Tuesday, October 15, 2019
A taxpayer that is engaged in a trade or business can recover the cost of a business asset through depreciation. In other words, an asset is not depreciable unless it is used in the taxpayer’s trade or business or used for the production of income. In essence, the depreciation deduction is to account for the wear-and-tear of the asset as it is used in the business or to produce income for the taxpayer. But, the asset must have a determinable useful life of more than one year. Land, for example, is not depreciable because it does not have a determinable useful life.
But, there are other business and/or income-producing assets that are not eligible for depreciation. For example, natural resources such as sand and gravel deposits, as well as deposits for oil and gas are not depreciated. But don’t these assets wear out? They do and can be eligible for a depletion allowance. The deductible allowance for depletion is computed differently than is the deduction for depreciation. One method of computing it is called “cost depletion.”
The cost depletion method of computing deductions associated with oil, gas and other minerals – it’s the topic of today’s post.
Depletion is the descriptive term for the using of a natural resource by mining, drilling, quarrying or the like. A depletion allowance allows the owner of the resource to recover the cost of the reduction of reserves of the resource as production and sales occur. To be a resource “owner” entitled to a claim depletion, the taxpayer must have an “economic interest” in the natural resource as an owner, and the legal right to the income from the extraction of the minerals. In addition, a depletion deduction is only allowed when there is production and sale activity from the minerals which provides income to the taxpayer for the tax year.
As noted, a taxpayer is entitled to recover the taxpayer’s cost basis in natural resources over the life of the resources. The cost depletion method of computing that cost recovery is tied to the quantity of the resource sold each year. There are unique rules that can apply when determining cost depletion on production payments, advance royalties, bonuses. In addition, sometimes the computational rules are different depending upon the particular natural resource involved. These unique aspects are beyond the scope of today’s post.
Via cost depletion, the taxpayer recovers the taxpayer’s capital investment (i.e., tax basis) in the minerals while the minerals produce income. Thus, with respect to oil and gas, for example, the cost basis of the property must be allocated between the land and the associated capital assets that were acquired with the land purchase – fences; tile lines; buildings; equipment; and the mineral deposit. The use of the cost depletion method is dependent upon having made these allocations.
Under the cost depletion approach, the taxpayer annually deducts a portion of the taxpayer’s capital investment, less prior deductions, that equal the fraction of the estimated remaining recoverable reserves that have been produced and sold during that particular year. Over the life of the deposit, the total cumulative amount recovered under the cost depletion method cannot exceed the taxpayer’s capital investment.
The IRS does not provide a form for computing the cost depletion deduction. However, a formula is utilized to make the computation. Under the formula, the deposit’s adjusted basis is divided by the units of the mineral deposit that remain as of the end of the tax year (i.e., total recoverable units). The result of that is known as the “depletion unit” or a rate per unit. That amount is then multiplied by the units of mineral that were sold within the tax year based on the taxpayer’s accounting method. The taxpayer bears the burden of establishing basis, remaining units and the units sold during the year. Treas. Reg.§1.612-1(b)(1)(i).
With respect to oil and gas, cost depletion is computed with respect to each oil and gas property by reference to the total number of recoverable units that the property is estimated to contain, and the number of units sold from the property during the tax year. Treas. Reg. §1.611-2(a). An account is to be maintained for each property and annually adjusted for units sold and for depletion claimed. Treas. Reg. §1.611-2(a). The total recoverable units is the sum of the number of units that remain at year end plus the number of units of minerals sold during the tax year. The landowner must determine the recoverable units of minerals via industry custom, and can utilize (by election) an IRS safe harbor. See Rev. Proc. 2004-19, 2004-10 IRB 563.
Consider the following example:
Jed buys a tract of land that contains a mineral deposit of sand and gravel. Jed paid $500,000 for the tract, and his accountant allocated $125,000 to the land and $375,000 to the minerals. Jed hired other experts to measure the amount of the marketable minerals via a geological survey and they determined that the deposit contained $100,000 tons of marketable minerals. During the year, 5,000 tons of minerals were mined and sold. Jed’s cost depletion deduction would be computed as follows: $375,000/$100,000 x 5,000 = $18,750.
In the second year (Year 2), another 5,000 tons of the sand and gravel are mined and sold. In Year 2, the property's basis has been reduced to $356,250 by the depletion allowed in the first year. Also, the units remaining as of the tax year have been reduced to 95,000 by the units sold in the first year. The cost depletion deduction in Year 2 would be $18,747.37 ($356,200/95,000 x 5,000).
The Importance of Basis
Clearly, properly computing income tax basis is critical to determining the proper depletion deduction. The basis number only applies to the mineral property. Thus, it doesn’t include non-mineral real estate or non-mineral assets that aren’t used for producing minerals. It also doesn’t include the residual value of land and improvements when operations end. Treas. Reg.§1.612-1(b)(1)(ii). But, it does include capitalized drilling and development costs recoverable through depletion. Treas. Reg.§1.612-1(b)(1).
Adjustments to basis will occur over time and include (as applied to oil and gas) oil and gas drilling and development costs that were capitalized. But, not included in any basis adjustment are any mineral exploration and development expenses that are treated as deferred expenses and any basis of depreciable property that is leased together with depletable mineral property. Treas. Reg. §1.612-1(b)(1).
Deductions for cost depletion stop once the sum of the depletion deductions equals the cost or other basis of the property plus allowable capital additions. Treas. Reg. §1.611-2(b)(2).
Recordkeeping is essential. The basis of the depletable property is to be recorded in a separate account, along with any capital additions and adjustments. Treas. Reg. §1.611-2(b)(1). If that’s not done, the cost depletion deduction may be lost for the tax year and/or upon later disposition of the property. See, e.g., Winifrede Land Company, 12 T.C.M. (CCH) 289 (1953).
Last year, I devoted a post to the issue of depletion of minerals. https://lawprofessors.typepad.com/agriculturallaw/2018/07/the-depletion-deduction-for-oil-and-gas-operations.html. Today’s post took a bit of a closer look at one aspect of depletion – cost depletion. The depletion deduction can be complicated, but when big dollars are involved, getting it right matters.