The fourth installment in our “Hold v. Sell” series discusses tax implications of holding v. selling minerals. The full series is available here.
Introduction
“I’m never selling my minerals. Period. Full Stop.” I believe people who hold this rigid belief are doing themselves a disservice. This advice often comes from a well-intentioned friend or relative and subsequently becomes gospel, never given further consideration. But to take this view without ever considering the pros and cons of selling versus holding is, to be blunt, lazy. It is easier to say “I’m never selling” and move on with your life. Mineral rights can be very valuable assets, so you owe it to yourself to hunker down, do the research, and determine for yourself what the right decision is. Everyone’s situation is unique. A mineral sale does not always make sense, just like holding does not always make sense. We live and operate in a world that is colored by shades of gray, not black-and-white.
My aim with this series is not to convince owners that they should sell or hold, rather it’s to provide the ammunition for informed decisions. I’ll present information from the perspective of both a mineral owner and buyer. An informed mineral owner is a powerful one.
Building directly off of the last installment in this series, this article focuses on the tax implications of of holding versus selling minerals. We will further discuss how taxes play into the “Sell the Minerals, Buy the Oil” strategy we have been fleshing out throughout this series.
Death and Taxes
Ordinary Income
Taxes. Gross. I think this accurately sums up 99.999% of peoples’ feelings on the topic.
As any mineral owner that receive royalties can attest, they are taxed…heavily. To the tune of nearly 50% in some cases. Because royalties are taxes as ordinary income, they are subject to three separate taxes: Severance, Federal Income and State Income (if relevant).
Severance tax is imposed by states on the extraction of all non-renewable resources. The rate and calculation method vary by state, but is about 5% on average. This is normally taken directly out of royalty checks by the operator.
If you live in a state that does not have state income taxes, consider yourself lucky. Otherwise, royalties are taxed at the state’s ordinary income tax rate, which varies, but on average is 3-5%.
Federal income taxes take by far the biggest bite. Currently, the highest ordinary income federal tax bracket is 37%. If you have sufficiently high income, you may be losing over 47% of your royalties to taxes when taking all three taxes into account. Ouch.
Capital Gains
There is a silver lining, however. Mineral rights are classified as a capital investment. When minerals are held for more than one year, they are taxed at a much lower rate than ordinary income; the long-term capital gains tax rate. Currently, long-term capital gains rates are 0%, 15% or 20%, depending on income level.
It is important to note that the capital gains rate applies only to the gain portion of a sale. Gain on sale is calculated as (assuming owner is in the 15% bracket):
(Sale Price – Basis) x 15%
Basis is either what a mineral owner paid for minerals or their value upon inheritance, minus depletion. Depletion is the amount of oil that has been produced to-date out of the total amount a well is expected to produce. Depletion can be difficult to calculate. As such, the IRS allows owners to simply take 15% of their royalty revenue every year as depletion.
When oil prices are low, your sale price and basis are likely close to one another, meaning you’ll owe little or no taxes. Conversely, when prices are high, the difference usually widens and you’ll owe more taxes.
Mineral Sale: Long-Term Capital Gains Tax Calculation
Let’s assume the following: (1) A mineral owner has held the minerals for greater than 1 year. (2) She qualifies for 15% capital gains. (3) She has a basis of $25,000. (4) She sells her minerals for $40,000. Her tax liability is calculated as follows:
($40,000 – $25,000) x 15% = $2,250 taxes owed
The owners net proceeds from the sale are $37,750. This represents an effective tax rate of 5.625%. Compared to the 30-50% paid on monthly royalties, this represents a significant savings.
Sell & Invest in Oil
Employing the sell minerals/buy oil strategy fleshed out in the previous article offers further tax advantages. As a reminder, the basic strategy is as follows: Sell your minerals today and invest the proceeds into an oil-tracking ETF. (The last installment in this series discusses the mechanics more in-depth. If you are finding this article useful, I encourage you to read through the entire series. All of the installments are available here.) ETFs are stocks which, like minerals, qualify for long-term capital gain treatment if held for more than one year. With that, let’s build upon our previous example.
ETF/Stock Sale: Long-Term Capital Gains Tax Calculation
Let’s assume our owner takes her $37,750 of net proceeds and invests in the largest oil-tracking ETF, the United States Oil Fund (“USO”). She holds her USO investment for more than one year. With oil at historic lows of $16 per barrel (as of April 2020), the owner is confident that prices will rebound. As such, she wants direct exposure to oil prices instead of using her minerals as a proxy. As we learned in the second installment of this series, minerals carry with them significant inherent risks, which the owner wants to avoid. If oil prices return to near their pre-crash levels of $50 per barrel, the owner’s investment will be worth $94,375! Her tax calculation is the same as it was for the mineral sale:
($94,375 – $37,750) x 15% = $8,494 taxes owed
Ultimately, the owner’s after-tax proceeds are $85,881. In total, the owner only paid $10,743 in taxes to generate $85,881 of cash. If oil prices were to hit their pre-crash recent high of $70, her investment would be worth $112,306, after taxes.
Recap
- Royalties are heavily taxed. Severance, state ordinary income and federal ordinary income taxes eat away anywhere from 30-50% of royalty proceeds.
- The long-term capital gain tax rate is significantly lower than the ordinary income rate at 0%, 15% or 25%, depending on your income level.
- An owner that sells her minerals and invests in an oil-tracking ETF stock strategy benefits from the long-term capital gain rate on both her sale of minerals and sale of the ETF stock, assuming they are each held for greater than one year.
The next installment in this series discusses the implications our currently historically low oil prices have on oil production and what that means for mineral owners.
are state taxes imposed by where I’m a resident or by where the oil is produced?
Rmartinez – disclosure: even though I did study accountancy in college, I’m not an accountant. That said, you pay state income tax in the state you reside on all income you earn, regardless of where the income originated from. At the same time, most states assess income tax on income earned in their state, even if you are a non-resident of that state. So you pay taxes twice, right? No, because most states give a tax credit for the tax paid to another state. For example, if your resident state is Pennsylvania and you pay Georgia state income tax on the income earned from a private placement investment located in Georgia, Pennsylvania will give you a state tax credit for the taxes you paid in Georgia from that investment. This helps avoid double taxation at the state level. This article on realtymogul does a great job breaking it down and where I pulled the examples above from.