What you earn from oil and gas royalties is treated as investment income. It's roughly similar to what you'd earn from a business you own, rental property or bond portfolio. What makes oil and gas royalties unique is how you calculate your income. The Internal Revenue Service allows you to subtract expenses right off the top of your income, reducing your tax even if your deductions are otherwise limited.
Royalties are payments from oil and gas producers for the use of land that contains oil and gas reserves. They're roughly similar to leases since the drilling company is effectively leasing the right to the land and to what comes under it. To this end, the IRS treats them as real estate. However, instead of coming at a flat rate, royalty payments are usually tied to the amount of oil or gas taken out of the land -- much like how stores in many malls pay a percentage rent to the mall owner that is tied to their sales.
Allowed Royalty Expenses
The IRS allows you to deduct any expenses that you incur in owning your royalty. For many investors, the most valuable deduction is the depletion deduction. Over time, oil and gas wells run dry, so the IRS allows you to recover that loss of value by writing off a portion of your income every year. While you're allowed to calculate the actual depletion of your well based on its reserves and what was taken out, most royalty owners take a straight 15 percent depletion deduction right off the top of their gross income. In addition, you can write off your share of state property and production taxes and of the transportation and marketing costs for the fuel that comes from your royalty. Your accounting and legal expenses are also deductible.
Royalty Income Tax Reporting
Your royalty income and expenses get reported on Schedule E. Schedule E requires you to report your royalty income on line 4 and then subtract all of your expenses below. The only number that goes onto your 1040 return from Schedule E is your net profit or loss. This means that all of your deductions are taken before they can be reduced by deduction limitations or the Alternative Minimum Tax. Once you carry your income over to line 17 of your 1040 return, it's included with your regular income and is subject to regular income tax.
You can buy and sell royalties like any other capital asset. They're also subject to capital gains taxes if you sell for a profit. If you sell them for more than their depleted value -- which is your original cost less all of the depletion you claimed while you owned them -- that depletion gets recaptured at regular income tax rates. However, if you use the proceeds from the sale of your royalties to buy more royalties or other investment real estate, you can structure the transaction as a 1031 tax-deferred exchange and defer paying any capital gains or recapture taxes.
- All States 1031: 1031 Exchanges of Oil and Gas Interests
- Kaplan Stewart: Understanding Percentage Rent in Retail Leases
- Geology.com: Mineral Rights
- R. King and Co: Oil and Gas Royalty Income Taxes
- IRS: Schedule E (Form 1040)
- KPMG: Section 1254 Recapture
- Asset Preservation Incorporated: Oil and Gas Investments
- Medioimages/Photodisc/Photodisc/Getty Images