It’s important to understand step-up basis for inherited mineral rights.
The decision to sell mineral rights or hold onto them may come down to your step-up basis.
The reason step-up basis is important for inherited mineral rights is that it determines how much you will owe in taxes. When you inherit mineral rights in Texas, you get a step-up basis.
How does step-up basis work for mineral rights?
A step-up basis means that you get to use the market value of the mineral rights when you inherited them as your basis.
Wait, what is a basis? A basis for tax purposes is how much you paid for the mineral rights. Wait a second, I didn’t pay for them. Correct. That is what step-up basis is. It lets you take the market value at the time of inheritance and treats it as if you had purchased the property for that price. This is where the tax benefit comes in.
Let’s imagine you bought a house for $500,000. Your basis in the house is $500,000 because that is what you paid for it. If you sold it for $600,000, you would only pay taxes on the gain of $100,000 (sales price – basis = taxable amount).
Let’s imagine your uncle purchased a home for $250,000. When they passed away, that home was worth $500,000 and you inherited the home. Even though you didn’t pay anything for the home, the step-up basis tax rule allows you to have a basis of $500,000 in the home (market value when inherited).
It works the same way in mineral rights. Regardless of what the family member paid for the mineral rights, your step-up basis in mineral rights is the market value at the time you inherit them.
How to determine market value when inherited?
As we have discussed, it is impossible to know mineral rights value until you sell. If it’s impossible to know the value until you sell, how can you determine the market value when you inherited? By working backwards.
The only way to determine the step-up basis of inherited mineral rights is at the time of the sale. Once you have a current market sales price, you can use the inflation adjusted price of oil to determine your basis.
Visit Inflationdata.com to view the inflation adjusted price of oil.
How does that work exactly? Let’s look at an example.
Example of step-up basis for inherited mineral rights
Let’s assume that you inherited mineral rights in 2018. Looking at inflationdata.com, we see that the inflation adjusted price of oil was $63.10 in 2018. Let’s assume that the price of oil when you sold was $80. Let’s also assume that the sales price is $1,000,000.
To determine your step-up basis, we use the sales price, current price of oil ($80/barrel), and inflation adjusted price of oil in 2018 ($63.10).
$1,000,000 sales price
X 78.875% (63.10 / 80)
= $788,750 your basis
$1,000,000 (sales price) – $788,750 (basis) = $211,250 (amount you owe taxes on)
Let’s assume a 20% capital gains tax rate. This means you would owe taxes on 20% of $211,250 or $42,250 in taxes. That sounds like a lot in taxes, but this is actually just 4.2% of the total sales price of $1,000,000.
Note: Inflationdata.com is always updating the inflation adjusted column, so the numbers may not match up perfectly.
Disclaimer: Speak with a CPA
We highly recommend speaking to your CPA. The IRS has given no official guidance on how tax basis for mineral rights should work. We believe that looking at the inflation adjusted price of oil at the time of sale is the most accurate way possible, but it is ultimately up to your CPA to determine the correct way to handle step-up basis for mineral rights.