Percentage vs. Cost Depletion: The Depletion Allowance

The big oil and gas tax benefit everyone hears about is the first-year intangible drilling cost deduction. But there's a second, quieter benefit that keeps working for the life of a producing well: the depletion allowance. Depletion shelters a portion of the income a well produces, every year it produces, and for many small investors it comes in a form — percentage depletion — that can be unusually generous. This memo explains what depletion is, how its two methods differ, and why the percentage method draws so much attention. It's general information; depletion is fact-specific and belongs with your CPA.

What depletion is

When you own an interest in a producing oil or gas property, the underlying reserves are a finite resource that's literally consumed as the well produces. Depletion is the tax deduction that recognizes this using-up — it's to natural resources what depreciation is to a building or equipment. Each year a producing property generates income, depletion lets you deduct an amount reflecting the portion of the reserves extracted, sheltering some of that income from tax. Unlike the one-time intangible drilling cost deduction, depletion is an ongoing benefit that recurs for as long as the property produces, and it's available to both working-interest and royalty owners.

Cost depletion

Cost depletion is the more straightforward and intuitive of the two methods. You take your basis in the mineral property and recover it gradually in proportion to the reserves produced: in any year, your deduction is roughly your remaining basis multiplied by the fraction of estimated remaining reserves extracted that year. Over the life of the property, cost depletion lets you recover your investment, but no more — once your basis is fully recovered, cost depletion stops. It's essentially a units-of-production way of writing off what you paid for the resource.

Percentage depletion

Percentage depletion works very differently, and it's where the real appeal lies for many investors. Instead of tracking basis and reserves, you deduct a fixed statutory percentage of the property's gross income — for oil and gas, generally 15% for qualifying independent producers and royalty owners. The remarkable feature is that percentage depletion is not capped at your basis: it can continue year after year as long as the property produces income, potentially allowing total deductions that exceed what you originally invested. That ability to deduct beyond basis is what makes percentage depletion one of the more unusual and valuable provisions in the code — though, as below, it comes with eligibility and income limits.

Which method you use

You don't choose one method for life; each year you generally compute both and take the larger deduction. Early on, when basis is high, cost depletion may win; later, once basis is largely recovered, percentage depletion typically produces the bigger deduction and keeps going where cost depletion would have stopped. This "greater of" approach is automatic in concept but detailed in practice, and it's handled on your return by your tax preparer. The headline is that percentage depletion's freedom from the basis cap means, for a long-producing well, it often becomes the dominant benefit over time.

The small-producer rule and limits

Percentage depletion isn't unlimited. It's available through the small-producer (independent producer and royalty owner) exemption — the major integrated oil companies generally can't use it on their production — which is precisely why it benefits individual investors and royalty owners. Two limits apply: the deduction is generally capped at 100% of the net income from the property in a given year (with disallowed amounts often carried forward), and a taxpayer's total percentage depletion can't exceed 65% of overall taxable income (again with carryover of the excess). These guardrails keep the benefit from zeroing out all of an investor's income, but within them the deduction is genuinely valuable. The specifics are intricate, so this is squarely a topic for your CPA.

Both working and royalty owners benefit

One point worth underscoring: depletion is available to both working-interest and royalty owners. This matters because, while the large IDC deductions belong only to the working interest, depletion shelters income on both sides. So a royalty investor who collects cost-free production income still gets to shelter roughly 15% of it through percentage depletion, even though they get none of the drilling deductions. For the royalty owner, depletion is the principal ongoing tax benefit; for the working-interest owner, it's one benefit among several.

A worked example

An illustration shows the two methods in motion. (Figures hypothetical and simplified.) Suppose a royalty owner receives $20,000 of gross income from a property in a year. Under percentage depletion, she could deduct roughly 15% — about $3,000 — subject to the net-income and 65% limits. Under cost depletion, her deduction would depend on her remaining basis and the share of reserves produced; early on, if her basis is meaningful, cost depletion might exceed $3,000, so she'd use it that year. In later years, once her basis is largely recovered, cost depletion shrinks toward zero while percentage depletion keeps delivering its ~15% — so she switches to percentage depletion and continues sheltering income the cost method no longer could. Over the full life of the property, the ability of percentage depletion to run past basis is what makes it so attractive. As always, the actual numbers and eligibility are for your CPA to determine.

Frequently Asked Questions

Glossary

Depletion Allowance

A deduction for the using-up of oil and gas reserves as they are produced; the natural-resource analog of depreciation.

Cost Depletion

A method recovering basis in proportion to reserves produced; stops once basis is recovered.

Percentage Depletion

A method deducting a statutory percentage (generally 15% for oil & gas small producers) of gross income, which can exceed basis.

Small-Producer Exemption

The rule allowing independent producers and royalty owners to use percentage depletion.

Disclosures