7873 / How is the depletion allowance calculated?

The IRC provides two different methods for calculating a limited partner’s individual depletion allowance. The first method is “cost depletion.” Cost depletion essentially involves recovery of a portion of the taxpayer’s adjusted basis each year, based on the amount of oil or gas recovered for that year and the total anticipated production. The second method is “percentage depletion.” Percentage depletion is determined based on a percentage of the taxpayer’s gross income from the property during the year, subject to certain limitations.¹ Assuming that a partnership and partners own a depletable interest in an oil or natural gas property (see Q 7871), there are no further restrictions as to who may use cost depletion. Percentage depletion is available only with respect to domestic oil or natural gas, and only certain individual limited partners are eligible to use the percentage depletion method (see Q 7874).²

If a limited partner is not eligible to use the percentage depletion method, the limited partner must use cost depletion to determine the total allowable deduction for depletion. If the limited partner is eligible to use percentage depletion, the limited partner must each year calculate a depletion allowance for each oil or gas property of the partnership using both the cost and percentage depletion methods, select the greater amount for each property, and deduct the sum of the selected amounts as the total depletion allowance.³ (Unless an election has been made, interests in a single tract or parcel of land are treated as one property. Interests in different tracts or parcels are treated separately.⁴ The election to treat interests in a single tract or parcel is made, if at all, by the partnership; individual partners cannot make this election.)⁵

In the case of an electing large partnership (see Q 7733), depletion was generally calculated at the partnership level (see Q 7872).

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1.  See IRS Pub. 535 (2019), pp. 35-38.

2.  IRC §§ 611, 613, 613A.