Tax season can be daunting for everyone, but for mineral and royalty owners, the complexity is even greater.
Whether you’re an individual collecting mailbox money or managing multiple royalty streams, navigating the intricacies of tax filings is crucial to maximizing your savings. The challenge lies in timely filing with the IRS while ensuring you’ve made every qualifying deduction to minimize your tax liability and avoid overpaying Uncle Sam.
While mineral and royalty owners may be familiar with some of the most common types of
deductions – like the depletion allowance, property taxes or intangible drilling costs – we’ve compiled five mineral taxation strategies that provide additional money-saving insights and deductions you may not have benefited from. If you’ve missed taking a deduction on this list in previous years, it could be worth talking with a tax professional about amending your prior tax returns to get a refund.
From Depletion Allowance to Intangible Drilling Costs – Top Mineral Rights Taxation Tips to Save Oil and Gas Investors Money
1. Verifying Income Reported on a 1099
Accounting mistakes are inevitable in a complex and fast-paced business such as oil and gas production and often compound over time. Underpayments from operators who intend to honor their obligations to interest owners can occur for many reasons, such as rounding errors on your interest decimal or incorrect commodity pricing used to calculate revenue. Or mineral and royalty owners might be charged with an improper deduction or fail to be paid on a well they did not know had been drilled.
For oil and gas interest owners with multiple revenue streams, ensuring the accuracy of what operators report on 1099s begins with ongoing due diligence and audits throughout the year. Many of the puzzle pieces needed to create a clear picture can be found in public data sources where drilling permits and production volumes reported to the state by operators are freely available. Then, compare what operators report on monthly revenue statements with 1099 forms.
Though finding and fixing underpayments is daunting, technology can simplify and accelerate the process by accessing bulk downloads and automatically verifying pricing, decimals and wells. You should be paid to leverage web-based solutions and check stub data exchanges. That’s where purpose-built mineral management tools like MineralSoft® and EnergyLink® from Enverus can assist in managing your assets, resolving operator underpayments and curing your yearly tax return headache.
2. Reducing Taxable Income With the Depletion Allowance
Oil and gas investments not only generate steady revenue streams for interest owners, but this asset class also benefits from a substantial federal income tax deduction that recognizes the underlying resource is depleting over time, causing reduction in the asset’s value. The depletion allowance enables mineral and royalty owners to take a 15% deduction on the lesser two options of either 100% of their royalty revenue without the depletion deduction or 65% of all income sources without the depletion allowance applied.
One advantage of the 15% depletion allowance is that it allows a mineral and royalty owner to capitalize more than 100% of the cost of their investment. Interest owners may be rewarded with a significantly higher deduction if they are willing to take extra steps to calculate the actual cost of their investment to be depleted instead of using the one-size-fits-all 15% per year deduction. Royalty owners can take the cost depletion if it exceeds the 15% depletion allowance. However, the calculations require a nuanced understanding of the remaining reserves.
Unlike the 15% depletion allowance, the cost deduction can never exceed 100% of the initial investment over the life of the well. In either case, only royalty income can be used with the depletion allowance, which excludes lease bonuses. Again, technology and purpose-built mineral management solutions can significantly simplify and automate the accounting required to perform cost depletion calculations.
3. Avoid Capital Gains Tax With a 1031 Exchange
Unless you have sold mineral or royalty interests within the last 45 days, keep the IRS section 1031, like-kind exchange, in mind for next year’s tax return. The 1031 exchange is a powerful tool to avoid hefty capital gains tax on your sale by investing the entire proceeds into another asset, deferring tax until the new asset is sold. Of course, owners can continue to kick the capital gains down the road with another 1031 exchange each time they sell a qualifying asset.
The IRS views mineral and royalty interests like real estate, which enables asset sellers to reinvest into homes, investment property, land and other mineral or royalty investments. Be sure to follow the rules carefully, which include identifying the replacement property in writing within 45 days, placing proceeds in escrow, and closing on the new investment within 180 days.
4. Fair Market Value for Property Taxes
Most states view your mineral and royalty interest just like real estate, appraise its value, and charge an ad valorem tax (i.e., property tax). Just like you might consider protesting a steep increase to your home’s value and property tax liability by a tax assessor-collector, oil and gas interest owners should understand their asset’s fair market value to challenge property tax increases when necessary. In turn, you’ll avoid overpaying property taxes and then deduct the expense on your annual federal income return.
The appraised fair market value of minerals and royalties is calculated differently from state to state (e.g., Texas uses discounted cash flow analysis based on future production forecasts, not past performance).
Individual mineral and royalty owners can turn to an oil and gas consultant for a third-party estimate of their assets, or leverage web-based services, such as Texas Mineral Appraisals from Enverus, for defensible, trusted data that you can submit to your appraisal district as part of a property tax protest. For mineral funds and more prominent royalty owners with a deeper level of oil and gas experience, turn to Enverus PRISM® and Forecast Studio to create your own forecasts to avoid overpaying property tax. You can also create go-forward portfolio strategies, acquisitions and cash flow.
5. Intangible Drilling Costs – A Huge Deduction for Working Interest
Drilling a well is one of the most tax advantaged types of investment, incentivizing oil and gas development with several major deductions and exemptions. For those who hold a working interest in a well, 100% of the Tangible drilling costs can be deducted over a 7-year depreciation period. Tangible drilling costs include all equipment required to construct the well, such as casing, cement and wellheads.
Ranging from 65% to 80% of a well’s price tag, intangible drilling costs account for the lion’s share of drilling and completing a well. Intangible drilling costs include labor, pad clearing, rig rental, hydraulic fracturing and consumables like drilling mud and frac fluids. Unlike tangible drilling costs, intangible drilling costs can be fully deducted on a single tax return.
There is no limit on these drilling cost deductions. And because intangible drilling costs are exempt from the Alternative Minimum Tax, the deduction can be taken even for the wealthiest investors and significantly offset their personal income.
Make Tax Season Easier—Watch Our Free Webinar
Want to dive deeper into smart tax strategies for mineral owners? Watch our on-demand webinar for practical tips on:
- Compiling revenue statements and 1099s the easy way
- Key deductions mineral owners often overlook
- Strategies to simplify tax prep and avoid costly mistakes
- Automating data collection with solutions like EnergyLink®
- Property tax best practices to protect your assets
👉 Watch the webinar replay now.
