Isidro purchases an interest in an oil-producing property for $100,000 on November 3. His geologist estimates 15,000 barrels of oil are recoverable. The entity sells 1,000 barrels for $20,000 during November and December of the year of acquisition. Assume the percentage depletion rate for oil is 15%. Operating expenses related to the revenues are $3,000.
- Advise Isidro on the amount of depletion he should deduct in the year of acquisition.
- At the end of the second year, the geologist estimates the remaining number of recoverable barrels is 18,000. Isidro has an offer of $190,000 for his investment. In the second year, the entity sold only 3,000 barrels of oil. Gross revenues were $50,000 and operating expenses totaled $4,000. If Isidro sells the property, what is the amount of his realized gain
- Write a memorandum explaining the details of Isidro’s gain. Include a recommendation about whether he should accept the offer
- Advise Isidro on the amount of depletion he should deduct in the year of acquisition.
Cost depletion is calculated on a units of production method. Each year the remaining depreciable basis is allocated based on the formula:
Units Recovered During the Year
Total Estimated Units Remaining
For Isidro, this results in a deduction for cost depletion of $6,667.
$100,000 x (1,000 ¸ 15,000) = $6,667
Isidro’s adjusted basis in the oil reserves after deducting depletion is $93,333 ($100,000 – $6,667).
Percentage depletion is calculated by multiplying the selling price of the oil by the statutory rate for the oil. Isidro’s sales are $20,000 and his percentage depletion is $3,000 ($20,000 x 15%). Isidro’s adjusted basis in the property after deducting percentage depletion is $97,000 ($100,000 – $3,000). Isidro should use cost depletion because it provides him with a greater deduction.
- At the end of the second year, the geologist estimates the remaining number of recoverable barrels is 18,000. Isidro has an offer of $190,000 for his investment. In the second year, the entity sold only 3,000 barrels of oil. Gross revenues were $50,000 and operating expenses totaled $4,000. If Isidro sells the property, what is the amount of his realized gain?
Isidro’s cost depletion is $15,556.
$93,333 adjusted basis x (3,000 ¸ 18,000) = $15,556.
Isidro’s adjusted basis is $77,777 ($93,333 – $15,556) at year end. If Isidro sells his investment for $190,000, he will realize a gain of $112,223 ($190,000 – $77,777).
Using percentage depletion, Isidro’s depletion amount is $7,500 ($50,000 x 15%). Therefore, his adjusted basis becomes $92,500 ($100,000 – $7,500). The sale of the investment realizes a gain of $97,500 ($190,000 – $92,500).
- Write a memorandum explaining the details of Isidro’s gain. Include a recommendation about whether he should accept the offer.
The memo should contain an explanation of the calculation of the cost depletion for both years focusing on why that approach is superior to the percentage depletion approach in the present situation. Isidro’s offer for the asset of $190,000 is low when compared to the estimated remaining reserves of 18,000 barrels. If 4,000 barrels generate about $70,000 in revenues, then the 18,000 barrels could generate about $315,000 [($70,000 ¸ 4,000) x 18,000] before expenses. Also, Isidro will be able to deplete the oil when extracted. If he chooses to use the percentage depletion method, he can deplete an amount greater than the basis of the investment. The sales offer seems reasonable only if Isidro is in need of cash quickly.
