Almost every income increase in this country is taxable, and profits from mineral rights are no exception. So whether you receive cash from selling your mineral rights or income from the leasing agreements, understanding how material rights are taxed can help you make the best decisions for your financial investment health.
- Know how the federal, state, and county governments apply taxes to mineral rights
- Be familiar with the standards used to determine your tax liability
- Learn how to use certain mineral rights tax rules to increase your investing performance and outcomes
What You Should Know About Mineral Rights Taxes
For the most part, the mineral rights tax structure is very similar to the standard personal income and property tax structures. However, depending on the type of mineral rights income you receive, you may pay taxes through one or more of these tax systems.
- Regressive tax: levies a tax on a percentage of mineral rights income regardless of the purchaser’s income
- Proportional tax: also known as a flat tax with no regard for the owner’s income
- Progressive tax: assigns higher tax percentages to high-level earners
Through different levels of government, you may be responsible for four types of mineral rights taxes: capital gains, income, ad valorem, and severance. The income sub-categories are rental and regular income. Severance and ad valorem taxes exist on the state and local levels.
Mineral Rights and Capital Gains Tax
Typically, a profitable sale of your mineral rights results in a capital gains tax liability. In this category, the biggest difference-maker in determining the amount you owe is the cost basis factor or the original value of your mineral rights. Whether you obtained the mineral rights through inheritance, purchase, or settlement, finding the cost basis can be challenging.
The IRS generally assigns a zero-cost basis to owners’ mineral rights, meaning the rights had zero value at the time of the initial purchase. Valid exceptions to this designation are:
- The property purchase included a specific amount for mineral rights
- The real estate valuation has a separate appraisal for mineral rights in determining the seller basis
- There is strong evidence of the mineral’s value at acquisition
People who inherit mineral rights frequently get a “step-up” in their cost basis, resulting in a lower capital gains tax. The other variable in calculating estate tax is personal income. If your annual income is below $80,000, you are exempt from paying capital gains. Subsequently, a single person making between $80,000 to $441,500 pays the 15% rate, and anyone earning more than $441,500 enters the 20% pay rate.
With few exceptions, the IRS considers income from mineral rights sales, leasing, and royalties taxable as either capital gains or income. If you have owned your mineral rights for more than a year, the profit from the sale is subject to capital gains taxes. A mineral rights sale with less than one year of ownership usually requires you to pay regular income tax on the profit.
For example, a $340,000 mineral rights sale with a zero-cost basis will create a $51,000 capital gains tax bill for a seller in the 15% pay rate. On the other hand, the regular income tax bill for $340,000 is $89,151.75, or about 25% more than the capital gains rate. So, It pays to hold onto your mineral rights for at least a year.
Royalty earnings classify as regular income. However, the IRS classifies leasing income as rental income. This rule allows you to lower your tax burden by claiming leasing-related expenses like land surveying, legal fees, and title creation. Also, you must pay taxes on the leasing payments in the year you received them, whether mineral extraction takes place or not.
Deductions and Deferments
If you bought mineral rights strictly for mining purposes, you might qualify for a cost depletion deduction. To calculate this deduction, divide the initial mineral rights purchase cost by the estimated value of the minerals before extraction. Another federal tax deduction for high-volume investors is Section 1031. It allows you to defer taxes on capital gains if you purchase a like investment within a 45-day timeframe.
The manner in how mineral rights are taxed varies from state to state. Thirty-four states charge severance taxes on the extraction of non-renewable, natural resources like oil, gas, and uranium. Since the non-renewable natural resources will likely leave the state for consumption elsewhere, the landowner must pay the state for the loss of the resources and the expense of extraction.
Most states calculate the severance tax on a value or volume basis or a combination of the two. For example, Oklahoma’s severance tax uses a percentage of the gross value of the resource as a basis. The state charges five percent on the first 36 months of production before raising it to seven percent thereafter. The Oklahoma Tax Commission requires the first purchaser of the minerals to pay the gross production taxes that were withheld from the payment to the mineral rights owner. Also, Oklahoma non-residents with an Oklahoma-based gross income of $1,000 or more must file a state income tax.
Many counties levy ad valorem taxes on property owners with active mineral extraction activity on their land. This type of mineral rights tax uses the same fair market value assessment method as other property taxes, except it assesses minerals, oil, and gas on the property. Fair market value refers to the price a willing seller and a willing buyer would agree to pay under neutral conditions. Since supply and demand affect fair market value, ad valorem taxes tend to fluctuate.
Deductions or Exemptions
Some states encourage the use of horizontal drilling. For example, Oklahoma offers a “holiday” tax incentive that lowers the single gross tax rate from seven percent to two percent for the first three years of production. Other states, like Colorado, offer an exemption for low-producing oil and gas wells.
Although several states do not tax mineral production, you can count on paying a healthy severance tax in mineral-rich states like North Dakota and Wyoming. Also, you can deduct state severance and ad valorem taxes from your federal income taxes. For the ad valorem deduction, married couples can claim up to $10,000.
How Mineral Rights Taxes Relate to Money
Saving money on your mineral rights tax obligations is one of the best ways to maximize the return on your oil and gas investments. As you can see, there are several ways to avoid paying large sums of money to the IRS, such as knowing the difference between capital gains and regular income tax rules, the mineral tax selling timeframes, and available deductions.
Getting the biggest net returns on your oil investments is what Eckard Land and Acquisition is about. For this reason, we strongly encourage our investors to consult with their tax professionals to reach the best tax solution for them. To learn more about how investing in energy can impact your financial portfolio, visit our resource center.