What expense category is Depletion?

For businesses in industries such as mining, oil and gas, or timber, their primary assets are natural resources that are consumed or depleted over time. The IRS provides a way to account for this reduction in value through a tax deduction called depletion.

Depletion is similar to depreciation, but it applies specifically to the extraction of natural resources. Understanding how to calculate and claim this deduction is essential for any business involved in mining, drilling, or harvesting timber. This guide will explain the rules for depletion expenses, the methods for calculating them, and how to track the associated costs.

The Depletion Expense Category

Depletion is a non-cash deduction that allows a business to recover its capital investment in a mineral property or standing timber as the resource is extracted and sold. As outlined in IRS Publication 535, this deduction is not a simple line-item expense but a specific calculation that must be figured annually.

The depletion deduction is reported on the appropriate business tax form, typically as part of the Cost of Goods Sold or as a separate deduction on forms such as Schedule C or Schedule E (for royalties).

Important Considerations When Claiming Depletion

The rules for depletion are specific and vary depending on the type of natural resource being depleted.

Who Can Claim Depletion?

To claim a depletion deduction, you must have an economic interest in the mineral property or standing timber. According to the IRS, you have an economic interest if you have acquired an investment in the resource, and you must look to the income from the extraction of that resource to get your investment back. This means that both property owners (lessors) and operators (lessees) can potentially claim depletion.

What Property Qualifies?

Depletion applies to:

• Mineral Property: This includes oil and gas wells, mines, and other natural resources such as geothermal deposits.
• Standing Timber: This refers to the trees in a woodlot or other tract of land that is held for commercial timber production.

The Two Methods of Depletion

The IRS provides two methods for calculating depletion for mineral property. For timber, only the cost method is allowed.

1. Cost Depletion: This method is based on the property's adjusted basis, the total number of recoverable units (e.g., tons of ore, barrels of oil), and the number of units sold during the year.
2. Percentage Depletion: This method is calculated as a percentage of the property's gross income. The percentage rate is fixed by law and varies depending on the specific mineral (e.g., 15% for many oil and gas properties, 22% for sulfur, 10% for coal).

For mineral properties, you must calculate depletion under both methods and deduct the one that results in the larger deduction for the year.

Basis Adjustment

Just like with depreciation, you must reduce the adjusted basis of your property by the amount of depletion you claim each year.

Examples of Depletion Expense Scenarios

• Mining: A company owns a coal mine. Each year, as it extracts and sells tons of coal, it can claim a depletion deduction to account for the value of the coal removed from the ground.
• Oil and Gas: An operator leases land to drill for oil. As barrels of oil are extracted and sold, the operator (and the property owner receiving royalties) can claim a depletion deduction based on the value of the extracted oil.
• Timber: A logging company purchases a tract of forest land. When the timber is cut, the company can claim a cost depletion deduction based on its basis in the timber and the volume of wood harvested.

Tax Implications and Reporting: How to Calculate and Report the Deduction

Calculation

• The formulas for both cost and percentage depletion are detailed in IRS Publication 535. 

The cost depletion formula is generally: 

(Adjusted Basis / Total Recoverable Units) × Units Sold During Year 

• Percentage depletion is Gross Income from the property multiplied by the applicable percentage rate, subject to taxable income limits.

Reporting

The depletion deduction is reported on your main business tax form (e.g., Schedule C, Form 1120). For timber-related activities, you must also complete and attach Form T (Timber) to your income tax return.

How Fyle Can Help Track Costs for Depletion

While Fyle does not calculate the depletion deduction itself, it is a critical tool for tracking the various costs that establish the "basis" of your natural resource asset—the starting point for any depletion calculation.

• Track Acquisition Costs: Capture invoices and proofs of payment for acquiring mineral rights, leasing land, or purchasing timber tracts.
• Capture All Related Costs: Track capitalized costs like exploration fees, development costs, and legal fees associated with the property.
• Centralize Key Documents: Store geological surveys, property deeds, lease agreements, and timber cruise reports directly within Fyle for a complete audit trail.
• Automate Your Accounting: Fyle syncs these capitalized costs directly to the correct asset account in QuickBooks, Xero, NetSuite, or Sage Intacct, providing your accountant with clean, documented data to set up the depletion schedule.