Claiming Depletion Deductions on Your Oil and Gas Income

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.

Considerations Prior to Signing a Pipeline Easement

Chris Zoller, Extension Educator, ANR for Tuscarawas County

Thousands of dollars have been paid and a large number of acres across parts of Ohio have been acquired through leases for the exploration of oil and gas resources. Some of these areas are seeing drilling activity as a result of these leases. The next step in the process is acquiring easements for the purchase of land to construct pipelines to move the extracted minerals to locations where they can be processed.

It is important for all landowners who are contacted about signing an easement to understand that an easement differs from a lease in many ways and comes with certain restrictions on the use of the land. A few years ago a 42” pipeline, known as the Rex Express Pipeline – East Project, was constructed through several Ohio counties. Prior to construction of this pipeline, the Ohio Department of Natural Resources Division of Soil and Water Conservation developed an agreement with the pipeline company that required certain practices be followed to preserve soil and water resources on the affected lands.

This document, Pipeline Standards and Construction Specifications, provides landowners with a number of factors to consider before signing an easement for the construction of a pipeline on their property. The document is available from your local Soil and Water Conservation District or on-line at: http://www.dnr.state.oh.us/tabloid/22295/Default.aspx

Landowners are encouraged to review this document and incorporate applicable provisions into their easement. All landowners are strongly encouraged to work closely with trained professionals to draft an easement agreement that is in their best interest and conserves soil and water resources.

Lower Crop Insurance Premiums for Most Corn and Soybean Growers in Ohio

By: Barry Ward, OSU Extension, Leader, Production Business Management, Department of Ag, Env., and Dev. Economics

Farmers throughout Ohio insuring corn and soybean yields or revenue with crop insurance should see lower premiums this year due to changes made by USDA’s Risk Management Agency (RMA).  These changes were based on reviews of actuarial soundness of these crop insurance products. In recent years, premiums paid (farmer premiums plus USDA paid premium subsidies) have been higher than dollars in claims paid out. The Federal Crop Insurance Loss Ratio (Ratio of claims to premiums) is meant to equal 1.0 in the long term. With long-term loss ratios below this 1.0 benchmark for corn and soybean policies in most of the cornbelt, RMA chose to examine the soundness of these policies. This adjustment to premium rates recognizes the latest technology, weather, and program performance information. Updated data pertaining to prevented planting, replant payment, and quality adjustment loss experience, was also used in determining rates changes.

 The following excerpt from an RMA article on “USDA Moving to Lower Insurance Premiums For Corn and Soybean Producers in 2012” explains in some detail the process taken to evaluate these crop insurance policies. “RMA contracted for a study by Sumaria Systems Inc., which examined premium rates, and the rating process, starting with the United States’ two major commodities: corn and soybeans. RMA then requested an independent expert peer review to provide feedback on the Sumaria study results. RMA will conduct further review and analysis of the study’s recommendations along with comments and issues raised by peer reviewers, making additional adjustments as warranted and appropriate. Accordingly, RMA is taking action to implement adjustments to premium rates in a “phased in” approach that allows for any further adjustment pending additional analysis of peer review comments.”

 As a result of this process Ohio growers should expect to see premiums decrease by an average of eleven percent for corn acres insured and thirteen percent for soybean acres insured.

 RMA Premium Adjustments not to be Confused With the New Trend-Adjusted Actual Production History (APH) Option!

With the new “Trend-Adjusted Actual Production History (APH) option) available to crop producers this year for most corn-belt states, producers choosing this option may see some of the potential premium savings from RMA adjustments reduced. Experts disagree on how this option may change your premiums and this should by no means discourage producers from considering this option. You should consult your crop insurance agent for details on this new option and premium changes as a result of adding the option to your policy.

 See the previous article by Chris Bruynis on the Ohio Ag Manager Site on the “Trend-Adjusted Actual Production History (APH) Option at: http://ohioagmanager.osu.edu/farm-policy/trend-adjusted-actual-production-history-aph-option-available/

 Web Links for further information: http://www.rma.usda.gov/news/2011/11/cornsoybeanpremium.html and http://www.rma.usda.gov/help/faq/rerating.html

Section 179 & Accelerated Depreciation Limits for 2012 and Beyond

By: David Marrison, Associate Professor and Extension Educator

Over the past decade, Congress has repeatedly allowed faster depreciation of capital assets to stimulate business investment by providing a “bonus” depreciation allowance in the year the asset is purchased. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 extended the depreciation bonus through 2012 to encourage new equipment purchasing.  Section 179 Expensing and Accelerated First Year Depreciation allowances have allowed business to write off capital expenditures immediately minimizing taxable income or creating a loss from these schedules. 

I.R.C. § 179 expensing allows farmers to elect to deduct part or all of the cost of qualifying farm assets in the year they are placed in service.  It applies to machinery, equipment, and special use or single purpose agribusiness buildings, such as bins, drying systems, and livestock barns. But it is not available for general purpose agricultural buildings, such as machine sheds and shops, nor is it often available to landlords who purchase or construct properties used by a tenant.

While it is a great tax incentive, there are limits to Section 179. The main limitation is the total cost of the deducted equipment in 2012 cannot exceed the total amount of the taxable income you are reporting.  Under current law, the dollar limit is $139,000 in 2012 and will be $25,000 each year thereafter. The maximum threshold for total of equipment & software that can be purchased under this provision has increased to $560,000.  Any amount not utilized in the current year can carry forward.  New or used equipment and certain software are eligible for this deduction.

Accelerated First Year Depreciation for 2012 is limited to 50% of the purchase price.  To qualify, the asset must have its original use begin with the taxpayer (only new equipment) and have a depreciable life of 20 years or less. Virtually all farm-use assets have a depreciable recovery period of 20 years or less, and accordingly are eligible. Bonus depreciation is most effective when applied to assets with a longer recovery period, such as machine sheds and shops (20 years), or drainage tile and culverts (15 years). Currently, the tax law does not extend bonus depreciation past December 31, 2012. 

The Future- With 2012 being an election year, anything is possible with regards to the percentage and limitation amounts for I.R.C. § 179 Expensing and Accelerated First Year Depreciation.  Farmers should watch the actions of Congress and plan accordingly.  With the reduction of the I.R.C. § 179 to $25,000 and the potential elimination of accelerated first year depreciation in 2013, farm business should examine if 2012 is the time to consider a capital equipment purchase. Be careful, however, to not the let the tax tail, wag the business dog.  Because depreciation is an amortized deduction, purchasing assets which are to be depreciated to reduce your tax liability may not be the best use of your cash.  Evaluate your current situation to determine if purchasing depreciable assets is appropriate.   Consultation with a tax professional is highly suggested.  Don’t buy “new paint” or “new steel” without first doing a comprehensive cost analysis.

Loss Limitations-It should be noted for years beginning after 2009, excessive farm losses are not deductible if you receive certain subsidies such as direct or counter cyclical payments.  Farmers receiving these payments are limited to the greater of $300,000 or the total net farm income for the prior five tax years.  These loss limitations may affect farmers who are receiving oil & gas bonus lease or royalty payments and who are using accelerated depreciation as a method to create a loss on their schedule F to offset the gain from the gas payments.  For more information, see the 2011 Farmer’s Tax Guide, page 26.

More information: Additional information on this subject can be found on the Internal Revenue Service’s web page at http://irs.gov.  Good resources include Form 4562, Instructions for 4562 and Publication 946-How to Depreciate Property.

Establishing a Crop-Share Lease Arrangement

By: Barry Ward, OSU Extension, Leader, Production Business Management, Department of Agricultural, Environmental, and Development Economics

 Although crop-share leases constitute a smaller percentage of total land leases today than they did 25 years ago, they are still an important type of lease arrangement in many areas.

In a crop-share lease arrangement, the crop-share that each party receives should be proportional to the value contributed toward production. Market-based payment to each party is the basic concept for developing an equitable crop-share lease. An equitable crop-share lease should be developed following some basic rules or principles:

1. The landowner and operator should share total returns in the same proportion as they contribute resources (or total economic costs which includes accounting costs and opportunity costs.)

2. Variable expenses that increase yields should be shared in the same percentage as the crop is shared.

3. Share arrangements should be adjusted to reflect the effect new technologies have on relative costs contributed by both parties.

4. Operators should be compensated at the termination of the lease for the undepreciated balance of long-term investments they have made.

5. Good, open, and honest communication should be maintained between the landowner and operator.

 

Some advantages of a crop-share lease include:

 • Compared to cash rents, less operating capital may be “tied up” by the operator due to the landowner sharing costs.

• Management may be shared between an experienced landowner and operator, resulting in more effective decisions.

• Sales of crops may be timed for tax management. Likewise, purchased inputs may be timed to shift expenses for tax purposes.

• Risks due to low yields or prices, as well as profits from high yields or prices, are shared between the two parties.

• A crop-share lease, where the landowner is recognized as providing “material participation” through their involvement in crop production and marketing, has the following tax related benefits:

°° Allows for the pre-death qualified use or “equity intent” test requirement for special-use valuation for federal estate tax purposes.

°° Allows the landowner to build Social Security base as the income is subject to self-employment tax.

°° Allows the landowner to take advantage of special tax provisions, such as Section 179, for expensing investments in capital investments increasing tax management options.

 

Some disadvantages of a crop-share lease include:

 • Landowner’s income will be variable because of yield and price variation and changes in shared production-input costs. This may be a particularly important concern for landowners in retirement.

• Accounting for shared expenses must be maintained.

• The landowner must make marketing decisions, except for nonmaterial participation crop-share leases.

• The need for operator and landowner to discuss annual cropping practices and to make joint management decisions is greater.

• Increased paperwork and record-keeping associated with participation in government programs and crop insurance is required.

• As prices or technology change, the lease should be reviewed to determine if changes need to be made as to what is equitable. Sharing arrangements may need to be changed.

• A “material participation” crop-share lease may reduce Social Security benefits in retirement.1

 

A newly revised bulletin titled “Crop Share Rental Arrangements for Your Farm” is available online at http://aglease101.org/

This bulletin is part of a newly revised set of leasing bulletins authored by the North Central Farm Management Extension Committee. http://www.ncfmc.org/

AEDE New Faculty: Allen Klaiber

The Department of Agricultural, Environmental and Development Economics (AEDE) at The Ohio State University is welcoming several new faculty during the 2011-2012 academic year.  This month we highlight Professor Allen Klaiber, who comes to us with his Ph.D. from North Carolina State University after previously serving on the faculty at Penn State.  He teaches several key classes dealing with statistical methods, environmental and resource economics and regional economic development.  A focus of much of his research is the valuation of environmental amenities using data from housing markets.  Some of you may have seen him at the Farm Science Review in September, where he participated in the panel discussion on shale oil development in Ohio.  In addition to being an economist, Allen is an avid birder and orchardist.

 

Welcome Allen!

 

 Departmental Website: http://aede.osu.edu/about-us/our-people/h-allen-klaiber-0    

 

Publications in Google Scholar: http://scholar.google.com/scholar?q=Allen+Klaiber&hl=en&as_sdt=1%2C36