year tied to production. It is accurate but record-intensive — you will need detailed cost and reserve data.
Percentage depletion is simpler and more common for royalty owners. Instead of tracking costs, you deduct a flat percentage of gross income from the property. For most wells, this rate is 15%, though it can be higher for marginal or stripper wells. The biggest advantage? Percentage depletion can continue even after you have recovered your initial investment.
However, it comes with rules. The deduction cannot exceed 100% of the taxable income from the property, and you must meet IRS qualifications.
Who Qualifies for the Deduction
The depletion allowance is available to anyone with an economic interest in the mineral property. This includes royalty owners, working interest owners and even those who inherited their rights. What matters is that your income depends on extraction from the property.
Not everything qualifies, though. Lease bonuses and prepaid royalties are taxed as income, but do not receive the depletion benefit.
How to Report Depletion
The reporting process is straightforward. Royalty income is reported on Schedule E (Form 1040). Oil and gas companies issue Form 1099-MISC, showing gross royalties. From there, you calculate your allowable depletion and record it as expenses on Schedule E.
For small landowners and royalty recipients, this is typically handled with percentage depletion. More sophisticated operators with detailed records may compare both cost and percentage methods each year and choose the one that provides the larger deduction.
Maximizing Your Tax Breaks
Like any IRS rule, the depletion allowance has nuances. To get the most benefit while staying compliant:
Run the numbers each year- Compare cost depletion and percentage depletion annually. Pick whichever gives the higher deduction.
Track your records- Keep detailed records of production, income and expenses.
Claim operating deductions- If you are more than a royalty owner — say, a working interest owner — you can also deduct costs like transportation, property taxes, lease payments and professional fees.
Mind the limits- Percentage depletion cannot exceed 100% of taxable income from the property. Unused amounts, however, may be carried over to future years.
The Bottom Line
Receiving oil and gas royalties can be life-changing, but they can add complexity to your taxes. While you cannot depreciate royalties, the depletion allowance offers a powerful way to reduce what you owe. For most royalty owners, the flat 15% deduction through percentage depletion is the simplest path, though larger operators may benefit more from cost depletion.