Taxes on Oil and Gas Royalties in Texas
Selling one’s mineral rights or royalty interests can eliminate the need to calculate and file the forms associated with depletion and property tax records. It may also alleviate the responsibility of maintaining careful records, complicated tax calculations, distribution of funds and K-1's related to the assets being sold.
The state of Texas collects property taxes on producing mineral interest. The amount collected is based upon the appraised value of the property. The County Appraisal Districts calculate the appraised value based upon the fair market value of the property. Appraisal notices are usually mailed beginning in May of every year. Some of the bigger counties may take longer to complete therefore the appraisals may not arrive until June or even July in some cases. Property taxes in Texas are mailed out in October and are due by the 30th of January. Again, with the bigger counties the statements may not be mailed until November. However, every county in Texas operates on the property tax schedule.
Tax statements can come from the County Tax Office, the County Appraisal District, Independent School Districts, Municipal Utility Districts, etc. Some counties designate one office to collect for all the taxing entities and other rely on two or more offices to collect for the taxing entities. This varies by county. Occasionally, if your property is close to the county line then a neighboring county or school district may also collect taxes on your property.
Texas, Kansas, Illinois, West Virginia and Arkansas all collect property taxes directly from the oil and gas royalty owner. Unlike Texas, Illinois, Arkansas and West Virginia send their taxes out during the summer months and are due in the fall but the schedule varies by state. In some instances, it also varies by county. It’s best to check the payment schedule with your county if you own oil and gas royalties or minerals in a state other than Texas.
Oklahoma, California, New Mexico and North Dakota collect property taxes from the well operators and then this is passed on to the royalty owner via a deduction from the royalty check. This deduction is the royalty or mineral owners prorated share of the property taxes and is listed as a state withholding tax on the royalty check.
Most states collect severance tax on oil and gas production. These taxes are based on either the value or volume of the production. The method by which severance taxes are calculated varies by state. Royalty and mineral owners will find that their prorated share of these taxes is deducted from their royalty checks. At times an operator may be granted a tax credit or lower tax rate in a situation where the amount of taxes due may be such a burden that a well would have to be plugged and abandoned. This may happen during periods of lower gas prices or low production. This lower tax rate would then be reflected in the amount deducted from the owner’s royalty check.
Oil and gas are depleting resources and the value declines based on the amount of production year over year. In a given field there is a finite amount of oil and gas available to be extracted and due to production this amount and, by extension, the value of the mineral interest lessens every year. Accordingly, the IRS allows for a tax deduction to be taken to account for this loss of value on oil and gas royalties.
Depletion is calculated in two ways: cost and percent depletion. Cost depletion is calculated based upon the original capital investment and the rate at which the minerals are being produced. Once the depletion allowance taken on a property matches the original capital investment the property is considered fully depleted. Percent depletion is calculated based upon the gross income for the year. The royalty or mineral owner can take the higher of cost or percent depletion as the allowance. Once the property is fully depleted the owner can no longer take cost depletion but can still use percent depletion. However, percent depletion can only be taken as long as the net income for the year is greater than zero.
There is a taxable income limit on the depletion allowance for oil and gas royalties. Your annual depletion deduction must be the smaller of the following: 100% of the taxable income from the property calculated without the depletion deduction or 65% of the taxable income from all sources calculated without the depletion deduction.
The 1031 Exchange allows the mineral owner the opportunity to defer capital gains taxes on the sale of oil and gas royalties or minerals. If the proceeds from the sale of minerals are put into another qualifying investment property or other minerals then it may be eligible for a 1031 Exchange. The property purchased must be of equal or greater value than the property sold. If the property purchased is of lesser value than the property sold then capital gains taxes must be paid on the difference.