The taxes to which mineral interests may be subject

What Taxes Do Mineral Owners Need to be Aware of?

If you own minerals, you need to understand that you may be subject to taxation at several levels of government.

First of all, understand that in many cases if your minerals are unleased, you will not incur any taxes from your mineral asset. You will not have earned any leasing income yet and many states do not allow for ad valorem (property) taxes to be levied on non-producing minerals.

However, once you have leased your minerals and production begins, you may be subject to taxation at all three levels of government (depending on the state where your producing minerals are located).

  • Federal: income tax
  • State: severance (production) tax, income tax
  • Local: ad valorem (property) tax

Federal: Income Tax

Leasing your minerals will provide you with another source of income, but of course it will be subject to federal income taxes. Your leasing income will include a signing bonus, possibly delay rental payments, and royalty payments if there is any production of oil and gas.

If you have an oil and gas lease, the lessee (the operator of the lease) may send you (the lessor) a Form 1099-MISC early in the year for what you were paid in lease income the prior year. The lessee is required to provide you with a 1099 if you were paid at least $10 in royalties or at least $600 in bonus or delay rental payments.

Bonus income paid to you for signing a lease or to extend the primary term of the lease should be reported on the 1099 as rental income in Box 1. If you receive any delay rental payments, these should also be reported as rental income in Box 1 of the 1099.

Income from signing bonus and delay rental payments is considered ordinary income and is taxed as such. Bonus and delay rental income is usually reported on Schedule E (Form 1040), Supplemental Income and Loss.

Royalty payments are reported on Form 1099-MISC as (appropriately) Royalties in Box 2. Royalties are also considered to be ordinary income and are normally reported on Schedule E.

The tax code does allow for royalty owners to reduce their tax liability by allowing for a depletion deduction (often referred to as the depletion allowance). Depletion is defined by the IRS as “the using up of natural resources by mining, drilling, quarrying stone, or cutting timber.”

As minerals are produced, the value of a mineral asset declines. The depletion allowance is intended to account for this decline in value and is therefore similar to accumulated depreciation. According to the IRS, the depletion allowance “allows a taxpayer who owns an economic interest in a mineral deposit… to reduce their taxable income and account for the reduction of reserves.”

There are two methods of determining your depletion allowance: cost depletion and percentage depletion. You must use the method that results in the greater deduction.

For oil and gas royalty owners, percentage depletion is the more commonly used method. The percentage depletion allowance for oil and gas is calculated using a rate of 15% of the gross income from a property based on the average daily production of crude oil or natural gas up to the depletable oil or gas quantity.

However, there is a limit to how big the depletion allowance can be. According to the IRS, the percentage depletion allowance generally cannot exceed 100% of the taxable income from a property figured without the depletion deduction.

For more help on understanding and calculating your federal income tax liability from an oil and gas lease, please contact your accountant or see this IRS publication.

Working oil pump on Nebraska Great PlainsState: Severance Tax

Most U.S. states levy a severance tax on the production of crude oil and natural gas (in some states such a tax is called a production tax) within the state. Severance tax rates vary from state to state. Depending on the particular state, the severance tax levy is based on either (or both in some states):

  • A percentage of the market value of production
  • The volume of production, as $ per barrel of oil, or $ per thousand cubic feet (Mcf) of natural gas

In states where the levy is a percentage of the market value of production, in many cases the percentage is the same for both oil and gas, although there are a few notable exceptions (such as Texas). Also be aware that some states offer incentives that can reduce the nominal severance tax rate for certain types of wells (horizontals, for example) or those drilled in certain areas or specific formations.

The severance tax is paid to the state by the oil and gas producer. Therefore, as long as the oil and gas producer is correctly calculating and paying the tax to the state, the severance tax should not be a concern for royalty owners.

As a royalty owner, your share of the severance tax will be deducted from your royalty payments. The deduction for your share of the state severance tax should be listed on your royalty payment check stub or royalty payment statement.

If you have questions about the severance tax deducted from your royalty payments, please contact the oil and gas producer from which you receive royalty payments or the state agency responsible for levying and collecting severance taxes.

State: Income Tax

Most oil and gas-producing states levy an income tax as well. As a result, if you are earning income from an oil and gas lease in a state that levies an income tax, you will owe state income tax as well as federal.

In most cases, state income tax codes treat oil and gas leasing income similarly to the federal tax code. For more information on how a state where you have an oil and gas lease taxes such income, please consult your accountant or the taxing authority in that particular state.

Woman calculates taxLocal: Ad Valorem Tax

An ad valorem tax is a levy on the value of a transaction or property. The term ad valorem is Latin for “according to value.”

For mineral owners, the ad valorem tax is a levy on the appraised value of their mineral interest, which like the surface is real property that can be taxed. Ad valorem taxes are levied by local government entities that have the power to levy property taxes, such as counties, municipalities, school districts, and special taxing districts.

As is the case with property taxes levied on surface property, ad valorem taxes are based on an appraisal of the fair market value of the mineral interest.

Since it would be difficult to appraise the fair market value for minerals that are not being produced, in many states ad valorem taxes on mineral interests are not levied until the minerals are in production. This means that your mineral interest will not be taxed until there is a producing well.

If you also own the surface, the ad valorem tax assessment on minerals will be added to your local property tax bill.

So how do local property taxing authorities determine the appraised (taxable) value for your mineral interest?

Many states follow the lead of Texas, which mandates that mineral appraisals be calculated using a complicated formula that uses crude oil and natural gas prices from the prior year in order to come up with an estimated future value of the oil and gas reserves still in the ground, and then discounted to arrive at a present value.

Owners of mineral property have the right to protest the appraised (taxable) value of their minerals, just like they do with surface property.

If you have questions regarding the assessment of ad valorem taxes on your minerals, please contact the property taxing authority where your mineral interest is located.

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