Among the readership of this magazine are numerous oil and gas royalty owners. The April filing date for individuals will soon be upon us. In this article, we are going to discuss practical income tax considerations of owning royalty interest in oil and gas. This article will not be an in-depth discussion of all issues involved in oil and gas taxation. The difference in individual situations necessitates individualized professional advice. The goal of this article is to make you aware of some of the issues that might be involved in filing an individual tax return with oil and gas royalties, so you can seek advice.
The two major types of interest for tax purposes are royalty and working interest. This article concentrates on royalty interest. Royalty interests generally are derived through land ownership. However, as time passes, surface rights are separated from mineral rights. Many times in Texas there are far more royalty owners on a tract than there are surface owners. The major methods through which royalty ownership is obtained are through land ownership, inheritance, gift or purchase. You will have a basis in your royalty depending on when and how it was acquired. With land, it would be an allocation of purchase price (or basis) based on the relative value of the royalty and surface interests. Inherited property would be based on the value at the date of death of the person you inherited it from. Purchase price would be the basis when you buy a royalty. In my experience, many small royalty owners never determine what their royalty basis is. This can be costly. When you sell or give away your royalty interest, then knowledge of your basis is important.
Let us talk about depletion. There are two types: cost depletion and percentage or statutory depletion. Cost depletion is a simple mathematical computation (once you figure out what your reserves are). You take your lease basis and divide it by the petroleum reserves, which give you a cost factor for production, which you multiply by annual production. Percentage depletion is figured by taking a percentage of gross income from the property, currently 15%. At one time, it was 27 ½%, then it was lowered to 22%. The producer may deduct the higher of cost or percentage depletion. Percentage depletion as well as cost depletion lowers the producer’s basis in the producing leasehold. Unlike cost depletion, which ends when basis gets to zero, percentage depletion continues as long as there is production from the property, but the basis is not reduced below zero.
Many enemies of the petroleum industry complain mightily about percentage depletion and how unfair it is to give petroleum producers an off-the-top 15% deduction from income. However, there are two provisions that limit the value of percentage depletion deduction to the taxable income from each property and the taxpayer’s total percentage depletion deduction cannot exceed 65% of the taxpayer’s taxable income computed before percentage depletion, certain carrybacks and Section 199A deduction. The first provision would generally not affect a royalty owner. The second provision could, in some cases, affect a royalty owner. However, when discussing the fairness of percentage depletion, let us not forget we are talking about a depleting asset here. The value of the property is reduced by each barrel of oil or MCF of natural gas produced.
Royalty income for individuals is reported on page 1 of schedule E. Report the gross income reported on your 1099’s (assuming your 1099’s are correct); otherwise, you might get a matching letter from the IRS. Deduct your production taxes and gathering, transportation and other charges. Remember you compute percentage depletion on gross income. Especially with gas wells, the check stub difference between net and gross can at times be substantial. Also don’t forget your ad valorem or property taxes on the production. If it’s a tax on the value of your oil and gas well, it belongs as a deduction on schedule E not schedule A.
Among other types of transactions that are common to royalty owners are lease bonuses, delay rentals, damages and shooting or seismic rights. Most of these items qualify as ordinary income items. However, landowners may receive damages, and these could be in large enough amounts that it would be beneficial to consult with an expert to determine what part of those damage payments are ordinary income, offset to repairs against property, i.e., fence or road repairs or a return of capital or possibly a capital gain. In future columns, we may examine the far more complex tax world of oil and gas working interest. Please remember this generalized information needs to be reviewed under the prism of your specific situation and by a competent professional who can apply the tax code to your circumstances.
About the author: David Porter has served as a Railroad Commissioner (2011–17) and Chairman (2015–16), as well as Vice Chairman of the Interstate Oil and Gas Compact Commission (2016). Prior to service on the Commission, Porter spent 30 years in Midland, Texas, as a CPA working with oil and gas producers, service companies and royalty owners. Since leaving the Commission, Porter works as a consultant for oil and gas companies. He also serves as Chairman of the 98th Meridian Foundation, a nonprofit concerned with water, energy and land issues.