How is the Sale of Mineral Rights Taxed?
This is where things get more complicated.
This is also where you can make a lot more money if you understand how mineral rights taxes work.
If you have owned the mineral rights less than 1 year, you will be taxed at ordinary income tax rates. However, the vast majority of mineral owners have owned the mineral rights for more than 1 year. This means you will be taxed at capital gains tax rates.
Let’s look at an example:
Example 1: John has an offer to sell mineral rights for $300,000. If he sells the mineral rights, he will pay capital gains tax rates of 15% or $45,000 in taxes.
Example 2: John decided to collect royalty income rather than sell his mineral rights. John collected $300,000 over 10 years of royalty income. During that time, John was paying a 24% ordinary income tax rate. This means John paid $72,000 in taxes. More importantly, it took John 10 years to collect the same amount of money and he was paying more in taxes.
In the examples above, the decision to sell mineral rights could be heavily influenced by taxes. The mineral rights taxes John has to pay and the time he has to wait to collect royalty income could easily sway John to sell.
The example above is also the worst case scenario assuming that John received the mineral rights with his home purchase and has a $0 basis in the mineral rights.
Step-up Basis for Inherited Mineral Rights
In the example above, we ignored step-up basis for inherited mineral rights. Most mineral owners inherit mineral rights. This means you get to use the step-up basis tax advantage.
Your basis in the mineral rights is how much the mineral rights cost you. When you inherit mineral rights, obviously they don’t cost you anything. However, this special step-up basis tax rule allows you to treat inherited mineral rights as though your cost (basis) is the market value at the time of your inheritance.
What this means is that you only pay on the difference between the sales price and the market value when you inherited the mineral rights. This could mean you owe very little or $0 in taxes when you sell mineral rights.
The best way to figure out step-up basis is to work backwards to determine the market value when you inherited the mineral rights once you sell the mineral rights.
We do this by looking at the inflation adjusted price of oil. You simply look at the price oil when you sell and compare is to the inflation adjusted price of oil when you inherited.
Here is a picture of coffee to help you stay awake before we look at an example:
Example: Step-up Basis Calculation and Taxes Due
In this example, lets assume you sold mineral rights for $300,000 that you inherited in 2009. The current price of oil is $80/barrel. Looking at the table linked above, the inflation adjusted price of oil was $68.26 in 2009.
To determine the amount of taxes due, we first need to determine your basis. Your basis will be $68.26 (market value when inherited) / $80 (current price of oil) = 85.325%. This means that your basis is 85.325% of the total sales price.
$300,000 Sales Price
X 85.325% Basis Percentage
$255,975 Your basis (you do NOT owe tax on this amount)
$300,000 – $255,975 = $44,025 This is your gain and how much you owe taxes on.
Remember that you still get capital gains tax treatment on the sale, so you only owe 15% taxes on a $44,025 sale. This means you owe taxes of $6,603.75 ($44,025 X 15%).
John will pay $6,603.75 in taxes on a $300,000 sale, or just 2.2% in taxes due to step-up basis rules.
As you can see from the example above, understanding mineral rights taxes is important. Due to step-up basis, John is able to pay just a tiny fraction in taxes for the sale of his mineral rights. Compare pay $6,603 in taxes and getting paid $300,000 TODAY vs paying $72,000 in taxes and getting paid over 10 years.
If you inherited mineral rights it nearly always makes sense to sell mineral rights due to stepped up basis.
While there is no way to know for sure, step-up basis has been constantly in threat of being eliminated. This tax loop hole is a mineral owners best friend. If the step-up basis tax treatment goes away, mineral owners are going to lose out on millions of dollars in potential tax savings.
If you inherited mineral rights and you are thinking about selling mineral rights, reach out to us and get a free consultation. Find out how you can save thousands on taxes by selling your mineral rights.