*The following post is meant to be purely informational. It is not tax advice and should not be interpreted as such. Speak to a tax professional about your specific situation.
Your natural reaction when you hear the word “taxes” might be to either a) immediately fall asleep out of sheer boredom or b) throw up your fist and curse Uncle Sam for being so greedy. However, understanding the different ways your mineral rights can be taxed is a relatively simple concept, and it can save you a boatload of money in the long run.
Let’s start with what everyone already knows -- if you’re currently receiving royalty payments from production, those checks are taxed at your ordinary income rate (which is typically 22-35% depending on your tax bracket). Here are the ordinary income tax rates for 2022:
A huge advantage to selling minerals is the tax treatment. The IRS classifies the sale of mineral rights as a capital gain event, which is one of the most favorable tax treatments in the U.S. tax code. Not only is capital gains tax typically lower than ordinary income tax, the tax is only assessed on the GAIN in the value of the asset (or “profit”), not on the entire proceeds of a sale. Let’s dive a little deeper.
Capital gains tax is a federal tax on profits from the sale of an asset. Typically the sale of mineral rights qualifies as a "long-term" capital gains event. Long-term capital gains tax rates are 0%, 15% or 20% depending on your taxable income and filing status. Here are the capital gains tax rates for 2022:
*Be aware that your specific State may also have a capital gains tax. Consult your CPA.
As you can see, capital gains tax rates are generally lower than ordinary income tax rates. And as we mentioned above, the tax is only applied to the gain you recognize from a sale. This is where your “cost basis” comes into play, and becomes just as important as the tax rate.
Cost basis is the original value of an asset for tax purposes, usually the purchase price. It can also be the value of an asset at the time of inheritance. This value is used to determine the capital gain, which is equal to the difference between the asset's cost basis and the current market value (the price at which you've agreed to sell).
Here’s an example with some easy math -- Let’s say you inherited mineral rights from your grandmother two years ago, and you’ve decided to sell for $120,000. As you’re estimating your tax bill, you understand that the minerals weren’t “worthless” when you inherited them two years ago, therefore you should be able to use a “cost basis” to minimize your capital gains tax bill. Based on some research, you determine that these minerals were actually worth about $80,000 two years ago (this number becomes your cost basis). Therefore you shouldn’t pay capital gains tax on the entire $120,000 -- you should only pay tax on the $40,000 GAIN in the value of the asset while you owned it during those two years ($120,000 sale price - $80,000 cost basis = $40,000 gain). For the purposes of this exercise, let’s assume your long-term capital gains rate is 15%, therefore your tax burden on this sale would only be $6,000 ($40,000 gain x 15% tax rate = $6,000 owed) As you can see, the tax treatment on the sale of mineral rights can be very favorable -- in this case, you were only taxed on $40,000 of your $120,000 sale!
Now, on the flip side of the coin, let’s consider the impact of holding your mineral rights in hopes of one day making $120,000 in royalty payments. Let’s say you believe that in 10 years you’ll make that amount in royalties. That may be a perfectly reasonable decision for you, however, just make sure you understand these four financial principles and strategies before turning down a strong purchase offer.
“A bird in the hand is worth two in the bush.” - As the old proverb suggests, it's better to be content with what you have than to risk losing everything by seeking more. Said another way: A lump sum purchase offer is guaranteed today, while future royalty payments are not.
Time value of money (TVM) - This is the concept that money available at the present time is worth more than the identical sum in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. Furthermore, inflation all but guarantees that the buying power of a dollar today is much greater than it will be in the future. In summary: $120,000 today is worth far more than $120,000 10 years from now.
Tax treatment on royalty payments - Let’s fast forward and say you do make a total of $120,000 in royalties 10 years from now. Good for you! However, just know that in addition to the TVM sacrifice, you’ve likely paid more in taxes over time than you would have if you’d sold for $120,000 10 years ago (since royalty payments are taxed at your ordinary income rate). Furthermore, there is no “cost basis” for royalty payments, so you’ll have paid tax on every single dollar of that $120,000, not just on the gain in the value. All this to say -- not only will every dollar you earn be taxed, but it will likely be taxed at a higher rate than the capital gains rate.
Hedge your bets - If you're torn between holding or selling your mineral rights, don’t forget that there’s always a third option -- you could sell just a portion of your interest. Many folks find this to be the best of both worlds as you can cash out now on a portion, while continuing to earn royalties on the remaining interest. “Sell half, keep half” is a popular strategy, however, you can sell any percentage of your mineral rights. Perhaps you’d like to sell 75% and keep 25%. That’s perfectly fine too. This happy medium is a tried and true strategy to mitigate your risk in an unpredictable market.