How Much Should I Depreciate My Oil Royalties for Income Tax Purpose?
Technically, you don't depreciate royalties. The Internal Revenue Service lets you depreciate buildings and capital equipment as it deteriorates, but the agency has you deplete oil and gas investments as the wells generally empty out. Depletion might not be depreciation, but it can still be a generous deduction that helps shelter your income.
Introduction to Depletion
Oil wells tap into finite resources in the Earth's crust. Every barrel of oil that is pumped out represents one less barrel left in the well; thus the well is one barrel closer to running dry and becoming essentially worthless. The IRS recognizes this and allows you to recapture at least a portion your investment by depleting the well. Any owner of an oil well can choose to use the cost method of depletion, but royalty owners and independent producers can also choose to use the simpler percentage method. Use whichever method gives you the biggest deduction.
To find your cost depletion, use the amount that you invested in the oil well and its projected production. Every year, you write off a percentage of your cost that corresponds to the percentage of the well's capacity that you removed. Alternately, you can start with a production estimate that is 105 percent of the proven reserves at the property. For example, if you pumped out 7 percent of the total capacity of a $100,000 investment, you would get a $7,000 depletion write-off. You can't deplete more than you spent on your well, though.
To claim percentage depletion, multiply your gross income by 15 percent. For example, if your royalties from the sale of oil are equal to $50,000, you'd be able to subtract a $7,500 depletion allowance for a taxable income of $42,500. Your gross income is what you sell the oil for near the property or the representative market or field price for any oil you refine yourself. If you refine more than 75,000 barrels per day at any point, though, you cannot use the percentage depletion method.
The IRS caps your depletion write-off at 100 percent of what your income from the property would be before you applied the depletion allowance. You also can't write off more than 65 percent of what your taxable income would be if you didn't claim depletion. The IRS requires you to choose a depletion allowance that is small enough to avoid hitting both thresholds.
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.