The Tax Code provides a special section applicable to farmers or those conducting a farming business. One part of that section pertains to the use of depletion.
Following is an overview of depletion.
What is Depletion?
Depletion is the use of natural resources through the activities of cutting, drilling, mining, or quarrying. Through the use of depletion, the owner of the natural resource can determine the amount of the resource’s value that has been used and the amount that remains.
Who Can Claim Depletion?
If you have an economic interest in minerals or timber, you can take a deduction for depletion. It is possible for one or multiple people to have an interest in minerals or timber and make use of depletion.
You have an economic interest in minerals or timber if both of the following are true:
- You have acquired through an investment an interest in minerals or timber.
- You have a legal right to income stemming from the extraction of minerals or the cutting of timber, to which you look as a return on your investment.
An economic interest does not exist as the result of a contractual relationship allowing you an economic or monetary advantage from products of the mineral deposit or timber. Likewise, a production payment retained on the sale of mineral property or timber is not an economic interest.
Mineral property refers to each separate interest you own in each mineral deposit in each separate tract of land. Two or more separate interests can be treated as a single or separate properties. Timber property is your interest in each standing timber in each tract of land.
There are two acceptable methods for calculating depletion:
- Cost depletion
- Percentage depletion
For mineral property, you must typically use the method that gives you the larger deduction. For timber, you must use cost depletion.
To calculate cost depletion, you must determine all of the following:
- The property’s basis for depletion
- The total recoverable units of minerals in the property’s deposits
- The number of units of minerals sold during the year
You must estimate the total recoverable units using a currently acceptable industry method based on the most accurate and reliable information you can obtain.
The number of units sold during the year is dependent on your accounting method. Under the cash method of accounting, the units sold are the number for which you receive payment during the tax year. Under the accrual method of accounting, the units sold are based on your inventories.
Once you have calculated your property’s basis for depletion, divide your property’s basis for depletion by total recoverable units and multiply by the units sold during the tax year.
Depletion of timber takes place when you cut standing timber. When you acquire timber property, you must make an estimate of the quantity of marketable timber that exists on the property. Depletion units are determined by taking the cost of the timber on hand at the beginning of the year, adding the cost of any timber units added during the year, determining the number of timber units on hand at the beginning of the year adjusted for any units added or removed during the year, and dividing the total cost by the total timber units.
To determine percentage depletion, multiply a percentage by your gross income from the property during the year.
Who can answer my questions about income taxes?
You can speak with a tax attorney to get answers to your questions and file your income taxes. Only a tax attorney will have experience working with the IRS to resolve tax issues and can offer you attorney-client privilege.
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Mark has been a contributor to legal web sites related to bankruptcy, tax, and criminal law since 2011. He has an Accounting degree from Texas A&M University.