How to Invest in Royalty Income: What You Need to Know

Royalty income presents an opportunity for individuals to generate passive earnings from the use of various assets. This form of income involves payments made to an asset owner for allowing another party to utilize their property, intellectual creation, or resource. Investing in royalties can serve as a diversification strategy, offering a potential income stream that may operate differently from traditional stock or bond market fluctuations. Understanding the mechanics of these payments and various investment avenues is a consideration for those seeking to expand their financial portfolio.

Understanding Royalty Income

Royalty income is a payment from one party (the licensee) to another (the licensor) for the ongoing use of an asset or intellectual property. This income stream is passive, allowing the owner to earn money without direct involvement in the daily operations or production processes that generate the revenue. The amount received typically varies based on usage, sales volume, or the level of production derived from the licensed asset.

The Internal Revenue Service (IRS) categorizes royalty income as taxable income. For individuals who receive royalties but are not actively engaged in the trade or business of creating the underlying asset, this income is reported on Schedule E (Form 1040), Supplemental Income and Loss. If an individual creates intellectual property as part of their trade or business, such as a self-employed writer or inventor, the royalty income is reported on Schedule C (Form 1040), Profit or Loss from Business. In the latter case, this income is subject to both income tax and self-employment taxes, which contribute to Social Security and Medicare.

Taxpayers receiving royalty income may be eligible for deductions and credits, such as business expenses, to reduce their taxable income. Non-resident aliens earning U.S.-sourced royalties typically face a 30% federal withholding tax, unless a tax treaty between their home country and the United States specifies a lower rate or an exemption. Royalty agreements are legally binding contracts that define the terms of these payments, including the specific percentage or fixed amount of royalties, usage rights, exclusivity clauses, and the duration of the agreement.

Common Sources of Royalty Income for Investment

Royalty income can originate from a range of assets, offering investors various opportunities to receive passive payments. These assets typically fall into categories where ownership of intellectual property or natural resources allows for licensing or extraction by others in exchange for a fee.

Music copyrights represent a source of royalties, stemming from the ownership of musical compositions or sound recordings. Payments are generated whenever a song is played publicly, streamed online, used in films or commercials, or reproduced in physical or digital formats. These payments are collected by various organizations, such as performance rights organizations and mechanical rights organizations, and then distributed to rights holders.

Oil and gas mineral rights provide another source for royalty income, where the owner of the subsurface minerals receives a portion of the revenue from the extraction and sale of oil and natural gas. Unlike an operating interest, holding a royalty interest in mineral rights does not involve the costs or liabilities associated with drilling and production. The owner receives a percentage of the gross revenue from the resources produced from their property.

Intellectual property, including patents and trademarks, generates royalty streams. Patent royalties are payments made to a patent holder by a licensee for the right to use, manufacture, or sell a patented invention. Similarly, trademark royalties are earned when a brand name or logo is licensed for use by another entity, such as in merchandise or franchising.

Book publishing royalties are payments authors receive from publishers for the sale of their copyrighted literary works. These royalties are calculated as a percentage of the book’s selling price or net receipts, varying by format and contract terms. Authors may also earn royalties from ancillary rights, such as film adaptations or foreign sales.

Pharmaceutical drug royalties arise when the owner of a drug patent licenses it to a pharmaceutical company for development, manufacturing, and sale. The licensor then receives a percentage of the drug’s sales. This model allows investors to gain exposure to the success of blockbuster drugs without incurring the substantial research, development, and marketing costs associated with drug creation.

How to Invest Directly in Royalties

Direct investment in royalties involves acquiring ownership of the underlying assets that generate these income streams. This approach requires thorough due diligence and an understanding of the specific asset class.

For music royalties, investors can purchase stakes in individual songs or entire music catalogs through specialized online marketplaces. These platforms include:

• Royalty Exchange
• SongVest
• ANote Music
• MusicBull

Platforms provide historical earnings data and analytics for listed assets. Investors browse available listings and can participate in auctions or make direct offers to the rights holders. Due diligence involves analyzing past income performance, assessing the longevity of the music’s popularity, and verifying copyright terms, which can extend for the life of the creator plus 70 years. These platforms may offer “term-based” investments, where royalties are collected for a fixed period, or “life of rights” investments, which convey ownership for the full copyright duration.

Investing directly in oil and gas mineral rights involves acquiring legal ownership of the minerals beneath a property, entitling the owner to a percentage of the revenue from extracted resources. Opportunities for purchase can be found through online marketplaces such as US Mineral Exchange, Energy Domain, and Red River Hub, as well as through direct negotiations with landowners or specialized brokers. Due diligence includes researching the geological potential of the land, reviewing existing leases, and examining the production history of nearby wells. It is advisable to consult with an attorney specializing in oil and gas law to review title documents and lease agreements. Mineral right owners receive monthly royalty payments, which are taxed as ordinary income, though depletion allowances may reduce the taxable amount. If the mineral rights are sold, the proceeds may be subject to capital gains tax if held for over a year.

Direct acquisition of patent royalties occurs through a licensing agreement with the patent holder. Investors seeking to acquire these rights can identify opportunities by directly contacting patent owners, working with patent brokers, or searching online marketplaces that list intellectual property for sale. The investment involves negotiating a licensing agreement that outlines the royalty rate, often a percentage of gross sales (3% to 6%), payment schedules, and the scope of the licensed rights. Due diligence focuses on the patent’s validity, enforceability, market demand for the patented technology, and the financial stability of the licensee. Legal counsel is essential to draft and review these agreements and to ensure proper recording of assignments with the U.S. Patent and Trademark Office.

Comprehensive due diligence is foundational for all direct royalty investments. This involves examining the asset’s financial history, market position, and legal standing to evaluate its viability and potential risks. Legal professionals review contracts, verify ownership, and navigate the complexities of intellectual property or real estate law. Income from direct royalty ownership is treated as ordinary income, and for high-income earners, it may be subject to the Net Investment Income Tax (NIIT) of 3.8%. Deductions, like depletion for natural resources or business expenses for intellectual property, can mitigate tax liabilities.

How to Invest Indirectly in Royalties

Indirect investment vehicles offer exposure to royalty income without the complexities of direct asset ownership. These methods allow participation in royalty streams through publicly traded instruments, which are readily available via standard brokerage accounts.

One approach is investing in publicly traded companies that derive significant revenue from royalties. These companies span various sectors, including entertainment, pharmaceuticals, and consumer goods. Some music labels or publishers generate royalty income from their extensive catalogs. Pharmaceutical companies may acquire and manage drug royalties. Consumer brands licensing trademarks also offer indirect exposure. Investors can purchase shares of these companies through any brokerage platform.

Royalty trusts present another indirect investment option, predominantly found in the oil, gas, and mining sectors. These are publicly traded entities that hold ownership rights to mineral deposits or productive wells but do not engage in the physical operations of extraction. Instead, they collect royalty payments from the operating companies and distribute a substantial portion of this income to their unitholders as dividends. This structure often allows royalty trusts to avoid corporate-level taxation, meaning the income is taxed only once at the unitholder’s individual tax rate. While distributions from these trusts are generally treated as ordinary income, some may be considered a return of capital for tax purposes, which can defer tax liability until the units are sold. Notable examples include the Permian Basin Royalty Trust or the San Juan Basin Royalty Trust.

Exchange-Traded Funds (ETFs) that focus on royalty-generating assets provide a convenient and diversified way to invest indirectly. These funds pool investor capital to acquire a portfolio of companies or assets that generate royalty income across various industries. Some ETFs may concentrate on global royalty companies involved in music, pharmaceuticals, or natural resources. Investing in a royalty-focused ETF offers immediate diversification across multiple royalty streams and underlying assets, mitigating the risk associated with a single investment. This method also benefits from professional management and high liquidity. The BetaShares Global Royalties ETF (ROYL) and the Tema Global Royalties ETF (ROYA) are examples of such investment products designed to provide broad exposure to the royalty sector.

All these indirect investment methods are accessible through a standard brokerage account. Purchasing shares in these companies, trusts, or ETFs provides exposure to the recurring income potential of royalties without the complexities and specific due diligence required for direct ownership of intellectual property or natural resource rights. Research the underlying assets and financial health of the chosen investment vehicle.