Let’s face it. Mineral rights owners are usually not big fans of paying tax. That’s why we have summarized the taxation of mineral rights.
This post will also address some of the issues regarding state taxes. States are becoming more aggressive with their tax collection efforts.
The magnitude of mineral rights income can boost landowners into the highest tax brackets. Accordingly, you will have tax planning considerations similar to many high-income taxpayers who have substantial investment income. Let’s get started.
How are landowner payments from mineral interests taxed?
Lease bonus and delay rental payments. Lease bonus payments and delay rental payments are considered ordinary income for IRS tax reporting and are subject to ordinary income tax rates. They are usually reported to mineral rights owners on Form 1099-MISC, Box 1 (Rents).
An individual landowner will typically report this income on their personal tax return on page 1 of Schedule E (Supplemental Income and Loss). This amount flows through line 17 of Form 1040 and is not subject to self-employment tax.
Royalty payments: Royalty payments are considered ordinary income and should be reported on an individual parcel owner’s Schedule E of Form 1040. The oil company usually reports the royalty payments to the landowner in Box 2 of Form 1099-MISC. Allowable depletion and other related expenses, like legal fees, can reduce royalty income.
Damage payments: The tax treatment of various types of damage payments can vary based on the specific type and reason for the payment. Payments made for lost profits, such as crop damages and interruption of surface operations, usually are taxed as ordinary income.
On the other hand, payments for damage to land or property rights are typically considered a return of capital and gain to the extent that any payments exceed the owner’s adjusted basis. Anticipated surface damages (as opposed to payments for loss of surface use) are taxable as ordinary rental income.
Easement/right-of-way payments: The tax treatment of these payments may vary depending on the substance and nature of the easement. Proceeds from perpetual easements or with only a contingent right to reversion are generally treated as a nontaxable return of capital (or investment) to the extent of the owner’s basis in the affected land.
Any excess is reported as a capital gain. When the easement is limited in time and subject to reversion, the grant will typically be treated as a lease or license and generate ordinary income.
What is “depletion” and how does it work?
Depletion deductions compensate a taxpayer for the natural reduction of an irreplaceable asset that results from drilling for oil and gas in place—similar to depreciation rules for other types of assets. A taxpayer must have an economic interest in the minerals to claim depletion deductions.
Generally, a taxpayer calculates depletion for each property using two different methods (cost depletion and percentage depletion) and deducts the higher amount from the two alternative computations.
Cost depletion involves gradually writing off the capitalized cost of a mineral property over the property’s lifespan as the oil and gas are extracted. To claim cost depletion, one must have a cost basis in the minerals.
This is typically determined upon their acquisition, and calculate the amount of minerals depleted during the year. Historically, only some landowners have allocated part of the basis to the oil and gas minerals, so most landowners cannot use the cost depletion method.
Percentage depletion is calculated as a statutory percentage of gross income from the property, but it is subject to several notable limitations. A taxpayer may claim percentage depletion even if the underlying property has no cost basis.
Most landowners use the percentage depletion method to calculate the depletion deduction because they lack a separate basis in the mineral rights and, therefore, cannot use the cost depletion method. It should be noted that depletion is prohibited against delay rentals and lease bonuses.
What about state and local taxes?
State and local taxation is a complex and ever-changing landscape for high-income taxpayers and those with significant investment income. This complexity is particularly pronounced when dealing with income from property or entities in multiple states.
For example, if you live in Florida and have a royalty interest in New Mexico, you may have to file a New Mexico tax return and pay tax in New Mexico. Those with any business or even partnership interests (a common form of royalty interest ownership) can have income tax filing requirements in many locations.
It is critical to note that every state has a different set of rules on the taxation of mineral interests (i.e., different rates and calculations for percentage depletion), and you should consult multi-state specialists to determine any applicable tax.
However, there are other considerations beyond income taxes. For example, taxpayers can be negatively impacted by the following:
- Impact of increased real estate values on property taxes;
- Increased efforts by many states and local jurisdictions to collect sales and use taxes.
- Nontraditional taxes and costs, including state impact fees or local business licenses.
One area of tax specific to mineral rights is a state severance tax imposed by some local jurisdictions on removing nonrenewable natural resources such as oil or natural gas. Landowners with royalty interests typically are responsible for such taxes.
Final thoughts
Because of increased income from significant oil and gas activity and the significantly higher new rates on oil and gas income, it is prudent to review tax planning, investment allocation, and asset strategies with your CPA and other advisors.
Careful consideration should be given to the timing of your royalty income and deductions, to the extent possible. The income tax benefit of items like charitable deductions should be analyzed along with potential tax phase-outs and state rate benefits.
The true benefit can only be determined by using projections to calculate any probable results. In addition, you must be aware of estimated tax requirements, including current IRS “safe harbor” rules, in order to avoid tax penalties.