Chris Zoller & David Marrison, Extension Educators, ANR and Peggy Hall, Director, OSU Agricultural & Resource Law Program
Many landowners have received income as a result of leasing their land for oil and gas drilling, while others may also be receiving income from drilling in the form of royalty payments. This is income for tax reporting purposes is considered ordinary income and must be reported as such on your state and federal income tax returns. Many landowners have asked about available strategies for minimizing the tax liability associated with this new wealth.
There are a number of ways landowners can potentially reduce their tax liability and be in compliance with the tax laws. Not all strategies are applicable to every situation, but landowners should give careful consideration to those that are available and maximize their tax savings.
One tax management strategy is to claim a depletion deduction. The IRS recognizes that oil, gas, and other minerals are used up or depleted as they are extracted and does allow for a reasonable deduction when calculating taxable income. To qualify, the landowner must have a legal ownership interest and be receiving income from the extraction. The deduction is allowed only when oil or gas is sold and income is reportable. The IRS requires a landowner to compare two methods when calculating the deduction:
• Cost depletion – a unit of production that uses the landowner’s basis in the property.
• Percentage depletion – a specified percentage (15 percent for natural gas) of the landowner’s gross income from the property, limited to the lesser of 15 percent of 100 percent of the landowner’s taxable income from the property or 65 percent of the landowner’s taxable income from all sources times 15%.
The method of computing the depletion deduction is not elective and tax filers must use the larger of the two amounts between cost and percentage depletion. Because most landowners do not have a cost basis in the minerals leased they automatically must use the percentage depletion method.
Example of Percentage Depletion:
Farmer Jefferson received royalty income of $12,055. This is the only income received from his real estate. To calculate the percentage depletion, Farmer Jefferson multiples $12,055 by 15%, which equals $1,808. He then compares this to the taxable income from all sources, say $30,000. The percentage depletion limit would be $30,000 times 65% times 15%, which equals $2,925. Because $1,808 is smaller than $2,925, Farmer Jefferson’s depletion would be $1,808 for line 18 on Schedule E.
Penn State University Extension has a detailed fact sheet on depletion deductions and other tax management options. To access this information go to: http://pubs.cas.psu.edu/FreePubs/PDFs/uh190.pdf. A similar Ohio State University Fact Sheet is under review and will be available soon. If you are interested in a copy of the OSU Extension Fact Sheet on this topic, please contact Chris Zoller at zoller.1@osu.edu or 330-339-2337.