How a $20,000 Lease Cost Turns Into $45,750 of Depletion Deductions

The drilling deduction gets the attention, but it happens once. Percentage depletion keeps working every year the well sells oil or gas, and for a qualifying investor it can deduct more than the lease ever cost.

That is unusual in the tax code. Depreciation stops when the asset's cost is recovered. Percentage depletion is computed from the well's income instead of its cost, so it keeps going after the cost is gone.

1. Two methods, and you take the larger

Cost depletion spreads the lease cost over the reserves. Under Reg. §1.611-2(a)(1), you divide the remaining basis by the barrels left in the ground and multiply by the barrels sold that year. When the basis reaches zero, cost depletion stops.

Percentage depletion is a flat share of the property's gross income. Section 613(a) ends with a floor: "In no case shall the allowance for depletion under section 611 be less than it would be if computed without reference to this section." Each year you compute both and deduct whichever is larger.

2. Who gets 15%

Section 613A(c) allows percentage depletion at 15% to independent producers and royalty owners. The allowance starts from an average of 1,000 barrels of oil per day, with natural gas converted to barrel-equivalents if you elect. Production from marginal wells runs under separate rules that can shrink that starting figure. Most individual investors in drilling programs fit. The two groups shut out are large retailers of oil and gas products, with a $5 million de minimis for retail sales, and refiners running more than 75,000 barrels a day.

The 1,000 barrels are shared across a family. Under §613A(c)(8), you, your spouse and your minor children split one allowance in proportion to each person's production. Few individual investors come near that volume through a program interest, but a family with several large programs should add them up.

3. You compute it, not the program

For a partnership interest, §613A(c)(7)(D) says depletion "shall be computed separately by the partners and not by the partnership." The program allocates you a share of the lease basis and reports your share of production and income. The depletion deduction itself is figured on your return.

That makes it easy to miss. A K-1 that shows production income but no depletion line is normal, and a return prepared from the K-1 alone can leave the deduction off entirely. Ask the program for your share of each property's adjusted basis and the production figures it uses, and keep a running basis schedule year to year.

4. A $20,000 lease cost over three years

An investor's share of a producing property carries $20,000 of lease basis. Their high income keeps the overall 65% limit out of play, and operating costs stay at $40,000 a year. Here is their share of the property for three years.

Three years of depletion total $45,750 on a lease that cost $20,000. At a 35% marginal rate, that is $16,012.50 of federal tax. In year 1, the $18,000 also clears the property-level limit, because taxable income from the property before depletion is $80,000.

5. Two limits, and only one carries over

The first limit works property by property. Under §613(a), percentage depletion on an oil and gas property is capped at the property's own taxable income, figured before depletion. Any amount above it is simply lost; there is no carryover for this limit.

The second works across the whole return. Under §613A(d)(1), total percentage depletion under the independent producer rule cannot exceed 65% of your taxable income, computed without the depletion itself and a few other items. Whatever this limit disallows moves to the following year and faces the 65% test again there.

6. Depletion past zero basis

The regulation says this plainly. Once total depletion equals the property's basis, "no further deductions for cost depletion shall be allowed," but "depletion deductions may be allowable thereafter computed upon a percentage of gross income" (Reg. §1.611-2(b)(2)). Basis never goes below zero, so the year 3 deduction in the example reduces nothing.

The alternative minimum tax normally treats depletion beyond basis as a preference. Section 57(a)(1) makes an exception for depletion computed under §613A(c), so for an independent producer the zero-basis deduction carries no AMT cost.

7. What a sale recaptures

When you sell the interest, §1254 treats part of the gain as ordinary income: the IDC you deducted plus "the deductions for depletion under section 611 which reduced the adjusted basis." In the example, depletion reduced basis by $20,000. The other $25,750 was taken against a zero basis, reduced nothing, and is outside that recapture.

8. What to set up

• Get the basis allocation in writing. Ask the program for your share of each property's adjusted basis as of acquisition.
• Keep a depletion schedule. Track basis, production and the deduction for each property every year, because the program will not.
• Check the 65% limit in low-income years. A year with little other income is when the overall limit bites, and the carryover needs tracking.
• Separate lease bonuses. Under §613A(d)(5), a lease bonus, advance royalty or other amount paid regardless of production is excluded from gross income for percentage depletion.

We set up the basis schedule from the program's allocation, compute both methods each year and carry the result onto the return with the K-1, so the deduction does not quietly fall off. Book a call; the K-1s and any basis statements the programs have sent are what we need.

General information, not tax advice for your situation. Figures are federal and current as of November 2026, and the example uses assumed production and prices.