Cost basis depletion involves an allowance based on the original investment. If one were to invest $5M in an oil well, the investor would be entitled to regain that capital investment. This process would take place as the oil is extracted and sold. IRS code “permits the taxpayer to divide the cost of the investment by the estimated total of recoverable units in the natural deposit. This cost per unit is subsequently multiplied by the number of units sold annually, which results in the depletion deduction permitted for that year.” This can be used for a maximum of $2M in deductions each year. The caveat with this method is that it can only be used to recoup the original cost basis.

Percentage depletion is much different in that it allows for a fixed deduction rate in extraction and selling operations every year in perpetuity. For oil and gas investments, this rate is “15% of the gross income based on your average daily production of crude oil or natural gas”. This method is allowed to carry on for as long as the investment is in use, regardless of whether the deductions outweigh the original investment cost.

Some taxpayers combine the best of worlds, utilizing cost basis at the outset before switching to the percentage method. This ensures the capital investment is recouped via cost basis while also allowing for extra deductions through the percentage basis.

It is important to consult qualified tax personnel before making these decisions as individual circumstances often can change the picture. However, as with anything, if the tools are used correctly great rewards can be reaped.

As an additional strategy please refer back to oil and gas investment website and the features and benefits of using mineral interests as replacement property when residential rental real estate is fully depreciated.