What it means
Natural resources run out as they are extracted, so tax law gives producers a depletion deduction to recognise the shrinking asset. There are two ways to compute it, and they work very differently.
Cost depletion tracks the actual investment: the owner deducts a slice of what the property cost, spread over the estimated recoverable units, and the total deductions can never exceed that cost. Percentage depletion ignores the original cost entirely.
The owner deducts a statutory percentage of gross income from the property, 15 percent for oil and gas, 22 percent for certain minerals such as sulphur and uranium and lower fixed rates for others, subject to a ceiling based on the property's taxable income (100 percent for oil and gas, 50 percent for most other minerals). The striking feature is that percentage depletion can keep going after the entire cost has been recovered.
Over a long-lived property's life, total deductions can exceed what the owner ever spent, which is why the method has always been controversial. Congress has narrowed it over the decades.
Since the 1970s, large integrated oil companies have been barred from using percentage depletion, so today it mainly benefits independent producers, up to a daily production limit, royalty owners, and small miners. The detailed rules, rates by mineral, and income limits appear in IRS guidance such as Publication 535, which walks through how the deduction is calculated and capped.
Owners must compute both methods each year and claim whichever is larger, so percentage depletion usually wins once the cost basis is used up. For a non-finance reader, the concept shows how tax codes deliberately subsidise industries: percentage depletion is less an accounting measure than a standing incentive to keep drilling and mining.
Royalty owners meet the same calculation from the other side. A family receiving a share of a field's revenue can claim percentage depletion on that royalty income, which is one reason mineral royalties pass through generations as tax-favoured assets.
In practice
Real-world examples.
Example
An independent oil producer deducts 15 percent of a well's gross income each year under percentage depletion, long after the well's purchase cost has been fully recovered. The deduction is limited by the well's taxable income.
Example
A family that inherited a royalty interest in a gas field claims percentage depletion on its royalty income, subject to the same percentage and income-cap rules. The yearly deduction reduces the tax on income that the family did not have to work for.
Example
A gravel pit owner computes cost depletion and percentage depletion each year and claims whichever is larger, switching permanently to the percentage method once the basis is exhausted. Gravel carries one of the lowest statutory rates.
Formula
Calculation
Annual deduction equals the statutory percentage, 15 percent for oil and gas, times gross income from the property, capped at the property's taxable income computed before the depletion deduction (100 percent for oil and gas, 50 percent for most other minerals). The taxpayer claims the larger of cost depletion and percentage depletion each year.
Worked example. A fictional gas property earns $400,000 of gross income and has $150,000 of taxable income before depletion. Percentage depletion = 15% x $400,000 = $60,000, which is below the $150,000 cap, so the full $60,000 is allowed. If cost depletion for the same year were only $20,000 because the original cost has been almost fully recovered, the owner claims the larger $60,000.Case study
Seen in the real world.
This case study is fictional and illustrative. Red Mesa Energy, a made-up independent producer in New Mexico, owns a small gas well that cost $900,000 and generates $400,000 of gross income a year. In the early years it deducts cost depletion, recovering its investment slice by slice. By year four the cost basis is fully recovered, so the company switches to percentage depletion: 15 percent of gross income is $60,000, comfortably under the taxable income cap.
The deduction continues year after year even though the original $900,000 has already been fully written off, which is exactly the outcome critics point to and defenders call an incentive for risky independent drilling. Red Mesa's finance manager keeps a schedule showing both methods side by side every year, so the choice of the larger deduction is documented. The company, well and figures are invented, and real calculations depend on the current rules and the taxpayer's circumstances.
Watch out
Common mistakes.
- Assuming the deduction stops when the original cost is recovered; percentage depletion, unlike cost depletion, can continue and can exceed the total investment over the property's life.
- Forgetting the taxable income ceiling, which can cut the deduction sharply in low-margin years.
- Thinking all producers qualify; major integrated oil companies lost the right to use percentage depletion decades ago, and eligibility now centres on independents and royalty owners.
Questions
People also ask.
What is the difference between cost and percentage depletion?
Cost depletion spreads the actual investment over recoverable units and stops at that cost, while percentage depletion deducts a fixed share of gross income each year with no tie to cost.
Who can use percentage depletion?
Mainly independent producers and royalty owners in oil and gas, plus owners of other mineral properties at their own statutory rates; large integrated oil companies are excluded. The percentage differs by mineral, from 22 percent for certain minerals such as sulphur and uranium and 15 percent for oil and gas down to 5 percent for some common materials.
Why does percentage depletion exist?
As a deliberate policy incentive to encourage domestic exploration and extraction by smaller producers, which is also why it remains politically debated.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%