Mineral rights refer to investing in the right to harvest materials -- frequently fossil fuels -- from a piece of land. When you invest in them, you get the right to get a piece of the profit that gets earned from selling those minerals. These investments are taxed differently from stocks, bonds or other ways of investing your money. The special tax treatment can save you money, but it can also come back as a higher tax bill when you sell.
The profit you make from mineral rights is taxable as regular income, generally at the same rates as what you make at work. This means you won't qualify for special tax treatment on the money you get when your minerals are extracted. However, you technically aren't taxed on your gross income. You're taxed on your profit, which means you can subtract expenses before the taxes are calculated.
Typically, oil and gas producers pay special taxes when they extract minerals from the ground. These taxes, called severance taxes, get passed through to you when you receive your royalty payments. Because you only declare profit to the IRS, you can deduct your severance taxes. You can also deduct any additional expenses that get passed through to you, such as transportation or processing charges. In addition, any expenses that you incur in owning the mineral rights may also be deductible.
A given mineral rights investment represents a finite amount of minerals to be extracted. The upshot of this is that, for example, once all of the oil has been pumped from a piece of ground, its mineral rights become worthless. The IRS allows you to claim an additional write-off every year, called depletion, to compensate you for this. The depletion allowance varies, depending on the type of mineral and the method you choose. As an example, as of 2013, you can deduct 15 percent of your oil and gas royalties' gross production as depletion. If your gross production of oil is $100,000, you'll only be taxed on $85,000 of it before subtracting any other expenses.
Tax on Sale
If you sell your mineral rights, you are subject to two different types of taxes. If you're able to sell for a profit, your gain will be subject to capital gains tax. However, if you are able to sell for more than your depleted value, which is the property's cost less the total of all of the depletion you claimed, the difference between the depleted value and the selling price, up to the cost, will be subject to a depletion recapture tax. That tax is levied at your standard tax rate.
For instance, if you buy mineral rights for $100,000, deplete them to $70,000 and sell them for $90,000, the $20,000 difference between your depleted value and your sale price would be subject to the recapture tax. If you sell for $115,000, you'd pay recapture tax on the $30,000 difference between your $70,000 depleted basis and your $100,000 cost and pay capital gains tax on the $15,000 difference between your $100,000 cost and your $115,000 selling price.
Instead of merely owning the rights to the income when someone else develops the land tied to your mineral rights, you can develop the land yourself. When you become an active partner, you take on more risk and expense because you or your money is directly involved in the work of drilling and developing the rights. Doing this allows you to write off more of your expenses and may even enable you to claim losses from the working interest against your other income.
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.