Exploration Costs

The costs of determining the existence, location, extent, or quality of any mineral deposit are ordinarily capital expenses if the costs lead to the development of a mine. You recover these costs through depletion as the mineral is removed from the ground. However, you can choose to deduct domestic exploration costs paid or incurred before the development stage began (except those for oil, gas, and geothermal wells).

How to make the choice. You choose to deduct exploration costs by taking the deduction on your income tax return or on an amended income tax return for the first tax year for which you wish to deduct the costs paid or incurred during the tax year. Your return must adequately describe and identify each property or mine, and clearly state how much is being deducted for each one. The choice applies to the tax year you make this choice and all later tax years.

Partnerships. Each partner, not the partnership, chooses whether to capitalize or to deduct that partner's share of exploration costs.

Reduced corporate deductions for exploration costs. A corporation (other than an S corporation) can deduct only 70% of its domestic exploration costs. It must capitalize the remaining 30% of costs and amortize them over the 60-month period starting with the month the exploration costs are paid or incurred. The 30% the corporation capitalizes cannot be added to its basis in the property to figure cost depletion. However, the amount amortized is treated as additional depreciation and is subject to recapture as ordinary income on a disposition of the property. See Section 1250 Property under Depreciation Recapture in chapter 3 of Publication 544.

These rules also apply to the deduction of development costs by corporations. See Development Costs, later.

Recapture of exploration expenses. When your mine reaches the producing stage, you must recapture any exploration costs you chose to deduct. Use either of the following methods.

• Method 1--Include the deducted costs in gross income for the tax year the mine reaches the producing stage. Your choice must be clearly indicated on the return. Increase your adjusted basis in the mine by the amount included in income. Generally, you must choose this recapture method by the due date (including extensions) of your return. However, if you timely filed your return for the year without making the choice, you can still make the choice by filing an amended return within 6 months of the due date of the return (excluding extensions). Make the choice on your amended return and write "Filed pursuant to section 301.9100-2" on the form where you are including the income. File the amended return at the same address you filed the original return.
• Method 2--Do not claim any depletion deduction for the tax year the mine reaches the producing stage and any later tax years until the depletion you would have deducted equals the exploration costs you deducted.

You also must recapture deducted exploration costs if you receive a bonus or royalty from mine property before it reaches the producing stage. Do not claim any depletion deduction for the tax year you receive the bonus or royalty and any later tax years, until the depletion you would have deducted equals the exploration costs you deducted.

Generally, if you dispose of the mine before you have fully recaptured the exploration costs you deducted, recapture the balance by treating all or part of your gain as ordinary income.

Under these circumstances, you generally treat as ordinary income all of your gain if it is less than your adjusted exploration costs with respect to the mine. If your gain is more than your adjusted exploration costs, treat as ordinary income only a part of your gain, up to the amount of your adjusted exploration costs.

Foreign exploration costs. If you pay or incur exploration costs for a mine or other natural deposit located outside the United States, you cannot deduct all the costs in the current year. You can choose to include the costs (other than for an oil, gas, or geothermal well) in the adjusted basis of the mineral property to figure cost depletion. (Cost depletion is discussed in chapter 10.) If you do not make this choice, you must deduct the costs over the 10-year period beginning with the tax year in which you pay or incur them. These rules also apply to foreign development costs.

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