If you have an economic interest in a natural resource, such as oil and gas wells, mines or standing timber, there are a few tax issues of which you should be aware. You may be able to take deductions, or claim a tax credit.
Here's a general breakdown on how your interest in one of these resources may figure into your taxes:
Do You Have An Economic Interest?
You have an economic interest if both of the following are true: you've acquired by investment any interest in mineral deposits or standing timber; and, you have a legal right to income from the extraction of the mineral or cutting of the timber to which you must look for a return of your capital investment.
If there's more than one person with an investment in the natural resource, that does not take away from your economic interest. More than one person can have an economic interest in the same mineral deposit or timber.
If you have a contractual relationship that allows you an economic or monetary advantage from products of the mineral deposit or standing timber, that relationship is not, in itself, an economic interest.
Deductions
If you indeed have an economic interest in a natural resource, you can take a deduction for depletion. Depletion is the process by which the cost or other basis of a natural resource (for example, an oil and gas interest) is recovered upon extraction and sale of the resource.
There are two methods of determining depletion allowance: cost depletion and percentage depletion. Here's the difference:
Cost Depletion. With this method, the cost is recovered ratably as the resource is extracted or the timber harvested. To figure cost depletion you must determine the following:
- The property's basis for depletion. (Total cost depletion cannot be claimed in excess of basis.)
- The total recoverable units of mineral in the property's natural deposit.
- The number of units of mineral sold during the tax year.
Percentage Depletion. With this method of computing depletion of natural resources, you multiply a certain percentage, specified for each mineral, by your gross income from the property during the tax year.
In many cases, the percentage depletion deduction cannot be more than 50 percent of your taxable income from the property figured without the depletion deduction. For oil and gas property, it can't be more than 100 percent.
Gross income. When figuring your percentage depletion, subtract the following amounts from your gross income from the property:
- Any rents or royalties you paid or incurred for the property.
- The part of any bonus you paid for a lease on the property allocable to the product sold for the tax year.
Taxable income limit. Taxable income from the property means gross income from the property minus all allowable deductions (excluding any deduction for depletion) attributable to mining processes, including mining transportation. These deductible items include the following:
- Operating expenses
- Certain selling expenses
- Administrative and financial overhead
- Depreciation
- Intangible drilling and development cost
- Exploration and development expenditures
When figuring your taxable income from the property for purposes of the taxable income limit, do not deduct any net operating loss deduction from the gross income from the property, and if you're a corporation, do not deduct charitable contributions from gross income from the property.
Also, if you dispose of any item of the property that was used in connection with mineral property during the year, you have to reduce any allowable deduction for mining expenses by the part of any gain. Check with your tax professional on how to figure the ordinary gain allocable to the property.
The term "mineral property" means each separate interest you own in each mineral deposit in each separate trace or parcel of land. You can treat two or more separate interests as one property or as separate properties. Again, your tax professional can point you to the regulations on how to treat separate mineral interests.
Which Method Should I Use?
Generally, you should use the method that gives you the larger deduction. Percentage depletion is allowed for nearly all natural resources, except timber. However, you might not be able to use percentage depletion for oil and gas wells unless you are an independent producer or royalty owner.
Production Taxes
There are product taxes levied by state governments on the value or quantity of production or extraction of natural resources.
Tax Credits
Some states offer natural resource producers a tax credit per unit of processed material. Check with your tax professional and/or with your individual state about possible tax credits.
Working Interest
You may run across a reference to "working interest." This means you have an operating interest in oil and gas wells with the responsibility and cost of developing and operating the property.
For more information about natural resources, contact an H&R Block tax professional.
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