Income Tax on Oil and Gas Royalties: Reporting, Deductions, and Filing Tips
Learn how to accurately report oil and gas royalty income, apply deductions like depletion, and navigate key filing requirements and state tax differences.
Receiving oil and gas royalties provides income but also carries tax responsibilities. Whether mineral rights were inherited or acquired through investment, understanding how these payments are taxed helps ensure compliance and avoid errors. This overview covers reporting requirements, deductions, and filing strategies for royalty income.
Determining Taxable Royalty Income
Payments received for the extraction of oil, gas, or minerals from property you own are generally considered royalty income. The Internal Revenue Service (IRS) classifies these royalties as ordinary income subject to federal income tax.1Internal Revenue Service. What Is Taxable and Nontaxable Income? All such income must be reported on your tax return.
The company making the payments typically reports these amounts to you and the IRS on Form 1099-MISC, Miscellaneous Information.2Internal Revenue Service. Instructions for Forms 1099-MISC and 1099-NEC Box 2 of this form shows the gross royalty amount paid during the tax year before any deductions, such as state severance taxes withheld by the payer.
This gross figure is the starting point for calculating your taxable income. Even without receiving a Form 1099-MISC, you must report all royalty income. Income is considered taxable when made available to you (constructively received), even if not yet deposited.
Calculating Depletion Allowances
Royalty owners may be eligible for a depletion deduction, accounting for the exhaustion of mineral reserves. This deduction allows recovery of the investment in the mineral property over time, as permitted by the Internal Revenue Code.3Legal Information Institute (Cornell Law School). 26 U.S. Code § 611 – Allowance of Deduction for Depletion To claim depletion, you generally need an economic interest in the property, meaning you invested in the minerals and rely on extraction income for capital return.
Two methods exist for calculating depletion: cost and percentage. You must typically calculate both each year and claim the larger deduction. Cost depletion depends on your adjusted basis in the property, total estimated recoverable units (e.g., barrels), and units sold during the year. The deduction is calculated by determining a per-unit rate (basis divided by total units) and multiplying it by units sold. This method reduces your property’s basis annually, but not below zero. Establishing the initial mineral basis and reliable reserve estimates can make cost depletion difficult for some owners.
Percentage depletion uses a statutory rate applied to the property’s gross income for the year.4Legal Information Institute (Cornell Law School). 26 U.S. Code § 613 – Percentage Depletion For oil and gas, this rate is generally 15% for independent producers and royalty owners, applied to average daily production up to certain limits. Gross income for this purpose usually refers to sales revenue near the wellhead, excluding items like lease bonuses.
This deduction has limits. It cannot exceed 100% of the taxable income from the property (before the depletion deduction). If a property has a net loss, percentage depletion cannot be claimed for it that year. Furthermore, the total percentage depletion from all oil and gas properties is generally limited to 65% of your overall taxable income from all sources (calculated without the depletion deduction). Disallowed amounts can usually be carried forward. Unlike cost depletion, percentage depletion may continue even after the property’s basis reaches zero.
Differentiating Active vs. Passive Income Streams
How oil and gas income is classified affects loss deductions. IRS rules categorize income and losses as “passive” or “nonpassive”.5Legal Information Institute (Cornell Law School). 26 U.S. Code § 469 – Passive Activity Losses and Credits Limited A passive activity typically involves a trade or business where the taxpayer does not “materially participate.” Losses from passive activities generally only offset income from other passive activities.
Royalty income, received for ownership without bearing exploration and production costs, is usually not considered passive. The IRS often classifies such royalties as portfolio income, similar to interest and dividends. Consequently, passive losses from other ventures generally cannot offset this royalty income.
Owning a “working interest,” where you share in development and operating costs, changes the classification. Income and losses from a working interest are typically nonpassive, regardless of participation level, if your liability is not limited (e.g., held directly or via a general partnership). If a loss from such an interest is nonpassive, subsequent income from that property is also treated as nonpassive.
If the working interest is held through an entity limiting liability (like an LLC, limited partnership, or S corporation), the automatic nonpassive treatment does not apply. The activity then falls under standard passive activity rules. Income or loss is passive unless you meet “material participation” standards, signifying regular, continuous, and substantial involvement in operations.6Internal Revenue Service. Publication 925, Passive Activity and At-Risk Rules Proving participation can be done using any reasonable method showing the nature and extent of your involvement.
Filing Essentials and Common Documentation
Accurate reporting of oil and gas royalty income and deductions requires specific forms and records. This income is primarily reported on Schedule E (Form 1040), Supplemental Income and Loss, Part I, line 4.7Internal Revenue Service. Instructions for Schedule E (Form 1040) Use a separate column for each distinct royalty property.
The gross royalty amount, often found in Box 2 of Form 1099-MISC received from the payer (if payments are $10 or more), should be entered on Schedule E. Report the full gross amount, even if taxes were withheld.
Schedule E is also where related deductions are claimed. These include:
- The depletion deduction (cost or percentage), typically on line 18.
- State production or severance taxes withheld by the payer, often detailed on the 1099-MISC or statements, generally entered on line 16 (“Taxes”).
- Other relevant expenses like property taxes on the mineral interest, legal, or accounting fees, entered on appropriate lines (5 through 19).
Maintaining thorough records is essential to substantiate reported items. Keep copies of Forms 1099-MISC, payer statements detailing gross amounts and withholdings, lease agreements, deeds, basis records (for cost depletion), and depletion calculation worksheets. Good records ensure accurate reporting and support if the IRS inquires.
Since federal income tax is not usually withheld from royalties, you may need to make estimated tax payments using Form 1040-ES. If you expect to owe at least $1,000 in tax for the year and withholding from other sources is insufficient, quarterly estimated payments are generally required to avoid underpayment penalties.
State-Level Tax Variations
Royalty owners must also consider state taxes. Most states with oil and gas production impose income tax on royalties from properties within their borders, based on the “source income” principle. This means you might owe income tax to the state where the minerals are extracted, even if you live elsewhere.
This often requires filing non-resident income tax returns in the states where productive properties are located. Some states may mandate payers to withhold state income tax from payments to non-residents.
Many resource-producing states also levy severance taxes on the extraction of natural resources like oil and gas.8National Conference of State Legislatures. State Oil and Gas Severance Taxes These taxes, distinct from income taxes, are typically based on the volume or value of production. While imposed on the producer, the cost is often passed to royalty owners, reducing net payments. Severance taxes compensate the state for resource depletion.
State income and severance tax rules vary significantly regarding rates, calculation methods, deductions, and filing thresholds. If you live in a state with income tax, you can often claim a credit for income taxes paid to another state on the same royalty income, mitigating double taxation. This credit usually applies only to income taxes, not severance taxes, and depends on your resident state’s laws. Understanding these state-specific rules is necessary for compliance.