With tax season upon us, mineral and royalty owners face the daunting task of filing for their oil and gas revenue streams. Adding to the unique complexities are the different tax implications and deductions at the federal, state and local level. Anyone who has filed taxes for oil and gas income knows of the most common taxes (e.g., severance tax) and deductions (e.g., depletion deduction), but even the most veteran interest owners may be unaware of some of the lesser-known rules and nuances that can potentially minimize your tax burden.
Whether you’re an individual mineral owner, fund or institutional investor, read on for expert insights that will help you better navigate your taxes and avoid overpayments.
1. Capital gains tax
Your mineral and royalty revenue streams are treated as ordinary income by the IRS, taxed at your appropriate bracket. But depending on how you acquired your mineral and royalty interests, you could be subject to capital gains if you sell assets.
An exemption from capital gains can be claimed if you acquired interest by providing a service (e.g., a geologist or landman). In these cases, the oil and gas income is still subject to income tax. If this situation applies to you, be sure to check with a CPA to ensure the correct elections within the required time period are made (normally 30 days after acquiring) to minimize your tax burden.
2. Estate planning
In addition to your personal tax implications, mineral and royalty owners should consider the tax implications for those who inherit or are gifted oil and gas interests. This includes giving some thought to the value of your minerals and royalties for estate planning purposes and understanding at what point they become subject to the federal estate tax.
In previous decades, the so called “gift tax” was a practical concern for many taxpayers with a lifetime exemption for individuals of $1 million in 2003. Today it’s more of a theoretical concern as the lifetime exception is now $12.92 million. Even so, fair market value (based on expected future income) for the minerals asset class can still add up quickly for some interest owners, potentially exceeding their lifetime exemption and exposing their estate to the hefty gift tax. This underscores the critical need to accurately assess fair market value independent of offer letters or property tax appraisals.
Whether you are selling, passing on through an estate plan or gifting, there are important income tax implications that require you or the person receiving oil and gas interests to accurately calculate basis to determine gain on the disposition of assets.
3. Lease level reporting
Mineral and royalty revenue streams often combine income from multiple operating companies and leases. However, the IRS requires your income from oil and gas assets to be reported at the lease level. While 1099s may suffice for smaller interest owners with income from a single lease, reporting on an operator-by-operator basis can have important tax implications.
Calculating oil and gas revenue over many operators and tracts has historically been a nightmare but technology has greatly simplified the task. Enverus’ mineral management platform MineralSoft automates the reporting and helps you stay compliant with quarterly or semi-annual tax payments by accurately estimating taxes based on your historical production numbers.
4. Cost depletion vs. statutory deduction
The depletion deduction is intended to recognize that the extraction of natural resources reduces the value of the asset and that the owner should be able to recover some of that loss through tax deductions. Oil and gas interest owners typically take the statutory deduction of 15%. What is less commonly understood is that taxpayers can claim the cost depletion if it is higher than the statutory percentage, like taking an itemized instead of standard deduction.
Simple in concept yet complex to calculate, cost depletion is the previous year’s oil and gas production divided by the remaining reserves considering individual components (oil, gas, NGL). This is then applied to the current year’s cost basis. This is a difficult calculation for a single lease, so larger portfolios are even more complex.
MineralSoft and EnergyLink can help you get to the numbers you need to file on a cost basis instead of statutory. Because most minerals-based businesses and funds typically choose accelerated bonus depreciation in year one to maximize their tax deductions upfront and optimize return on capital deployed for other acquisitions, cost depletion is not an option. However, if you have opted to take the 10-year depreciation, you may consider speaking to a tax professional about amending deductions for previous year tax returns if you have always taken the statutory depletion deduction.
Check out the workflow video below to learn how MineralSoft and EnergyLink can help you calculate cost depletion.
5. Severance tax
Depending on how you own your mineral and royalty interests (e.g., limited family partnership, LLC, S corp), you could be subject to franchise taxes in the states where you own assets. Regardless of whether you hold your oil and gas interests as an individual or in a business entity, everyone must pay severance tax in most producing states. For example, Texas has a 4.6% tax on crude oil income, one of the lowest rates in the country, and a 7% tax on natural gas. Pennsylvania, on the other hand, is one of the largest producing states without a severance tax, but does collect an impact fee called the Unconventional Well Fee.
When it comes to paying your severance taxes, know exactly what the rates are for crude oil, natural gas, and condensate/NGL, which vary widely from state to state. Some with variable rates that change each year (e.g., North Dokota is 5% for oil with a variable rate for natural gas).
6. Property tax
Most mineral owners understand that they need to pay property taxes on their producing assets. Texas, for example, views minerals as real property appraised at the lease level with value assigned to each interest owner. The Texas ad valorem property tax is based on a projection of future (not historical) income using discounted cash flow analysis. Every state has their own unique methods for arriving at the fair market value you are taxed on.
The key is fair market value and the calculations that go into it are often unclear. Just like the appraisal of your home by a tax assessor collector, you don’t want to overpay if your minerals are over-appraised. Know protesting taxes is worth it based on your assets and when to turn to technology or experts for production forecasts and reserves analysis.
Let’s get ready to file
For many mineral and royalty owners, what’s important may not be whether they are personally familiar with all the federal, state and local tax nuances, but rather that their CPA or advisor be familiar with oil and gas accounting best practices. This is often the case when mineral or royalty interests are passed on to family members in non-producing areas of the country where CPAs are less likely to understand the nuances of oil and gas taxes and deductions.
For funds and institutional investors, a clear view of taxes and deductions is critical for your overall economic analysis for acquisitions and cash flow forecasts. In the digital oilfield, technology is increasingly vital to success, from analyzing historical production for estimating future PDP and PUD returns to automating tax preparation to accurately file and claim deductions.
Tax season doesn’t have to be dreadfully complicated. Tools like Enverus MineralSoft and EnergyLink make managing mineral portfolios easier than ever before. Our comprehensive platforms expedites the entire mineral management process, including acquisitions and portfolio management with on-demand expertise during tax season and throughout the year.
Are you a mineral or royalty manager that needs help collecting data on your minerals for tax season? Fill out the form below to speak with an Enverus expert and see how our solutions can help.