In preparation for tax season, we wanted to provide you with an extensive update on the latest considerations around how minerals and royalties are taxed in 2023.
Covered in a couple of previous episodes, most recently in 2022 (MRP 146: How Mineral Rights and Royalties are Taxed in 2022), we have discussed various aspects of taxation for mineral and royalty owners. While many things have remained the same, there are some changes or upcoming changes that we believe are important to highlight.
Before we dive into the details, we have prepared a free resource guide for you to download. This guide contains additional resources that you can consult to ensure you’re maximizing your allowable deductions and not letting anything slip through the cracks. You can find the guide here:
Click here for our FREE IRS Mineral Valuation and Tax Resource Guide.
As a reminder, we are sharing this information for educational purposes only and this should not be construed as tax, legal, or investment advice. Get help from your financial advisor to see if investing in mineral rights, royalties, or non-operated working interests make sense for you.
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Tax Considerations for Mineral Rights and Royalties
When it comes to taxes, it’s crucial to think about major events that occurred during the previous year. Here are some key events that you need to consider:
- Leasing Mineral Rights: If you leased your mineral rights, the lease bonus payment you received is generally treated as ordinary income. If the lease bonus payment was more than $600, you should receive a 1099 form from the leasing company. Even if you don’t receive a 1099 form, you still need to report this income on your tax return.
- Inherited Minerals or Royalties: If you inherited minerals or royalties, it’s important to note that they may not incur tax liability in the year of inheritance. However, if you decide to sell them in the future, knowing the value at the time of inheritance is crucial for establishing a “step-up” in cost basis which could help minimize your capital gains tax liability.
- Sale of Minerals or Royalties: If you sold some or all of your minerals or royalties last year, the sale may be subject to long-term capital gains tax if you owned the property for more than a year. The capital gain is determined by subtracting the basis assigned to the minerals from the sales proceeds. To learn more about establishing a step-up in cost basis, listen to our episode with Rob Prentice for more information (MRP 32: Rob Prentice on IRS Mineral Rights Valuation and the National Association of Royalty Owners).
Tax Considerations for Royalties
Royalty income from oil and gas is typically treated as ordinary income and taxed similarly to lease bonus payments. As a royalty owner, you should receive a 1099 form from the operator or crude/gas marketer reporting your royalty income. The IRS classifies royalty income as passive-type income derived from the landowner’s royalty, overriding royalty, or net profits interest. It’s important to review the 1099 forms for accuracy and report royalty income on Schedule E as rents and royalties.
Did you know that the 1099 that you receive from the operator might not be correct? This is why it is important to double check the number reported to the IRS on your 1099 against your revenue statements to make sure the gross royalty amount matches. To learn more about this, check out MRP 97: How to Audit Your Oil and Gas Royalty Statements.
Deductions for Royalty Owners
As a royalty owner, there are several deductions that you may be eligible for. It’s important to keep receipts for expenses incurred with royalty income, as these expenses may be deductible. Additionally, you may be able to deduct attorneys’ fees, consulting fees, and other costs associated with managing your royalties. Most royalty owners are also eligible for the depletion deduction, which compensates for the natural reduction of an irreplaceable asset based on the depletion of oil and gas reserves when they are produced and sold.
Depletion Deduction for Royalty Owners
The depletion deduction allows mineral interest owners to recover their cost basis as the oil and gas reserves are produced and sold. There are two methods of computing the depletion deduction: cost depletion and percentage depletion.
- Cost depletion involves writing off the capitalized cost of the mineral property over its useful life or units of production. This requires a professional appraisal to understand the fair market value at the time of acquisition, unless you purchased the interests, in which case the capitalized cost is the cost of the asset when you purchased it. You also need to know the reserves associated with that interest, known as the Estimated Ultimate Recovery (EUR).
- Percentage depletion allows you to deduct a percentage of your gross income from oil and gas royalties. The percentage is usually 15%, but there may be limitations and factors that affect the deduction. The IRS allows mineral owners to take the larger of the two methods when filing their tax returns. While percentage depletion is simpler, cost depletion may be more favorable in certain situations.
An important consideration for royalty owners is estimating the recoverable reserves for a well on which they are receiving royalties. The calculation of cost depletion for a given year is determined by dividing the volume produced by the recoverable reserves and multiplying it by the cost basis in the property. However, small royalty owners may face challenges in obtaining the data required for this calculation since it requires a professional appraisal and reserves estimate which can cost several thousand dollars to obtain. For more information on estimating recoverable reserves, you can refer to this article: Using the Depletion Deduction to Minimize Oil and Gas Tax Liability.
Deductions for Working Interest Owners
Working interest owners have a different tax situation compared to royalty owners. A working interest owner is an individual who owns an ownership stake in an oil and gas lease, providing them with the right to explore and produce oil, gas, or other minerals. Working interest owners bear their proportional share of the cost of drilling, completing, and operating a well. There may be tax benefits for owning a non-operated working interest, and you may be able to deduct costs such as intangible drilling costs (IDCs) or development costs in the year they are incurred. It’s important to consult your CPA for advice specific to your situation.
Cost Basis and Inheritance of Mineral Rights
Determining the cost basis for inherited mineral rights is crucial for tax purposes. The cost basis is used to calculate the capital gain when the property is sold. It’s recommended to obtain a professional appraisal to determine the fair market value at the time of acquisition. Having an accurate cost basis is important for minimizing tax liability. Additionally, the cost basis can be relevant for estate planning and estate taxes. It’s important to consult with a CPA and attorney to determine the best approach for handling inherited mineral rights.
Sale of Mineral Rights
If you are considering selling your mineral rights, there are tax implications to consider. Generally, if the property has been owned for more than a year, the sale will be taxed as “long-term capital gains.” This means that you would only have to pay taxes on the profit from the sale, which is determined by subtracting the cost basis from the sales price. One way to minimize your tax liability is to obtain a professional appraisal to establish a step-up in cost basis. This can help reduce the taxable capital gains. Another option to consider is a 1031 exchange, which allows you to defer capital gains taxes on the sale by reinvesting the proceeds in similar properties. However, performing a 1031 exchange requires careful planning and compliance with IRS requirements, so it’s essential to seek advice from a competent tax advisor.
Tax Planning Considerations and Estate Taxes
Tax planning is an important aspect of managing your mineral and royalty interests. Estate tax rates can vary, and it’s crucial to stay informed about the latest regulations. Currently, federal estate tax rates range from 18% to 40%, with an exemption amount of $13.61 million per individual. However, the exemption amount is scheduled to decrease at the end of 2025, unless legislation is passed to extend it. Proper tax planning, including understanding the cost basis of inherited properties, can help minimize estate tax liability. It’s advisable to consult with a tax advisor to ensure you have a comprehensive plan in place.
Conclusion
In conclusion, it’s essential to stay up-to-date with the latest tax considerations for minerals and royalties. This information is provided for informational purposes only and should not be considered legal or tax advice. Consult your CPA or attorney for personalized guidance regarding your specific tax situation. We appreciate you listening to our podcast, and we hope that the additional resources provided in the tax resource guide will be helpful to you.
Resources Mentioned in this Episode
FREE DOWNLOADS:
- Download my free royalty audit worksheet to help you get started. This free Worksheet has a template to help you perform a quick end of year royalty audit against your 1099’s to make sure they are correct before you file your taxes.
- Click here for our FREE IRS Mineral Valuation and Tax Resource Guide.
OTHER HELPFUL STUFF:
- MRP 20: Taxes on Mineral Rights and Royalties
- MRP 97: How to Audit Your Oil and Gas Royalty Statements
- MRP 105: What You Should Know About the Depletion Deduction
- MRP 54: Using a 1031 Exchange to Defer Capital Gains Tax
- MRP 118: Guide to Proposed Tax Law Changes for Mineral and Royalty Owners
- MRP 32: Rob Prentice on IRS Mineral Rights Valuation and the National Association of Royalty Owners
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