A Minerals and Royalties Tax Primer

If you own property with known oil and gas reserves, and you have the mineral rights, you may receive “royalties” – the payments you receive from these resources. Such royalties depend on the number of units, such as barrels of oil, removed from your land. The company or individual leasing the land for extraction pays you the royalties, which are subject to federal, state and sometimes local tax.

LEASE BONUS PAYMENTS

You probably signed a lease with the company or person drilling for oil or gas on your property. That entity is known as the lessee. If you received a lease bonus payment prior to the drilling or extraction, this is reported as ordinary income on your federal tax return. Lease bonus payments are reported to property owners by the lessee on Form 1099 MISC, Box 1, under “Rents.” You must report your lease bonus payment on the first page of Schedule E, Supplemental Income and Loss. This payment is also included on Form 1040, line 17, but you don’t pay self-employment tax. If the lessee needs more time to begin drilling, you might receive a delay rental payment, which is also reported as ordinary income.

FEDERAL TAXES

Once a well produces oil or gas, you should start receiving royalty payments, and this continues as long as the well is productive, unless your lease includes other specifications. According to the Internal Revenue Service, royalties on oil and gas are taxed as ordinary income. You might need to make estimated quarterly tax payments to the IRS and your state if your royalties are significant. You can reduce the tax bite by using depletion, comparing your royalty income from other sources of ordinary income. As this is a fairly complicated formula, you might wish to contact a tax professional.

REPORTING ROYALTIES

You generally report your oil and gas royalties on Part I of Schedule E, Form 1040. According to the IRS, if you hold an operating oil, gas, or mineral interest that generates income — that is, income other than royalties — you should use Schedule C to report income and expenses.

SELLING THE PROPERTY

If you decide to sell your oil or gas-producing property, the money you receive is not considered royalties but simply the sale of real estate. If you sell some percentage of future production in the property, this money is considered as a loan from the buyer by the IRS. Do not include it as income for tax purposes. Once production starts, include all the payments as income, but deduct any production expenses. After figuring that amount, deduct depletion to figure the taxable income.