You may have seen the headlines regarding the proposed tax law changes that are being considered as a way to help pay for the massive spending being considered between the $1.2 trillion infrastructure bill and the $3.5 trillion budget resolution related to the infrastructure bill being considered in Washington DC.
There are several proposed changes that may have significant effects on mineral rights and royalty owners. From the way that estate taxes are paid on mineral rights to elimination of the percentage depletion deduction, oil and gas mineral and royalty owners could be faced with a big tax bill. In this episode, Justin and I summarize these changes and they might mean for you and your family in our guide to proposed tax law changes for mineral rights and royalty owners.
As always, this information is being shared for educational purposes only and should not be construed as legal or tax advice!
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Estate Taxes
There are several potential legislative changes that are being considered that would have a huge impact on the way that generational wealth s a change to inheritance taxes (https://www.natlawreview.com/article/2021-estate-planning-outlook-transfer-tax-changes-horizon)
One of the major changes being considered is modifying the way that estate taxes are handled in order to raise money to cover the increased federal spending. This would include:
- Lowering Estate Tax Exemption. The current estate tax exemption is $11.7 million and it is proposed to lower this to $3.5 million as Joe Biden mentioned during his campaign.
- Raising Estate Tax Rates. Biden’s campaign plan was to also raise the estate tax rate from 40 percent to 45 percent. It appears that current plans have not addressed this increase yet.
- Changes to the ability to realize a step-up in cost basis of assets at the time of death. This is one of the most onerous proposed tax reforms as Biden’s American Families Plan states that the proposed reform will end “the practice of stepping up the basis for gains in excess of $1 million ($2.5 million per couple when combined with existing real estate exemptions)” and “make sure gains are taxed if the property is not donated to charity.” This would hit mineral owners who in the past only had to pay realized gains when a property was sold. If this becomes law, it is our understanding that taxes would be due at death, regardless if you sell the property. This might force many that inherit mineral rights to have to sell in order to pay the tax bill.
Elimination of the Step Up in Cost Basis
We spoke about the concept of a step up in cost basis as a way to minimize taxes under current tax laws with Rob Prentice in MRP 32: Rob Prentice on IRS Mineral Rights Valuation and the National Association of Royalty Owners. And again in MRP 59: The Alternate Valuation Date with Rob Prentice.
The current tax law allows heirs to claim a step-up in basis upon the time of death for inherited property like mineral rights. The reason this is so advantageous is because if you were to inherit an asset with a low cost basis and had to inherit that low cost basis along with it, when you go to sell the asset down the road you would be hit with a potentially high tax bill due to the appreciation of that asset over time.
Instead, by having an appraisal done you can take advantage of a step-up in cost basis based on the value of the property at the time of death or the alternate valuation date. Then, when you go to sell the property at close to that new cost basis, you have the advantage of much smaller capital gains tax bill.
By eliminating this basis adjustment, many mineral owners will be faced with significantly higher capital gains tax bills when they go to sell their property and in some cases may be forced to sell their minerals in order to pay the federal tax bill due.
A bulletin published by law firm BakerHostetler said, “These proposals seem to contemplate capital gains taxes at death, in addition to the estate tax (presumably with an estate deduction for capital gains taxes paid), with a carry-over basis (instead of a capital gains tax) for assets used in certain family businesses and family farms.”
Mineral Rights Estate Tax Example
Let’s say that you have a family member who inherited 100 Net Mineral Acres worth $200 per acre in 1961 their cost basis would be $20,000. If you were to inherit this property today and it is now worth $5,000 per acre or $500,000 total, under these proposed changes, you would inherit the original cost basis of $20,000 and could potentially be faced with $480,000 in tax liability. If the limit were dropped from the proposed $1MM to a much lower level, you would be faced with a capital gains tax bill at the time of death. At the current long-term capital gains tax rate of 23.8% this would be more than $114,000 that you would owe to the federal government at the time of inheritance. Most people I know wouldn’t be able to pay this type of tax bill and would be forced to sell the minerals in order to cover the tax liability.
Also, the Biden Administration has indicated that they would try to change the way long-term capital gains taxes and qualified dividends are taxed to ordinary income for all income over $1 million. Currently, the maximum long-term capital gains tax rate is 23.8% on the sale of assets held more than a year and proposals are considering almost doubling this to 43.4% for taxpayers with more than $1 million in annual income.
Income Tax Changes
- Another change being considered is an increase in the top income tax bracket and limiting deductions from 37% to 39.6% for taxpayers with more than $400,000 of income
Gift Tax Changes
Currently you can give $15,000 each to an unlimited number of people each year without gift tax. Potential changes would drop this limit to $10,000 and a total of $20,000 maximum for the total gifts you make to anyone in trusts
Percentage Depletion Deduction and Intangible Drilling Costs
Another major impact to mineral and royalty owners would be the elimination of the percentage depletion deduction that is also proposed. We’ve talked about percentage depletion deduction and how important it is to royalty owners in several episodes but you can listen to MRP 105: What You Should Know About the Depletion Deduction for a deep-dive on the subject and what it would mean for royalty owners if it were eliminated. The proposed legislation targeting oil and gas revenue would also eliminate the ability to expense Intangible Drilling Costs for those who invest in Working Interests.
Our Key Takeaways:
- If you are considering gifting mineral rights or royalties, then now may be the time to do so while higher gift tax exemptions are in place.
- Potential changes are not finalized yet but likely exemptions will be lowered as a way to force families to pay more tax to help pay
- Potential changes being considered are reducing the estate tax exemption from $11.7 million to $3.5 million that Joe Biden mentioned during his campaign. Also, I would expect a change to the estate tax rate from current 40% to something higher on the amounts that exceed the exemption.
- It sounds like one option to potentially take advantage of the current $11.7 million estate tax exemption, would be to gift property to an irrevocable trust.
- From what we’ve read, retroactive changes aren’t likely so the earliest that any changes would go into effect would be January 1st, 2022. Hopefully debate on this can be pushed into 2022 when mid-term elections might change some representatives and senators’ stance on the issue.
- We are not attorneys or tax professionals so get with your attorney and CPA to get guidance specific to your situation.
- There is a lot of uncertainty about these changes right now but this shouldn’t prevent mineral owners from implementing estate planning strategies to minimize tax exposure.
- Elimination of percentage depletion deduction would affect ALL royalty owners.
- Elimination of the ability to leverage a step-up in cost basis at the time of death may force some mineral owners to have to sell in order to cover the tax bill.
Resources Mentioned in This Episode
- Start Here: MRP 20: Taxes on Mineral Rights and Royalties
- More Information on the Percentage Depletion Deduction that all royalty owners can take advantage of (at least for now): MRP 105: What You Should Know About the Depletion Deduction
- Mineral Rights Forum Post – NARO is looking for stories on how royalties have helped your family
- BakerHostetler Bulletin: White House Adds Details to Its Far-Reaching 2021 Tax Reform Plans
- TIPRO OPPOSES BILL TO ELIMINATE PERCENTAGE DEPLETION AND INTANGIBLE DRILLING COSTS TAX DEDUCTIONS
- National Law Review: 2021 Estate Planning Outlook: Transfer Tax Changes on the Horizon
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