The Taxman Cometh: What to Know about Taxes on Mineral Rights

Where there is income, there are taxes. If you’ve just leased the mineral rights to your land to an oil and gas company, you may wonder, how will the revenue from royalty and lease payments affect my taxes?

How Taxes on Mineral Rights Royalties are Figured

The royalties paid to you from the company leasing your mineral rights is based on the amount of minerals (in units such as barrels and tons) extracted. According to the Internal Revenue Service (IRS), the royalties earned from oil, gas and mineral properties are taxable as income. Minerals are generally taxed at the county, state and federal levels. Here’s a glance at the taxes you should know about.

  • Ad Valorem Tax: These are taxes collected annually at the county level. In many states, this tax is only paid when there is active mineral production. The amount of taxes paid is based on fair market value, therefore it fluctuates along with supply and demand. This is a tax based on value, not revenue.
  • State and Federal Taxes: Since royalty payments are considered revenue, they are taxed just as other forms of income would be taxed. Some states are exempt. At the federal level, taxes are determined based on your overall income tax bracket. If the landowner is a farmer, and two-thirds of his income is from farming, he doesn’t have to pay estimated taxes on the income from his mineral rights royalties or leases. If the farmer earns more than one-third of his income from leases and royalty payments on mineral rights, he does need to make quarterly estimated tax payments to avoid underpayment penalties during his annual tax preparation.
  • Severance Tax: Most states collect a severance tax on the extraction of gas and oil. These funds go toward the expenses related to mineral extraction, including environmental protection measures and new road construction on the drilling site. Some of these taxes may also be used for conservation efforts. For example, in Colorado, expect to pay two to five percent based on the gross income from oil and gas.

Some taxpayers can apply for cost depletion. This is figured by dividing the cost of the investment (initially buying the land with mineral rights) by the estimated value of the minerals to be recovered from the land. This option is only for taxpayers who purchased the land specifically for mining purposes, not property owners who later chose to lease their mineral rights for additional income.

For high volume land owners who buy and sell property frequently, Section 1031 of the Internal Revenue Code (IRC) is helpful. This deferment program allows landowners tax-free disposition of property, including oil and gas land, if the selling and buying of land happens within a 45-day window. Essentially one investment is simply being replaced with another, rather than cashing out on a traditional sale-only transaction.

Paying Taxes on Mineral Rights Leases

Lease payments on mineral rights are considered rental income, and are taxed as such. Taxes are paid on lease payments in the year they were paid, despite whether or not the well was producing. Much like other income, these taxes can be reduced by claiming expenses related to leasing the land. These might include fees from lawyers, land surveying, contract creation and title costs. If you’re a high-income taxpayer, you may also owe investment income tax. Speak with your accountant for the thresholds in your state.

Taxes and Planning for the Future

Since mineral rights leases can last for several years, it’s a good idea to include this revenue in your estate planning. As you age, consider gifting your income from mineral rights leases and royalties to your children or grandchildren. These transactions become tax deductions that can lessen your federal and state tax burdens as you age.

If you’re juggling multiple oil and lease contracts, consider incorporating this side-business and becoming an S-Corp or LLC. The income will then be treated as a business, and offers personal liability protection and tax breaks.

Since each state has individualized tax laws, it’s best to consult your attorney for specific details. To learn more about oil and gas production in Denver, Colorado contact BWAB.