Updated: Jun 1, 2020
During tax season, Petroleum Evaluations Group (PetroEval) is busy helping mineral owners save money on taxes. Many mineral owners are not aware of how their royalty checks are taxed, or what the tax implications are for selling their minerals. This article aims to provide a simple guide to understanding the tax implications of retaining or selling your mineral rights. We start by considering all the different types of taxes and tax breaks out there. Then we get into the tax implications of selling your mineral rights and how PetroEval can help reduce your long-term capital gain taxes with a retrospective valuation.
Federal Income Taxes
If you are currently collecting royalty checks, there is a good chance you will have to pay taxes. A mineral owner regularly pays federal income tax on oil and gas royalties. This is the same as paying taxes out of your paycheck. There are seven Federal income tax brackets in the United States ranging from 10% to 37%. As an individual makes more money throughout the year, they move up to higher tax brackets, progressively paying a higher tax rate for the additional money they earn.
State Income Taxes
Mineral owners also have to pay state income taxes. Most states also apply a progressive income tax. In Oklahoma, citizens pay between 0.5% and 5.25%. In North Dakota, citizens pay between 1.1% to 2.9%. In Texas there is no state income tax.
State Severance Taxes
In addition to Federal and State income taxes, mineral owners have to pay a specific oil and gas severance tax. A severance tax gets its name from it being a tax imposed on someone for “severing” a non-renewable resource from his or her property. In Oklahoma, the severance tax is 5% of all oil and gas revenue for the first three years, and 7% of all oil and gas revenue after three years. In North Dakota, the severance tax is 5% of all oil and gas produced. In Texas, the severance tax is 7.5% from all gas produced and 4.5% of all oil and condensate produced. Severance taxes can get more complicated if there is a large spike in the price of oil and gas and can change any given year depending on the decisions of state governments.
Depletion Allowance Deductions
In summary, royalty checks are taxed three times by: (1) federal income tax, (2) state income tax, and (3) state severance tax. Sounds pretty bad, huh? But the federal government does help mineral owners out by allowing them to claim a “depletion allowance”, a tax break due to the oil and gas on a property being depleted.
There are two ways to calculate this tax break. The first is “percent depletion.” This approach allows an individual to take a 15% reduction on the taxes they owe the federal government from any income made from oil and gas royalties. With percent depletion, if a person made $100,000 in royalties one year, they would only need to pay taxes on $85,000 of that income because they can claim a $15,000 deduction (15% of $100,000). Many people like to use the percent depletion approach because it is simple to calculate.
Another option is to use the “cost depletion” approach. This requires hiring a professional to establish the fair-market-value of the mineral rights when they were first inherited and also the amount of oil and gas reserves that are underground. Then, the tax deduction is calculated using the following formula:
Deduction Amount = (Oil and Gas Produced During Tax Year ÷ Total Oil and Gas Reserves) X Fair Market Value of Property on Date of Inheritance
The cost depletion deduction can sometimes be greater than 50% of the oil and gas revenue a mineral owner makes from royalties. But calculating cost depletion deductions can be very complicated. Most individuals only benefit from applying the cost depletion approach if they have inherited their mineral rights in the last ten years and have had wells start producing on their properties in the last five years. PetroEval can help mineral owners with calculating cost depletion deductions.
So, How Much Do I Pay In Taxes When I Keep My Mineral Rights?
For most mineral owners, the net result of paying federal income taxes, state income taxes, state severance taxes, and claiming a depletion tax deduction, results in them paying between 20% and 30% in taxes on all their oil and gas royalties. When a royalty check is sent out, it usually already accounts for severance taxes, so an individual can assume that they will have to pay approximately 25% of what they make from oil and gas royalties in taxes every year.
Taxes If You Sell Your Mineral Rights
If you sell your mineral rights, you will have to make a one-time tax payment to the IRS. Money made from selling your mineral rights is not considered personal income. Rather, it is considered a long-term capital gain. As a result, you would have to pay a long-term capital gains tax. Long-term capital gains tax is usually 15% of any money made above a tax-basis. A tax-basis, is the value of the mineral rights when they were inherited. So, if a person inherited minerals three years ago which were worth $100,000, and then sold them last year for $200,000, they would need to pay 15% of the $100,000 the property gained in value since their inheritance, or, $15,000. Petroleum Evaluations Group regularly generates reports for mineral owners that establish the value of their inherited minerals for the purposes of a tax basis (often called a retrospective valuation). This can save mineral owners many thousands of dollars when it comes to paying long-term capital gains tax after having sold their mineral rights. Without a tax-basis report, a mineral owner will have to pay 15% long-term capital gains tax on the entire value of the property that they recently sold.
So Should I Keep or Sell My Minerals?
Often time’s mineral owners believe that they should never sell their mineral rights, and there are many reasons for this being a sound decision. Nevertheless, you usually end up paying a lot more in taxes if you keep your mineral rights, than if you sold them. Selling minerals is a personal choice. But if you DO sell them, make sure to get a retrospective valuation in order to reduce your long term capital gains tax liability.