“I inherited my mineral rights. How are they taxed when I sell them?” This is common question many mineral rights owners have. The punchline is they receive very favorable tax treatment. The longer answer revolves around the concepts of capital gains and basis, which we explore below. **While I know the below to be true, I’m not a CPA. As such, you should always consult your accountant or tax advisor for tax-related questions.
Capital Gains
Mineral rights are a capital investment. Therefore, the capital gains tax rate applies to mineral sales. There are short-term and long-term capital gains rates. As long as you’ve owned minerals for more than one year, the minerals qualify for long-term capital gains tax. This is very important qualification. Long-term capital gains rates are 0%, 15% or 20%, depending on your income level. Compare those to the current (2020) ordinary income tax rates, which is the same as the short-term capital gain rates:
- 10% on income up to $9,875
- 12% on income over $9,875
- 22% on income over $40,125
- 24% on income over $85,525
- 32% on income over $163,300
- 35% on income over $207,350
- 37% on income over $518,400
Most owners end up in the 15% long-term capital gains bucket. This represents a significant savings compared to ordinary income rates.
Only the GAIN is Taxable
Capital gains tax applies only to the gain on sale. Gain is calculated as (assuming owner is in the 15% bracket):
(Sale Price – Basis) x 15%
The closer your sale price is to your basis, the less taxes you’ll owe. If your sales price is below your basis, you would actually receive a tax deduction.
Basis
Basis is the fair-market value of minerals upon inheritance, minus depletion taken. We’ll circle back to depletion below. Value at inheritance is the piece that usually trips most people up, and rightfully so. Very rarely (more like never) is there documentation establishing value at the time of inheritance. So how do you determine the fair-market value of minerals 10, 20, 30 year ago?
Minerals are not like houses, where you can review the publicly-available sales records. Instead, we need to try and place ourselves in the year of inheritance. Based on how the world looked at that time, we make reasonable assumptions to establish a fair-value. We need to consider things like the price of oil, potential number of wells drilled and the productiveness of those wells.
For example, let’s say you decide to sell in today’s market. Oil prices are at historic-lows of $10-$15 per barrel. At first blush, it may seem selling at this point in time is a bad idea, but there are serious potential tax-advantages in doing so. Let’s assume you inherited minerals in 1986 when oil was trading at an inflation-adjusted price of around $45 based on the chart below. You currently have an offer on the table for $50,000.
With oil prices today 1/3 of where they when you inherited them, is it more likely your minerals are worth more today than upon inheritance? I’d say definitely not. Even if today’s wells are 3x more productive than when you inherited (they aren’t – wells have just gotten a lot bigger, not necessarily more productive), that means the value of the oil is the same today as it was at inheritance because you are now getting 1/3 the dollars for each barrel.
Looking at the chart below, it’s hard to argue your minerals should have a higher basis now than any other point in history. As such, from a tax-efficiency perspective, a sale in today’s market makes a lot of sense.
Depletion
I mentioned above your basis is fair market value less 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. If your minerals have never produced, depletion is a non-factor. Even if your minerals have been producing, your offer price will factor that in (i.e. be lower), so your sale price will be closer to your basis even after taking depletion into account.
Takeaway
The important takeaway here is that if you sell your minerals in today’s market, you will almost certainly be in a very advantageous position from a tax-perspective. Even if you inherited minerals less than one year ago, you almost certainly wouldn’t owe taxes either since no one would argue minerals are worth more today at negative or $10 oil than they were at any point in the previous year. It is reasonable to assume you would end up owing little or not taxes on a mineral sale in the current environment. If you choose not to sell today and oil prices rebound, this changes the equation and you will likely owe more taxes.
There are some interesting ways savvy mineral owners can take advantage of this current environment.
