I often receive questions from forest landowners about depletion, such as:
- What is depletion?
- How do I calculate depletion?
- What do I need to do to claim depletion on my tax return?
Keep reading to find out the answers to these questions about depletion and more!
What is Depletion?
Depletion is a tax deduction for the recovery of timber basis.
The concept of depletion is closely related to the concept of basis. For a refresher on how to calculate timber basis, check out my Back to Basis series that explores the concept of basis in-depth.
The term “depletion” is only used in the natural resources context. For instance, depletion deductions are available for oil and gas reserves, as well as mining.
Timber is only eligible for “cost depletion,” a deduction based on the cost basis of the timber. Other natural resources may deduct “percentage depletion,” a percentage of the gross revenues from extracting and selling the natural resource.
Depletion is very similar to depreciation. Just like depreciation is a deduction to recover the cost of a long-term asset (such as equipment), depletion is a deduction to recover the cost of timber (or another natural resource).
How is Depletion Calculated?
1) Calculate an Accurate Timber Basis
The first step to properly calculating depletion is calculating an accurate timber basis.
Generally, each “block” of timber should have its own set of timber accounts tracking its basis. Many forest landowners keep all of their timber in a single block for easy recordkeeping. However, multiple blocks of timber are permitted in certain instances.
Each block should have at least four accounts: a land account, a depreciable land improvements account, a timber account, and an equipment account. Additional accounts and subaccounts may also be used, such as separate subaccounts for timber by species or type. Also, subaccounts separating merchantable and young growth timber are often used.
Each timber account and subaccount should have two data points: volume of timber and basis of timber. Volume is generally kept in units such as thousand board feet (MBF), tons, or cords. Other units are also allowed if they make sense for a forest landowner’s situation.
2) Calculate the Depletion Rate
The second step to properly calculating depletion is to calculate the “depletion rate” for the applicable timber account or subaccount.
The depletion rate for an account or subaccount is calculated as follows:
Depletion Rate = Total Timber Basis / Total Timber Volume
3) Calculate the Depletion Deduction Using the Depletion Rate
The final step is to calculate the depletion deduction using the depletion rate calculated in Step #2.
A forest landowner may take a depletion deduction when timber is harvested and sold. If a forest landowner sells less than an entire timber account, he will have a depletion deduction for the proportion of timber sold from that account.
Depletion Example #1
Tim Burr owns forestland with a merchantable timber account that contains 200,000 MBF of timber with a basis of $3,000,000.
In 2022, Tim harvests and sells 50,000 MBF of timber. What is his depletion deduction for 2022?
$3,000,000 basis / 200,000 MBF BEFORE HARVEST = depletion rate of $15 per MBF
50,000 MBF sold x $15 per MBF = $750,000 depletion deduction
If a forest landowner sells or harvests timber comprising an entire timber account, the calculation is even simpler—the entire cost basis for that block or account may be deducted.
Depletion Example #2
Same facts as Depletion Example #1, except that Tim harvests and sells all 200,000 MBF of timber on his property.
Tim’s deducts his entire merchantable timber account cost basis of $3,000,000.
Part II of Form T walks through a depletion calculation and is a great way to calculate depletion. A forest landowner may also be required to file Form T with his tax return…more on this below!
How is Depletion Claimed on a Tax Return?
Where and how depletion is claimed on a tax return will depend on whether a timber activity is classified as a business or an investment.
For a timber activity classified as a business, timber depletion will be deducted on Form 4797.
For a timber activity classified as an investment, timber depletion will be deducted on Schedule D.
A forest landowner may also be required to file Form T if they are making an IRC § 631(a) election or are more than an “occasional” seller of timber.
Conclusion
This article is just a quick overview of depletion. Real-life depletion calculations are often more complex. Stay tuned for an in-depth depletion article in the future! And reach out if you have any other depletion questions.
