Leasehold Costs
Leasehold costs include costs related to obtaining the property, such as bonuses paid to the landowner for signing the lease, broker’s fees to acquire the lease, and legal fees to secure proper title to the lease. While the monthly cost of a lease is expensed, the leasehold costs are capitalized.
Once an oil and gas program begins producing income, tax benefits related to the capitalized leasehold costs may be recovered by using one of the depletion methods we described in the previous chapter. The cost depletion method is calculated by dividing production sold during the year by the estimated proven reserves and multiplying that fraction by the leasehold costs for the year. The percentage depletion method is calculated by multiplying production sold during the year by the average price of oil/gas and multiplying that by 15%. The investor must use whichever method offers the greater deduction for that year. In general, cost depletion is used in the first year, while the percentage method is used in all other years.
cost depletion = (annual production sold / estimated reserves) x leasehold costs
or
percentage depletion = annual production sold x average price of oil or gas