Last Updated on When it comes to mineral rights taxes, there’s a little something for everyone. Whether county, state, or federal, it’s important to know where and how you’re getting taxed on your mineral royalties to pay as little as possible back to the government.
Which taxes apply to your royalties, and at what levels? And how do you account for the income in a way that doesn’t leave you vulnerable as the rights owner?
As we break down this issue, so you will learn everything you need in the event of an audit or while filing your annual tax returns. Learn what mineral rights taxes are, how to report oil and gas royalties on a tax return, and which taxes to look out for. With a little preparation and the right insights, you’ll be ready to file a report you and the IRS can be happy with.
What Are Mineral Rights Taxes?
Simply put, mineral rights taxes are income tax applied to royalties paid to you by a company leading your land for mineral processing.
As an owner of mineral resources, you have an opportunity to lease out your land to any private industry or government agency with interest in them. Whether sedentary or fluid minerals, once your land begins yielding minerals, you can expect royalty payments from the lessee until their contract ends or the minerals run dry.
But, like any other source of income, there are taxes to be paid from the second you begin earning it. This is where mineral rights taxes come in.
The Internal Revenue Service (IRS) classifies all royalties earned from oil, gas, and mineral properties as taxable income. Most often, taxpayers will report royalty income on Schedule E, either as rents and royalties or working interest. Sometimes, they may opt to report it as both and do so on Schedule C.
A Note On Section 1031
Of course, not all landowners are single plot owners. High volume investment is common in the mineral resource industry, with owners buying and sell their property as needed. For these owners, the Internal Revenue Code (IRC) Section 1031 can be handy.
This is a deferment program that provides for the tax-free disposition of property, provided it is bought or sold within a 45-day window. And it includes oil and gas land. Deferring capital gains tax this way relies on exchanging royalty rights for a property and then using that income to buy another piece of land also under the 1031 “umbrella.”
The process is complicated and, usually, should be handled with a tax expert’s advice with some experience in these applications.
Which Mineral Rights Taxes You Should Know?
When a company leases your mineral rights properties, they will make royalty payouts based on how many minerals are extracted from your land. This is usually measured in units like barrels or tons.
The IRS will tax you on these royalties. Mineral rights taxes are, generally, in effect at the county, state, and federal levels. And there are certain taxes you’re going to want to be aware of ahead of time.
Ad Valorem
Ad Valorem is an annual oil and gas tax collected at the county level. This is handled based on the fair market value of mineral rights, which means it tends to fluctuate based on supply and demand. Of interest is the fact that, in many states, this tax only comes into effect once mineral production is actually active. The tax itself, however, is based on mineral rights value, not income.
State and Federal
Royalty payments are, officially, considered income. What this means is that they will be taxed just like any other traditional form of income. With the exception of a few states, this is the case everywhere you go.
Federally, taxes are based on the overall tax bracket of the person paying. Farmers earning two-thirds of their income from farming don’t pay estimated royalties taxes. For farmers earning over a third of their income from royalties on mineral rights, quarterly estimated tax payments apply. These must be paid to prevent underpayment penalties in their tax preparation.
Severance Tax
In most states, severance taxes are collected on oil and gas extraction. The funds from these go on to pay for mineral extraction expenses or conservation work, such as:
- environmental protection
- construction of new roads at drilling sites
How To Report Oil and Gas Royalties On Tax Return?
Physically reporting your income taxes is the next step in the process. Once a well or dig on your land begins to produce minerals in either oil or gas form, you’ll start receiving royalty payments.
But this is also when you’ll want to start preparations for income tax season. If oil and gas royalties for your lease are substantial, you may be on the line for estimated quarterly tax payments, both to the IRS and whichever state you are in.
The lease payments made to you for mineral rights are officially considered rental income and taxed accordingly. One downside to this is that taxes must be paid on rent in the year of payment, regardless of whether or not the well produced. As with any other income, you can reduce these taxes by claiming land lease costs. This may include:
- attorney’s fees
- land surveying
- contract creations
- general ownership costs
In the case of a high-income tax, another deduction is possible: investment income tax. Discuss this with your accountant, and specifically ask about the relevant thresholds in your state.
For many mineral rights owners, the word “depletion” will come up next. To reduce your income taxes, you may calculate depletion allowance by comparing royalty income with your other income sources to owe less overall. It’s an effective technique but relatively complicated, so you’ll want to work with a reputable tax expert.
When production begins, include all payments as income. Make sure to deduct any and all production costs. Payments minus expenditures and deductions will make up the overall taxable income to report to the IRS.
Conclusion
Mineral rights taxes can feel like pumping the breaks on a fast car. There’s a lot of money to be made by leasing your land to interested parties to mine and exploit. Still, that income comes taxed, just like any other industry.
Depending on your state laws, mineral rights taxes will affect you to a lesser or greater extent. From Ad Valorem to State and Federal and Severance, it’s important to have your ducks in a row. It would be best if you were ready, come tax season, to know how to report oil royalties on a tax return accurately and make any deductions you can so Uncle Sam doesn’t get every cent.
Looking for expert insights and a wealth of knowledge into the mineral management process and want to know more about buying mineral, oil, and gas assets? Visit Pheasant Energy today, or give us a call, and let us help you dig out something valuable.
Sir: Thank you for review of my question. How does the mineral owner determine reserves in deetermining depletion deduction (cost or %).
Thanks John
Very educative, thank you.