An owner of undeveloped or partially developed land (who also owns the mineral rights to the property) is considering whether to lease mineral rights on the undeveloped property or to sell the rights. An E&P company or other lessee wants the right to explore, drill and/or develop any minerals discovered.
If the owner leases the rights, the owner will reserve a royalty interest. For example, the owner may retain one-eighth of the interest of the minerals produced in the form of a royalty (some royalties have been as high as 25 percent in recent years for valuable holdings). The lessee will usually agree to sweeten the deal with a cash payment, commonly referred to as a lease bonus.
The owner retains the title to the minerals. The lease bonus is taxed as ordinary income as are the royalty payments once production begins. Even though the transaction is called a lease, and the lessee has a cash outlay for the lease bonus, the lease bonus is non-deductible. The lessee recovers the lease bonus cost through depletion once the property begins production.
If the minerals are not developed during the term of the lease, the lease will expire and the owner contractually regains all mineral rights and has the right to negotiate a lease with another party. However, the lessee may request to extend the lease. The payment to extend the lease, commonly referred to as a delay rental is also taxed as ordinary income by the owner. The lessee must add the delay rental cost to the cost of the lease bonus, and recovers those costs through depletion once production begins.
In the event, the lease expires, the lessee is able to deduct any unrecovered lease bonus and delay rental costs in the year of expiration.
In the rare event that the owner decides to sell the mineral rights (e.g. original owner dies and new owner prefers immediate payment), the income on the sale is treated as capital gains.
Conclusion: Even though capital gains tax rates are generally lower than ordinary income tax rates, generally the mineral interest owner will choose to lease rather than sell because the upside of the royalty far outweighs the favorable tax treatment of capital gains.
To view other scenarios and learn more about this topic, visit: Oil & Gas Update: Tax Implications of Buying and Selling Mineral Rights
The oil and gas industry has experienced booms and busts of varying lengths since the dawn of mineral exploration. The current climate for O&G suggests continued consolidation, however forecasts by industry experts anticipate the boom may be back by 2018. For any owners or buyers of mineral interests, the market may be ripe for making deals now — with a careful eye toward the tax implications of buying and selling mineral rights. No two deals are alike, and it’s important to learn the potential tax impact and the types of taxes you may be paying.
Scott Allen, CPA, joined Cornwell Jackson as a Tax Partner in 2016, bringing his expertise in the Construction and Oil and Gas industries and 25 years of experience in the accounting field. As the Partner in Charge of the Tax practice at Cornwell Jackson, Scott provides proactive tax planning and tax compliance to all Cornwell Jackson tax clients. Contact him at Scott.Allen@cornwelljackson.com or 972-202-8032.