Oil and Gas Tax Deductions

Royalty owners vs. working-interest owners

The tax picture for an oil and gas interest depends first on what kind of interest it is. A royalty owner receives a cost-free share of production and bears no drilling or operating costs, so the deductions available are relatively few — principally depletion, plus severance and property taxes withheld or paid. A working-interest owner, who bears the costs and risk of drilling, has access to a much broader set of deductions, including intangible drilling costs and depreciation. Because the two are taxed so differently, it is worth being clear about which you own before applying any of the deductions below. Everything here is educational information, not tax advice.

The depletion allowance

The most important deduction for a royalty owner is the depletion allowance — a tax topic that recognizes a mineral interest's value declining as the reserves are produced, the mineral equivalent of depreciation, and that can shelter part of royalty income. Mineral and royalty owners generally can benefit from it. How it is computed — the method, the amount, and any limits — is technical, changes over time, and is a question for a CPA; see our depletion allowance overview.

Intangible drilling costs (IDCs)

Intangible drilling costs are the non-salvageable costs of drilling and preparing a well — labor, drilling fluids, site preparation, and similar expenses that have no salvage value. For a working-interest owner, IDCs are one of the principal tax incentives for investing in drilling, and they typically make up a substantial share of a well's cost. This deduction is available to those who bear drilling costs, not to a passive royalty owner. How and when it is claimed is technical and belongs with a CPA.

Tangible costs and depreciation

The tangible costs of a well — equipment with salvage value such as casing, pumps, tanks, and wellhead hardware — are generally capitalized and recovered through depreciation over time rather than deducted all at once. Like IDCs, tangible-cost depreciation is a working-interest deduction, reflecting the working-interest owner's investment in the physical well. A royalty owner, who owns none of the equipment, does not take it.

Operating expenses and taxes paid

Working-interest owners may also deduct ongoing lease operating expenses — the costs of running producing wells. And for both royalty and working-interest owners, the severance (production) taxes withheld from or paid on production, and often ad valorem property taxes on the mineral interest, are generally deductible. For a royalty owner these taxes, together with depletion, are usually the bulk of the available deductions. How they are reported is a question for your CPA.

What this means for owners

For a royalty owner, the headline is that royalty income is partly sheltered: depletion plus severance and property taxes reduce the taxable amount, which is why oil and gas royalties are often more tax-efficient than the gross check suggests. For an investor considering a working interest, the deductions are far larger — IDCs, depreciation, and operating expenses — but so are the costs and risks. Either way, the specifics turn on your interest, your basis, your income, and current tax law, all of which change and interact. This page is educational information only and not tax advice; a qualified CPA who works with oil and gas owners should compute your actual deductions.

Related reading

The Depletion Allowance

Oil and Gas Royalties

Severance Tax by State

Oil & Gas Encyclopedia — all terms