Mineral rights refer to the natural resources (i.e. oil, gas, coal, metal, ores, stones, etc.) that can be found on property and the ownership of those resources. These minerals can be extracted for their monetary use or value. One of the least desirable aspects of earning money from oil and gas minerals is the taxes you have to pay on them. If you’re new to mineral rights investing, then it may be worth it to seek out a professional to help reduce your tax burden and ensure you’re paying the proper amount of taxes. Since mineral rights investments can have different forms, the taxes are calculated accordingly. Here is some of the basic information you need to know and answer the question of “how are mineral rights taxed?”
County, State and Federal Tax
Mineral rights are subject to county, state and federal tax. For state taxes, the amount you have to pay depends on how valuable the minerals are. From the county level, your mineral rights are viewed similarly to property tax. In this regard, the county will appraise the mineral rights to determine the fair market value and collect tax on producing minerals. Federal tax is also collected on any income made from oil and gas minerals. This income is treated as if it were income from a regular job and is filed as personal income tax.
Possible Tax Deductions
Taking advantage of tax deductions with mineral rights investing can save you a significant amount of money. Any severance taxes you are provided can be deducted, as well as processing fees or any expenses incurred as a result of owning the mineral rights. A mineral rights owner can also take advantage of a yearly depletion allowance, which can vary depending on many factors. The main concept surrounding the depletion allowance is you can deduct a certain percentage of the royalties earned, which can reduce your tax burden by hundreds or thousands of dollars.
Proper Tax Planning Is Essential
Taxes on oil and gas minerals can bring along many different complexities. While you want to make sure you are following all of the laws from the state, county and federal levels, you also don’t want to be paying more taxes than you have to. Every mineral rights investing situation is unique, so getting proper tax planning advice from a professional can give you peace of mind. Doing so can also put thousands of dollars back into your pocket over several years and make your investments that much more valuable.
Mineral Rights Summary Including Tax Positions
Eckard Land & Acquisition understands many mineral rights owners don’t keep up with all of the latest tax laws and regulations as they relate to their mineral rights. And even if you are knowledgeable in this area, it never hurts to have another set of eyes look over your situation to ensure all bases are covered. Here are some important points summarized so every mineral rights owner can have a better understanding of their options and tax positions.
1. Ownership of a mineral right can happen via 2 different options
2. The treatment of the sale of a mineral right for tax purposes depends on how the property was held by the owner:
- If the property was held for use by a trade or business, the sale would be taxed under Section 1231 of the tax code and reported on Form 4797 of the tax return.
- If the property was held for investment purposes, the sale would be treated as a capital gain or loss reported on Schedule D of the tax return.
- The ultimate tax treatment of Section 1231 gain and capital gains varies by each taxpayer and can be different each year. You should consult with your tax advisor regarding your specific tax treatment.
3. Your tax basis in a mineral right includes the purchase price paid for the rights as well as any fees associated with the purchase. Your tax basis is reduced (not below zero) by any cost depletion deducted.
4. Income from mineral rights is typically in the form of royalties. Income from royalties is treated as ordinary income and taxed at your ordinary income tax rates. Royalty income is reported on Schedule E of an individual income tax return. Deductions for depletion (cost or percentage) expense can reduce the amount of taxable income from royalties. You should discuss with your CPA and determine which depletion method is most appropriate for your tax situation.
5. Treatment of certain costs of ownership in mineral rights such as production tax, severance tax and delivery fees are deductible expenses that reduce the amount of taxable income from royalties. Typically, royalty interests do not incur expenses pertaining to the production or development.
6. Mineral rights are assets of their owner. Upon death those rights become part of the decedent’s estate. The tax basis of those rights is “stepped up” to their value on the date of death of the owner (or alternate valuation date). That “stepped up” basis becomes the basis of the mineral rights to the beneficiaries of the estate. The estate will pay income tax on income received from the mineral rights while the rights are held by the estate.
7. Mineral rights can be gifted. The tax basis of gifts is the same to the recipient as it was for the person making the gift. The person making the gift may have to file a gift tax return to report to the IRS the value and basis of the gifts as well as the recipient of the gift. The recipient of the gift will be subject to tax on the income from the rights each year. If the gifts are made to minors, they may be subject to “kiddie tax” on the income.
8. Condemnation of mineral rights is not a tax issue. You should discuss with an attorney or refer to state code for Texas Government Code Sec. 402.031 and Chapter 21 of the Texas Property Code. Generally, property can be taken for public use only. In order to have a deductible loss on condemned property, the owner can’t retain any ownership in the property. Also note, mineral rights typically take priority over surface rights.
9. Mineral rights could be donated to nonprofits if the organization chooses to accept them. The deduction for the donation would be the fair market value of those rights. You should be prepared to substantiate the deductible value to IRS. If the deduction claimed is $5,000 or more, you are required to send a certified appraisal along with your tax return as substantiation for the tax deduction.
10. Mineral rights are typically considered real property and may be exchanged under Sec. 1031 to help defer gains. You should consult with a CPA and examine the nature and duration of the rights to determine if they were held for use in a trade or business or for investment.
11. Lease bonuses are treated as ordinary income and reported as rent on Schedule E of your individual income tax return.
12. Fees pertaining to mineral rights for management would also be deductible expenses against royalty income and also reduce the amount of taxable income from royalties.
13. State Income Tax varies by state and would need to be discussed with your CPA. Tax potential depends on the owner’s residence state and their income.
Taxes play a significant role in mineral rights investing, and we are here to help you in every aspect. Be sure to contact us to learn more about our services and how we can help make the most of your oil and gas investments.