Mineral rights are the ownership rights to underground resources such as oil, silver, or natural gas.
You, as the mineral interest owner, may excavate the underground resources, drill an oil and gas well, or surface mine coal as long as you hold this right.
With that, you will also have a mineral rights tax applied to any royalties paid to you by a company leasing your land for mineral processing.
If you currently have mineral rights and you intend to earn from these resources, keep reading.
Just like any other source of income, there are taxes you must pay from the second you begin earning.
1. What are mineral rights taxes?
Mineral rights taxes are any and all of those taxes that will be assessed to you as the owner of mineral rights.
Income (state and federal), severance, and ad valorem taxes are some of the types of taxes that you might need to pay depending on the actions you take and the income that your mineral rights produce.
We’ll cover the differences between those in the next section.
2. What are the different types of mineral taxes you may need to pay?
Income (state and federal)
When you own mineral resources, you can lease out your land to any private industry or government agency that is interested in extracting the resources from the land.
As part of the lease agreement, you can request a certain percentage of the profits from any minerals extracted (the royalties).
The income you earn from mineral royalties is subject to federal income taxes.
Mineral, oil and gas royalties are treated as ordinary income and are taxed at your marginal tax rate.
Some states also charge income taxes on mineral royalty earnings too.
Income tax rates vary wildly from state to state with some charging a progressive tax like the federal tax structure.
Others choose to charge a flat rate while some have no income tax at all.
Ad valorem is Latin for “according to the value.”
The amount of the tax is based on the assessed value of a property or item.
Real estate property tax is a common example of ad valorem tax.
When you buy a home or land, the real estate’s assessed value determines the taxes that you pay.
For example, if you own a home that’s worth $100,000, then you’ll pay fewer taxes than if your home was worth $200,000 if the tax rate is the same.
Thirty-four states collect a severance tax on oil and gas extraction.
These are taxes owed when minerals are extracted.
They are often a significant source of revenue for each state.
For example, in 2017, 22 percent of North Dakota’s revenue and 8 percent of Wyoming’s revenue came from severance taxes.
Severance tax rates vary based on the state and the extracted material.
For example, in Wyoming, the severance tax rate for minerals such as limestone, jade, or clay is 2 percent while natural gas or oil is 6 percent.
3. What are the tax implications of selling mineral rights?
When you sell your mineral rights, it’s a different tax situation than earning a royalty.
This is because the IRS views the profits from the sale of mineral rights as a capital gain…not as income.
Capital gains are taxed at a different rate from income, but, just as with income taxes, capital gains tax rates vary based on income level (as follows):
Earn less than $80,000: capital gains rate is 0%
Earn between $80,000 and $441,450 (or $496,600 is married): capital gains rate is 15%
Earn more than $441,451 each year: capital gain rate is 20%
To calculate how much you will owe when you decide to sell your mineral rights, you multiple your capital tax rate by the difference between the sales price and your cost basis.
4. How do you determine your cost basis?
The cost basis in real estate is usually the original price or value of the asset (mineral rights).
However, with mineral rights, your basis is dependent on how you acquired the rights.
We’ll split up our explanation based on whether you purchased or inherited your mineral rights below.
According to the IRS, you’ll have no cost basis unless one of the following conditions exists.
- Seller’s cost included a stipulated amount for mineral rights
- Seller’s basis was the result of an estate tax valuation in which minerals and surface were valued separately
- Seller’s cost basis can be properly allocated between surface and minerals because of substantial evidence of value attributable to the minerals at the date of acquisition
In most cases, if mineral rights were acquired through the purchase of land or a home, then you’ll have a $0 basis in the mineral rights.
But this is not necessarily the case if you inherit mineral rights.
Most mineral owners have inherited their rights, which means you may have a stepped up cost basis.
In short, your tax basis in the mineral rights will be its value at the time when you acquired the rights through inheritance.
Unfortunately, many mineral owners aren’t sure of the value of their inherited mineral rights.
Unless you immediately sold the rights after you inherited them, it can be difficult to know the value of the rights.
Additionally, the IRS has not provided any guidance on how to value mineral rights when inherited in their oil and gas handbook.
However, you do have a couple of options if you’re in this position.
You can either talk to an experienced lawyer, hire a professional mineral rights appraiser or look at the inflation-adjusted average price of oil in the year acquired versus the year you sold.
5. Should you sell your mineral rights?
When it comes to mineral rights, conventional wisdom says to never sell.
Owning mineral rights costs you nothing because there are no liability rights.
In most cases, taxes are assessed only on properties that are actively producing oil or gas.
And mineral rights are almost always worth more tomorrow than they are today.
So, if you’ve received an unsolicited offer to purchase your mineral rights, it can safely be assumed that the true value of your rights is greater than the amount offered.
Otherwise, why would the party be interested in the first place?
That said, there are reasons why people choose to sell.
Here are some of the most common:
To pursue other opportunities
To eliminate the administrative hassle
To make estate planning easier
To simplify the division of assets in a divorce
To eliminate erratic royalty income
To diversify assets, reduce risk, and increase liquidity
To reduce family tensions
6. How do you maximize value when selling mineral rights?
If you want to maximize the value of your mineral rights, then competition is key.
You want buyers to compete to pay you the highest price.
Most mineral rights owners falsely believe that they can simply contact a few buyers and find a fair price.
Unfortunately, this may not happen.
You won’t always be able to reach enough buyers to sell for the maximum price.
This is because every buyer evaluates mineral rights differently.
So, to get the true value of your mineral rights, you’ll want to create competition.
Sites like US Mineral Exchange try to facilitate this.
Alternatively, a broker who specializes in mineral rights should know how to get you the best deal possible.
7. What is Section 1031?
Not all landowners are single plot owners, and high-volume investment is common in the mineral resource industry.
In this scenario, owners should refer to the IRC Section 1031.
Section 1031 is a tax deferment program that provides for the tax-free disposition of property as long as it is bought or sold within a 45-day window.
It includes oil and gas land as well.
When you defer capital gains tax in this manner, you sell your mineral rights and then use the income from that sale to buy another piece of real estate under the 1031 “umbrella.”
Because this process is complicated, we recommend working with a tax expert who has some experience in these applications.
8. How do you report oil and gas royalties on a tax return?
After you’ve dug a well and your land begins to produce minerals in either oil or gas form, you’ll start to receive royalty payments.
As mentioned above, you’ll need to report these on your taxes.
Keep in mind that you can reduce these taxes by claiming land lease costs.
Land lease costs may include:
General ownership cost
9. What is depletion?
Depletion refers to the amount of mineral reserves that are used up through the extraction process over time.
When depletion occurs, less oil or gas is available to extract.
Recognizing this, the IRS allows you to deduct depletion from your income taxes.
Depletion is calculated using either the cost or percentage method.
Alternatively, the cost method allows you to write off a portion of the acquisition price based on the fraction of resources extracted.
You should consult an accountant or tax lawyer who is experienced in oil and gas taxation to determine the best method for your specific circumstances.
10. When could the lease or sale of mineral rights generate additional tax consequences?
Charitable giving: If you gift your income from mineral rights leases and royalties to charity, then that gift can be tax-deductible.
Multiple oil and gas contracts: Owning more than one property where you lease the mineral rights and receive royalties could have tax complications.
We recommend looking into S-corporations or Limited Liability Companies for your leasing operations.
Both types of business entities provide personal liability protection and tax breaks.
Selling mineral rights: If you chose to sell your mineral rights, then you may increase the probability of a tax audit.
Taxpayers filing a Schedule C tend to be flagged for further review more often than other taxpayers.
If you report a significant income stream from ongoing royalty payments, then you could be at an increased risk of audit.
There’s a lot of money that can be made by leasing your land to interested parties to mine and exploit.
However, you’ll still need to pay mineral rights taxes, and it’s important to have everything aligned.
If you’re unsure of how to handle this process, search for an expert with insights and knowledge on the mineral management process.
Additional ResourcesIf you are looking to buy affordable land, you can check out our Listings page. And before you buy land, make sure you check out Gokce Land Due Diligence Program. If you are looking to sell land, visit our page on how to Sell Your Land.
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Disclaimer: we are not lawyers, accountants or financial advisors and the information in this article is for informational purposes only. This article is based on our own research and experience and we do our best to keep it accurate and up-to-date, but it may contain errors. Please be sure to consult a legal or financial professional before making any investment decisions.