How are Mineral Rights Taxed?

When you own mineral rights, they fall into three distinct phases of ownership.  Each phase has different tax implications.  Before we dive into this topic, determine which phase of ownership your mineral rights fall into:

Non-Producing / Non-Leased:  If your mineral rights do not generate royalty income, and you do not have an active lease, you have non-producing / non-leased mineral rights.  If you have not signed a lease agreement within the last 5 years, and you don’t receive royalty income, it is highly likely your ownership falls into this category.

Leased Mineral Rights:  If you have leased mineral rights, it means that you have signed a lease agreement or extension within the last 3 to 5 years.   However, you do not receive royalty income.

Producing Mineral Rights:  If you receive royalty income, even small amounts over time, that means that you have producing mineral rights.

Once you have determined what phase of ownership your mineral rights are in above, you can now look at the tax implications for your situation.

If you own non-leased or non-producing mineral rights, the good news is that there are no tax liabilities associated with this phase of ownership. Since the minerals are not currently generating any income or being actively developed, you won’t owe taxes on them. This is because the IRS only taxes income-producing assets, and in the case of non-leased mineral rights, no income is being generated.

While no taxes are due, it’s important to keep accurate records of your mineral rights ownership for future reference, especially if the property is ever leased or begins to produce income.

When you lease your mineral rights to an oil or gas operator, one of the first financial benefits you’ll typically receive is a lease bonus payment. This is a lump sum paid upfront in exchange for granting the company the right to explore and potentially develop your minerals.

However, it’s important to understand that this lease bonus is considered taxable income by the IRS.

Ordinary Income Tax

Lease bonus payments are classified as ordinary income, which means they are taxed at your regular income tax rate. The amount of tax you owe will depend on your total taxable income for the year and your tax bracket. Since lease bonuses can sometimes be substantial, it’s wise to plan ahead and account for the potential tax liability.

Reporting the Lease Bonus

You will need to report the lease bonus payment on your tax return for the year you received it. The company leasing your mineral rights will typically send you a Form 1099, which will outline the amount of income you earned. This income is then reported on your federal tax return, usually under “Other Income” on Schedule E or Schedule C, depending on how you manage your mineral rights.

Important:  When you are paid a lease bonus, taxes are typically not withheld.  This means that you need to set aside money from your lease bonus to pay your taxes when they are due.

State Income Taxes on Leased Mineral Rights

In addition to federal taxes, you may also owe state income taxes on the lease bonus, depending on the tax laws in your state. It’s a good idea to consult with a tax professional familiar with both federal and state tax laws to ensure you’re correctly reporting and paying the appropriate taxes on your lease bonus.

Properly planning for the taxes on your lease bonus can help prevent surprises at tax time, especially if the bonus is a large amount.

Once your mineral rights begin producing oil or gas, you will start receiving oil and gas royalty payments. These payments represent a percentage of the revenue generated from the production of your minerals. However, because this royalty income is taxable, it’s essential to understand the tax implications and how to manage them.

Royalty Income as Ordinary Income

Like lease bonuses, royalty payments are considered ordinary income and are taxed at your regular income tax rate. You will receive a Form 1099-MISC from the oil or gas company at the end of the year, detailing the total royalty income you earned. This income must be reported on your federal tax return, typically on Schedule E (Supplemental Income and Loss).

The Depletion Deduction

One of the major tax benefits available to mineral rights owners with producing properties is the depletion deduction. This deduction allows you to recover some of the income you earn from selling a finite resource, like oil or gas, as the reserves are depleted over time.

State Taxes and Withholding

Royalty income may also be subject to state income taxes, depending on the laws of both your home state and the state where the mineral production occurs. Some states require automatic withholding of state taxes from your royalty payments, which will be reflected in your 1099 form.

Property Taxes for Mineral Rights

In addition to federal taxes on royalty income, you may also owe yearly property taxes related to the mineral rights.  This varies by state.  In Texas for example, there is no state income tax so you don’t pay any tax on royalty income to the state.  However, you will owe property taxes related to the income each year.  Oklahoma does charge income tax on the royalty income, but does not collect any property tax.   The rules vary by state so it’s important to determine how your state taxes mineral rights and whether you owe any property taxes related to mineral rights.

Understanding how to properly report and deduct expenses, like depletion, can help reduce your taxable income from producing mineral rights.   We recommend speaking with your tax professional about how to account for depletion and reporting taxable income from royalties on your tax return.

One of the biggest reasons mineral owners choose to sell their mineral rights is the potential for significant tax savings.

When you sell mineral rights, the income you receive is usually treated as a capital gain instead of ordinary income. Capital gains are taxed at lower rates, which can save you a lot of money compared to holding onto the rights and collecting royalty income over time.

How Capital Gains Tax Treatment Works

When you sell your mineral rights, the profits from the sale are considered capital gains. The tax rate on long-term capital gains (assets held for over a year) is usually much lower than the tax rate on ordinary income like royalty payments.

Example:

Let’s say you sell your mineral rights for $500,000. The capital gains tax rate depends on your income, but it’s often around 15% for many people. In this case, you’d pay $75,000 in taxes (15% of $500,000), and you get to keep $425,000.

Now, let’s compare that to holding onto your mineral rights and earning $500,000 in royalty income over time. Royalty payments are taxed as ordinary income, meaning they’re subject to your regular tax rate, which could be anywhere from 24% to 37% depending on your income bracket.

If you’re in the 32% tax bracket, for instance, you’d owe $160,000 in taxes on that same $500,000 in royalty income, leaving you with only $340,000. In this scenario, selling your mineral rights and taking the capital gains tax treatment saves you $85,000 in taxes!

Step-Up Basis: Further Tax Savings

An additional advantage of selling mineral rights is the step-up basis, which can lower your tax liability even more.

The step-up basis applies when you inherit mineral rights. Instead of calculating taxes based on the original purchase price of the rights (which could be very low), the IRS allows you to “step up” the value to the current market price at the time of inheritance.

Let’s look at the same example with a $500,000 sale of inherited mineral rights. Thanks to the step-up basis, your tax calculation might only be based on a small portion of the total sale. In some cases, this can result in an effective tax rate as low as 5%.   It is also possible to owe $0 in taxes depending on when you inherited mineral rights.

Using 5% as an example, you would only owe $25,000 in taxes on your $500,000 sale, allowing you to keep a whopping $475,000! This dramatically reduces your tax burden and maximizes your financial gain.

For many mineral owners, the combination of capital gains tax treatment and the step-up basis results in an effective tax rate between 0% and 10%, making selling your mineral rights a financially savvy decision.

Never Sell Mineral Rights?

The common advice to never sell mineral rights ignores tax consequences.  It also ignore diversification.

We have seen a lot of mineral owners collect really high royalty income and get taxed at 40%, giving away a massive chunk of their income.  Upon reviewing their situation, we determine they inherited the mineral rights.  With step-up basis and capital gains tax treatment, they could have saved hundreds of thousands of dollars by selling.

Every situation is unique.  Do not blindly give away all of your money in taxes by collecting royalty income when you could save a fortune in taxes on inherited mineral rights.

If you do decide to sell, find a high quality mineral rights broker that knows your market to ensure you get the best price.

Curious if you will be receiving a 1099 related to your mineral rights?

You should receive a 1099 if you:

• Receive Royalty Income
• Receive a Lease Bonus

You should not receive a 1099 if you:

• Have non-leased / non-producing mineral rights
• Sell Mineral Rights

In some cases, a mineral buyer may elect to send you a 1099 when you sell mineral rights.  However, most mineral buyers do not send one and it is not required.  It is up to each mineral owner to report the sale of mineral rights on their taxes.

Selling your mineral rights can offer significant tax savings and provide a way to maximize the value of your mineral rights. By taking advantage of capital gains tax treatment and the potential benefits of the step-up basis, you can keep much more of your earnings compared to collecting royalty income over time.

Every mineral owner’s situation is unique, and we understand that this can be a complex decision. If you’re considering selling your mineral rights or simply want to learn more about how the process works, we’re here to help.

Contact us today with any questions—we’ll be happy to guide you through your options and help you make the best decision for your financial future.