Mineral and Gas Royalty Taxation
To make an informed decision on whether or not to sell your mineral or royalty interest it is important to understand how various taxes and tax incentives can affect your decision.
| How Taxes Impact You If You Sell or Hold Your Mineral Rights (Summary) | |||
| Taxes When You Sell | Taxes When You Hold | ||
| Severance Tax (State) |
None due on sale proceeds | Deducted from monthly royalty checks. Up to 12.5% of value annually depending on state. | |
| Ad Valorem Tax (County) | None due on sale proceeds | Pay yearly (most states). Varies widely. Average +- 5% of fair market value. | |
| Income Tax (State) |
0 to 10.1% depending on state* | 0 to 10.1% depending on state* | |
| Income Tax (Federal) |
Owned < 1 year
35% max Owned > 1 year 15% max |
Max 35% - Ordinary income | |
| * Those states that assess state income taxes generally set the rate as a percentage of your Federal taxable income. That tax rate can be as low a 0% and as high as 10.1% depending on the state in which you reside. In most states the top marginal rate is the same as short term and long term capital gains rates. There are, however, a few exceptions as noted on the capital gains tax rate state chart. View capital gains tax rate for your state. | |||
SEVERANCE TAX:
States that rely on natural resources for a substantial share of their revenues typically derive the revenue from state severance taxes. Severance taxes are excise taxes on natural resources “severed” from the earth. They are measured by the quantity or value of the resource produced and are typically paid by the producer and then deducted from the gross value paid on the royalty checks. Royalty owners pay their pro rata share of these taxes.
There are a number of well incentives providing for a reduction in severance tax offered by various states.
For Example:
- Tight Sands Completions (TX, AR)
- Horizontal Wells (OK,LA,TX)
- Wells deeper than 15,000’ (OK, LA, TX)
- Previously inactive wells (TX, LA)
- Marginal wells or wells on gas lift (LA)
- Secondary/Tertiary recovery (TX)
These incentives must be applied for by the well operators and the process is typically complex and time consuming and are often overlooked by operators.
Almost all producing states collect severance taxes on oil & gas production. Those that don't currently, such as Pennsylvania, New York, and Iowa are currently contemplating adding the tax. Rates vary from 0 to 12.5% of value annually based on the state the production is located and is deducted from your monthly royalty checks.
AD VALOREM TAXES:
Mineral interests are considered real property and therefore are subject to ad valorem taxes levied by various taxing entities in the county in which the interest is located.
The tax is based on the “fair market value” of the resource. In effect, this means that the value is what the interest would sell for in an “arm’s length” transaction under the prevailing market conditions.
Most states provide for ad valorem taxation only on producing mineral interests, however, some states tax non-producing minerals and royalties although at a greatly reduced valuation.
The “fair market value” of a mineral interest in a producing well is determined to be the pro rata recoverable reserves of the well discounted to present value. Obviously, this is an arbitrary and negotiable valuation.
This valuation is determined utilizing the following four variables:
- Historical well production decline curves
- Total operating expenses
- Projected future commodity pricing
- Discount rate, or time value of money
Taxing entities utilize the services of independent contractors to assess the value of all real estate located in their county. They generally mail out the assessments in the first quarter of the year. The property owner is then given a period of time to appeal the assessments. Ad Valorem taxes are then generally due and payable by December 31 and assessed late fees if not paid on time. Tax payers that don’t pay their Ad Valorem taxes run the risk of their properties being sold by the taxing entity in what is generally referred to as a tax sale.
Ad Valorem tax rates vary widely from state to state and county to county. The tax can be as high as one month's gross production yearly depending on tax rate and the timing of commodity pricing. On average, it appears that Ad Valorem taxes in states that assess the tax average around 5% of value annually.
FEDERAL INCOME TAXES:
Oil & Gas royalty income is considered ordinary income and as such is subject to federal taxation at the personal tax rate you fall under in the tax code. The maximum federal personal income tax rate as of 2009 is 35%.
The net proceeds from a sale of royalty interests are treated as ordinary income if held for less than a year, but treated as long term capital gains with a current (2009) maximum rate of 15% if held for more than a year. See our capital gains calculator.
DEPLETION:
While the previous three sections concern forms of taxation reducing your net income, there is relief available through the IRS code in the form of depletion.
The depletion allowance available for natural resources is similar to depreciation allowed for other classes of real estate however is a much larger percentage deduction. Due to the fact that oil & gas are depleting assets, the IRS allows a depletion deduction to offset the income generated. According to the IRS code you are allowed to take a deduction for depletion provided both of the following conditions are met:
- You have acquired the interest in the minerals by virtue of a capital investment.
- You have a legal right to income from the extraction of the minerals from which you seek a return of your capital investment.
Two types of depletion are available.
Cost Depletion:
Cost depletion is calculated based on the relationship between current annual production as a percentage of total recoverable reserves. Each year the deduction is limited to the percent of the total recoverable reserves produced during the calendar year. Additionally, the total amount recovered under this method can never exceed the total amount invested in the property by the taxpayer.Percentage Depletion:
The use of the percentage depletion method is subject to several qualifications and limitations under the IRS code. Currently, the allowable deduction is 15% of gross revenue. An additional advantage of this method is that the cumulative depletion deductions over the life of the property can be greater than the taxpayers total capital investment in the propertyA taxpayers annual deduction utilizing percentage depletion is, however, limited to the lesser of the following:
- 100% of the taxpayers income from the property calculated without applying the depletion allocation.
- 65% of the taxpayers taxable income from all sources calculated without applying the depletion allocation.
1031 EXCHANGES:
The IRS code further provides the taxpayer with a means of capital gains deferral through the use of Section 1031 of the code. Basically, what the code states is that when you sell your mineral or royalty interest you may defer the capital gains applicable to the sale provided that you purchase a “like-kind” property of equal or greater value which includes minerals, royalties, oil and gas working interests and real estate. If the sale price of your property is greater than the purchase price of the replacement property then you are required to pay capital gains on the difference. The IRS allows up to 45 days after the sale of your property for you to identify the new investment property, and then 180 days between the sale of your property and the purchase of the new property.
1031 exchanges are complicated transactions and require extensive documentation. There are trained individuals called Qualified Intermediaries available for hire and are necessary for the completion of such transactions.
2010 PROPOSED OBAMA BUDGET:
The 2010 proposed budget by the Obama administration if passed would be devastating to the domestic Oil & Gas industry. The current administration proposes to repeal the following:
- Enhanced oil recovery credit
- Marginal well tax credit
- Expensing of intangible drilling costs (IDC)
- Deduction for tertiary injectants
- Passive loss exception for working interests in oil and gas properties
- Manufacturing tax deduction for oil and gas companies
- Percentage depletion for oil and natural gas
The rig count in the U.S. has dropped by well over 50% from 2008 to 2009. Should the above repeals be passed, the rig count will drop considerably more. Additionally,many marginally producing wells, which comprise the vast majority of oil and gas wells in the U.S., will no longer be profitable and will be plugged and abandoned even though there are remaining reserves available.
While most of the above proposals (except percentage depletion) don’t directly affect your royalty checks, they will affect future drilling and marginal wells on your property.
Please understand that the above tax increases are being proposed on an industry that already pays an average 40.4% income tax rate (based on 2007 income tax expense, as a share of net income before income taxes) compared to 26.7% for all U.S. manufacturing companies. These proposed tax increases are guaranteed to increase our dependence on foreign oil and damage our national security.
The net effect on you as a mineral or royalty owner if the current administration is successful making their objectives law is that you could loose valuable tax deductions on your royalty income, the number of domestic oil and gas wells drilled in the foreseeable future would be greatly reduced, and that many marginally producing wells would be plugged.
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