Federal Income Taxation on Oil & Gas Royalties

When you allow an oil and gas company to extract resources from your property, your compensation often includes two elements. First, you may receive lease bonus payments, which are paid at the time of the lease's signing and often correspond to the amount of land used. Second, you'll get regular royalties that give you a cut of the revenue earned from your oil and gas extracted from your property. You'll pay federal income tax on oil and gas royalties and lease bonuses, but you aren't held responsible for self-employment taxes like you would be if you ran an oil and gas business.

When it comes to federal income tax on oil and gas royalties and lease bonus payments, you can expect to add that income to the wages you receive from other sources like jobs and self-employment and pay the regular marginal tax rate for that total income, minus any deductions. As of 2019, the tax rates are 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent and 37 percent, and the bracket you fall in will depend on your filing status and total taxable income. So, if you're married filing jointly and end up with a taxable income of $100,000 (including oil and gas royalty and lease bonus income) for the 2019 tax year, you'd find yourself in the 22 percent tax bracket.

On top of your federal income taxes, you'll usually also have to pay state income taxes on your oil and gas royalty and lease bonus income, unless you live in a state like Wyoming that has no state income tax. Your city may also charge local income taxes. It's helpful to consult with a tax professional to learn how your locale treats this income so that you properly save money for your taxes.

Each time you have oil and gas extracted from your property, your natural resources get depleted, leaving less to extract and earn royalties on in the future. The IRS allows you to compensate for this loss through the depletion deduction, which is 15 percent as of 2019. This means that you can subtract 15 percent from your oil and gas royalty income and only pay taxes on the remainder. So, if you earned $10,000 in oil and gas royalties for the tax year, you get a depletion deduction of $1,500, leaving you with a taxable royalty income of $8,500.

The IRS also lets you deduct common expenses you incur as part of the terms of your lease. For example, the oil and gas company may require that you help pay part of the cost of transporting the minerals and that you pay some processing and marketing fees. You can subtract these expenses from your royalty income to get a lower taxable figure.

You'll take both the depletion and related expense deductions on IRS Schedule E under the "Expenses" section.

If you estimate that you'll have to pay at least $1,000 in taxes on your oil and gas royalty income, it's a good idea to make estimated tax payments to the IRS. This is because the oil and gas company you have a lease with usually doesn't take the taxes out of the royalties they pay you. You can easily make your estimated payments through the Electronic Federal Tax Payment System website. If you don't pay enough estimated taxes, you may be hit with an underpayment penalty that adds to your tax burden.

In January of the following year, the lessee will usually send you IRS Form 1099-MISC, which will show your total royalty payments along with any extras like lease bonus payments you received. You can find lease bonus payments in Box 1, Rents, and your royalties in Box 2, Royalties. However, even if you don't get this document, you still must report the income and pay income tax on oil and gas royalties and other related payments received.

You'll list your lease bonus payments and oil and gas royalty income under the "Income" section of Schedule E's Part 1. Your related income after deducting expenses will transfer to Line 17 of Schedule 1 and then be added to your total income on Line 6 of IRS Form 1040.