You just signed your first of many mineral leases – congratulations!
You have entered into one of the most exciting industries and markets in the world. You’re excited to start collecting royalty payments, and rightfully so.
But, without knowing the ins and outs of the various payments you can receive through mineral leases, excitement can quickly become anxiety.
Mineral Leases: Bonuses, Taxes, Royalties, and More
Oil and gas companies negotiate royalty payments with mineral owners up front. These numbers are included in the language of the mineral leases they execute.
Royalties are calculated as a percentage of the revenue from the minerals extracted from your property. For example, if oil is selling for $60 per barrel and the you negotiated a 1/16th royalty, you would receive $3.75 for every barrel of oil recovered from your land.
Royalty payments are subject to federal, state and, sometimes, local taxes.
Lease Bonus Payments
Let’s take a look at a handful of payment and tax scenarios so you can collect royalty payments without receiving collection calls from Uncle Sam. Long before you receive a royalty payment, you will typically receive a “lease bonus” payment. These payments are reported as ordinary income on your tax returns.
Lease bonuses are paid as a set dollar amount for each acre of land in the transaction. For example, if you had 100 acres and the lease bonus was $100, the total payment would be $10,000.
There are two parties involved in mineral leases. As the mineral owner, you are known as the “lessor”. The company or person drilling for oil or gas on your property is the “lessee”.
At the end of the year, you will receive a Form 1099 MISC from the lessee. Your total lease bonus payments are in Box 1 under the heading “Rents”. Take that number and report it on the first page of Form Schedule E, Supplemental Income and Loss.
In addition to Schedule E, be sure to report all royalty payments on Form 1040, line 17. But not to worry, you don’t have to pay self-employment taxes on royalties from mineral leases.
If the lessee needs more time to begin drilling, they might provide a delay rental payment, which is also reported as ordinary income.
Lastly, if you hold an operating oil, gas, or mineral interest that generates income — that is, income other than royalties — the IRS recommends you use Schedule C to report all of your income and expenses.
Mineral Leases and Federal Taxes
Once a well produces oil or gas, you should start receiving royalty payments. In most cases, payments continue as long as the well is productive. Some operators negotiate other arrangements, so it is important to know the specifics up front.
If your royalty payments are a substantial amount, you might need to make estimated quarterly tax payments to both the IRS and your State.
Many mineral owners reduce their tax burden by using “depletion”. Depletion is calculated by comparing your royalty income to other sources of ordinary income. It’s a fairly complicated formula, so it’s not a bad idea to work with a reputable tax professional to ensure you get the numbers right.
Once production starts you include all payments as income, but deduct any production expenses. Your payments minus expenses and depletions equal your taxable income to report to the IRS.
The End of the Road: Selling Your Property
While royalty payments from mineral leases are considered ordinary income, money from the sale of mineral interests is not. In this case, your income is categorized like any other real estate asset transaction and a long-term capital gains tax is assessed.
If you choose to sell a percentage of future production, it gets a little complicated. Instead of considering the funds as a royalty payment, the IRS sees this income as a loan from the buyer.
Since the IRS sees your percentage sale of future production as a loan, do not include it as income for tax purposes.
We wanted to put together a quick primer on royalty payment taxes for any of y’all who are new to mineral leases. But we know you might have questions or tips we didn’t cover. So we want to hear from you!
What questions do you have about mineral and royalty taxes? What advice would you give to someone just getting started? Please leave a comment below!