Depletion Deduction

Like many forum members, I am working on 2023 taxes. My wife and I have been doing our taxes using mineral software and TurboTax. I am retired but had consulting partnerships and have handled my own taxes for years.

We have been claiming the Percent Depletion deduction for our wells that are mostly 6-10 years old. 4 new horizontal wells began producing in Ward County in February 2023. The royalty income almost tripled for the year

We have been looking at using Cost Depletion for the new wells which are in the same lease. The wells are on a section which my wife inherited. The land and then mineral rights have been owned by the family since 1897. Money was paid for the land after 10 years of working and improving the land. A Texas Land Patent was awarded in 1907.

Since the land was inherited, my question is whether the IRS will accept the contention that we have en economic interest? We have good data for the adjusted cost basis, forecast of future production and income, and 2023 production.

If you have used cost depletion please weigh in. If you have experience with the IRS on this issue, please give any guidance you can.

Thanks to all?

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Cost depletion is complicated to calculate and will require an estimate of the reserves and estimated life of the minerals. You will need professional assistance to do this. That is why most mineral owners use percentage depletion, it is easy to calculate. The total accumulated cost or percentage depletion is limited to your basis in the property. First question is what is your basis at this time. It is the value of the minerals at the date of death of person from whom your wife inherited the minerals LESS all percentage depletion you and she have claimed over the years. The original value would ideally be set by the value on an estate return, perhaps by an appraisal at the date of death. If the value was low, you may find that the total accumulated percentage depletion has already reduced your basis to zero, or close to zero. In that case, your available cost depletion will be very low, because Cost depletion is limited to your basis at the end of 2022. You can claim percentage depletion even if your basis is zero. While accumulated percentage depletion (and/or cost depletion) reduces your basis down to zero, your basis never becomes negative. So you can continue to claim percentage depletion once your basis is zero. But you cannot claim cost depletion once your basis is zero.

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@TennisDaze - are you sure % depletion reduces your cost basis? My understanding was that it does not - it’s simply a 15% reduction of your gross revenue. This is an advantage to going with % depletion and keeps it super simple (which I think was the point of the change in the tax law).

On the other hand, cost depletion requires reduction of your basis. Anyone got better info than me on this topic, since my info came from google?

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ABSOLUTELY! There are no freebies from the government with respect to taxes. When you research on google, AI, Reddit, keep in mind that these generally present only simplistic partial responses. For definitive answers, you need to follow the data to the original source - in this case the Internal Revenue Code and IRS Publications. Here is my prior post on this issue - IRC Section 1016(a)(2) specifically provides for the reduction in basis for depletion allowed as deduction on a tax return. Royalty owners can deduct the higher of cost depletion or percentage depletion on their tax returns, subject to certain limitations which rarely affect them. Most royalty owners do not have the reservoir engineering information required for cost depletion calculations and so use percentage depletion. IRC Section 613A. IRS Publication 551 (12/2022) Basis of Assets, under Adjusted Basis – Decreases to Basis states “The following are some items that reduce the basis of property. Deductions previously allowed (or allowable) for amortization, depreciation, and depletion.” Here is the link https://www.irs.gov/publications/p551 The reduction in basis continues until the basis is zero. The mineral owner can continue to claim percentage depletion and the basis remains at zero. Upon sale, there is no recapture of depletion deduction. If the basis is zero, then mineral owner recognizes 100% of the sale price as long term capital gains.

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What if a property owner of both the surface and mineral estate severed the non producing mineral rights from the surface and had both in a living trust? This would be two separate entities within the living trust?

If the minerals are non-producing, there is nothing to deplete. LOL.

Thank you for your follow-up! I had everything pretty well worked out except for the basis. The death and permitting for the new wells took place over 4 month period and we had figured the basis increased with the purchase of the Anadarko lease by Luxe Energy. The well drilled by Luxe starting producing in 2019. Wells 2-5 started producing in 2023.

If I understand you, the basis is late 2018 when the death occurred. The basis would not reflect the addition of well #1 which started producing in 2019?

Thanks so much!

You apparently know nothing about Estates and Living Trust in Texas. Mineral rights can become producing. It is important to try to have assets set up correctly prior to them becoming producing. I don’t trust your opinions on anything. Nor your buddy Bob!

The owner should have had a record of the basis of the property and then allocated the basis between surface and minerals at the time of severance. The total combined basis would change because there was no purchase or inheritance. From that point forward, each entity would need to keep a basis record for tax purposes.

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Thank you for the answer. The surface is not hard to value, but non producing mineral rights and the percentage of the number of net mineral acre value is. Some may be a 100% interest in an acre and some are less than a 100%/acre. I value your opinion and thank you again.

Often, mineral owners are limited to percentage depletion because of a lack of any significant basis in the minerals. The basis in the minerals is separate from the surface value. Even though a mineral interest might have gone from non-producing to generating lucrative royalties, the tax basis does not increase until there is an inheritance or sale. A fair market value appraisal at the time of inheritance can establish a step up in basis for the purposes of cost depletion.

Any mineral owner who purchased or inherited their minerals while those minerals were generating significant income should consider their eligibility for cost depletion. Due to the complex and technical industry-specific nature of this deduction, the typical tax preparer does not have all the information needed to analyze whether cost depletion would be beneficial to their clients. Under the right circumstances, the tax savings from cost depletion can be much greater than the savings from percentage depletion.

This is generalized information only and not legal advice. Each owner’s circumstances may vary.

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A. Your basis from 2018 is value of minerals on probate. Likely not much.

B. Depletion allowable is greater of cost or percentage.

C. Regardless of which one it is, the depletion reduces basis until $0. At which time percentage is only allowable and is allowable in excess of basis in perpetuity with no recapture provisions.

D. Other than severance and mktg, only other deductions allowed against royalty income are advalorem taxes. Not a business. This is Portfolio Income. Cannot offset Passive Losses. Is subject to the 3.8% Net Investment Tax if overall income puts you over mark.

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You can deduct other expenses related to the production of royalty income, such as the postage for mailing tax payments, division orders, etc and legal fees, related accounting fees, lease negotiation fees, office supplies such as paper used for printing check copies. Consult your CPA regarding Schedule E.

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Not on E there not. On A as 2%”s only. This is portfolio income amigo. Check your regs. And if a cpa lets u put these on E he or she doesn’t understand the nature of income. And relying on a cpa doesn’t get u off the hook in the unlikely event of audit.

Caveat Emptor

You need to consult a CPA who really knows the Internal Revenue Code with respect to oil and gas royalties and who can advise you as to eligible expenses. You may be missing costs which are deductible on Schedule E. Start with the IRS Instructions for Schedule E which notes that you can deduct all ordinary and necessary expenses, such as taxes, management fees, and agents’ commissions. Line 10 - Include fees for tax advice and the preparation of tax forms related to your rental real estate or royalty properties. Line 17 - Deduct the cost of ordinary and necessary telephone calls which exceed the base service fees for your home. Line 19 - Any ordinary and necessary expenses not listed on lines 5 through 18. Keep in mind that the expenses must be directly incurred, in an accounting sense, for the production of royalties. So you may have to determine what portion of the total legal or accounting fees relate to the minerals. If you are doing all your own legal and accounting work, then you cannot deduct the value of your own labor. You may not deduct any state income taxes withheld on Schedule E.

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You really shouldn’t be providing tax advice. The rules you refer to relate to passive or active income on schedule E. Royalty Income is not passive nor active. It’s portfolio income. Ie INVESTMENT income. E is just where it’s reported. I’ll say it again. Portfolio. Like investment income, the expenses of which are treated as pursuit of and maintenance of that income. A deductions. Professional fees. Office expense. Etc. A. Don’t feel bad. Many many people get it wrong…

You are wrong. Taxpayers are allowed to deduct all ordinary and necessary expenses which are directly related to the production of royalty income on Schedule E. This is clearly delineated in the instructions. I do have experience in tax matters and audits and have never once seen the direct expenses disallowed or moved to Schedule A. Large owners may receive the royalties through a partnership or Sub S return, but that ends up on Schedule E and the direct expenses are still deductible. If you are advising people not to deduct direct expenses (eg legal fees for lease review and negotiations), then they are losing money. There are limitations on passive losses, etc., which must be handled accurately. I suggest that you take an AICPA course in Schedule E and the proper reporting of royalty income and expenses. 2023 Instructions for Schedule E (2023) | Internal Revenue Service (irs.gov)

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Got busy and forgot to respond. You are still incorrect. IRS instructions are notoriously general in nature. Schedule E/8825 have a primary purpose to report Rental Income and Expense. The instructions do not create a good bifurcation of rules related to the different NATURE of incomes required to be reported on E. That said, here is the best reference I could find to show you that only DIRECT costs are deductible. Taxes, Depletion, repairs - Not INDIRECT expenses. You can deduct them. No one cares and the IRS will never have the time to evaluate. It is immaterial either way, so mileage will vary…

Expenses attributable to property that the taxpayer holds for the production of rents or royalties would normally be itemized deductions. However, special rules make them deductible from adjusted gross income (AGI) as expenses attributable to property held for the production of income (see [IRC § 212](javascript:void(0))), and as depletion (see [IRC § 611](javascript:void(0))) ([IRC § 62(a)(4)](javascript:void(0))). These deductions include interest, taxes, depreciation, repairs, etc. To be attributable to rent or royalty income, an expense must be directly incurred, in an accounting sense, in the rental of property or for the production of royalties (S. Rep. No. 885, 78th Cong., 2d Sess. 25 (1944), reprinted in 1944 CB 858, 878). The taxpayer’s property does not have to actually produce income, as long as it is held for the purpose of producing rents or royalties ([Reg. §1.212-1(b)](javascript:void(0))).

That is correct and what I said - ALL DIRECT EXPENSES are deductible on Schedule E. DIRECT EXPENSES related to the production of royalty income include legal fees for negotiating or enforcing lease provisions; postage to mail taxes, division orders, etc.; accounting fees (portion related to royalties and minerals); property taxes; office rent and employee salaries which are directly related to the royalty income; Enverus or other subscriptions; and so on. They also include the charges for severance tax and costs of marketing, transportation, gathering and other fees which on the check detail. These latter costs are related to an individual well and production month. The other direct expenses are related to all the royalty income from all the wells.

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I’ll give you credit for tenacity. At least that’s something.

Let me come at it a different way. 3 types of income. Active. Passive. Portfolio. Mineral Royalties are Portfolio. Interest, Dividends and Capital Gains are Portfolio. That’s not a debate.

Same types on income.

“Directly related” to investment income are the same expenses.

Accounting Fees Investment Advisory Fees Computer to manage investments Software Office supplies/postage/internet ad nausea Rent, which is goofy if all you have is portfolio but have had many clients do so. Schedule A baby Investment publications Investment seminars

Where you think these little guys go on a tax return? Hmm?

True severance and marketing are allowed because they are deducted at the source. And ad valorem because they are not optional. Definitely direct or you lose the asset. But those 3 are it. An employee to manage royalties? Ok if that’s your best use of money.

But. These all go on A. Port. Fol. E. Oh.

But knock yourself out. 40.8% of incorrectly placed portfolio deductions is still immaterial. I don’t care what you do. Honestly. I’ve seen every form of incorrect application of law in my time. Gives me a good laugh.

Best of luck amigo.