Property owners’ development of natural resources may create tax obligations
Q: A company has asked for access to shale deposits on our land. Would we be taxed on money we receive from allowing access?
A: Almost certainly, yes. Royalty, bonus or other income paid to landowners in exchange for access to resources on their land is generally categorized as ordinary income. Depending on filing status and total income amount, taxpayers typically do need to report these earnings to the Internal Revenue Service (IRS).
Q: We’ve been asked to sign a natural resource extraction agreement. How would we report payments from that lease agreement?
A: Natural resource extraction agreements involve “delay rental,” “royalty” and “lease bonus” payments. Landowners who receive these payments are “royalty owners” who typically do not have a working interest in the extraction operations. This income is reported on Part I of Schedule E (Form 1040), Supplemental Income and Loss. Landowners who do have a working interest in the extraction operations must file using Schedule C (Form 1040), Profit or Loss from Business.
Q: If we get a bonus in addition to lease payments, how would we report that income?
A: Taxpayers who lease their property so a company can extract natural resources may receive a lease bonus. The bonus may be paid in a lump sum or over several years. The company leasing the land should provide you with a Form 1099-MISC, Miscellaneous Income, noting the amount of bonus payments as “Rents” in Box 1. Taxpayers usually report lease bonus income as rent on Schedule E.
Q: How would we report periodic payments for our share of profits from the natural resources?
A: The company may periodically pay you for your share of profits generated from your property’s natural resources. These “royalty payments” must be based on natural resource production on a recurring or intermittent basis, according to your lease terms. The company should give you a Form 1099-MISC, noting the payments as “Royalties” in Box 2. Most taxpayers report royalty payments they receive as “royalty income” on Schedule E.
Both rental and royalty income (or loss) is also calculated on Schedule E, transferred to Form 1040, Line 17, to be combined with other sources of income.
Q: Do we get tax credit for the depletion of our resources?
A: Possibly. Depletion is the “using up” of natural resources through mining, drilling, quarrying of stone or cutting of timber. The IRS allows a “depletion deduction” so taxpayers who own economic interests in natural resources can reduce their taxable income and account for the reduction of reserves.
Depending on the type of resource, you might have the option to use either “cost” or “percentage” depletion. If you qualify for both options, use the method that yields the greater deduction. For federal tax purposes, the percentage depletion rate varies according to the mineral being produced. Taxpayers claim depletion and other allowable deductions on the “Expenses” section in Part I of Schedule E. See IRS Publication 535, Business Expenses, for more information.
Q: If we had a working interest in the extraction operations, would we get any deductions?
A: Possibly. If you have working interests in extraction operations, you might be able to offset your natural resource income by deducting expenses such as overhead, dry holes and certain legal and administrative fees and county health department water testing fees. You also may deduct business expenses such as depreciation, tangible or intangible costs, utilities, as well as car, truck and travel expenses related to resource extraction. Severance tax and operation expenses must be detailed on an Authorization for Expenditures (AFE) statement provided by the exploration company.
Q: Must I report the free gas the company is offering?
A: It depends. If the company returns natural gas extracted from your property to you, the value of the gas received is probably nontaxable. However, free natural gas from the company may be taxable if the gas you receive is not from your retained ownership interest. Generally, ownership of raw gas extracted by a leasing company is based on the lease terms and state law.
Q: Is federal tax withheld from natural resource income?
A: Typically, no, so you might want to make estimated tax payments. See Publication 505, Tax Withholding and Estimate Tax, for more information. Income from leasing mineral property and royalty payments for extraction of natural resources can be significant, so familiarize yourself with the tax rules to avoid an unexpected tax bill. See Publication 525, Taxable and Nontaxable Income, and the Instructions for Form 1040, Schedule E and Form 1040, Schedule C.
The information for this column was provided by the Internal Revenue Service (www.irs.gov) and prepared by the Ohio State Bar Association (OSBA). Articles appearing in this column are intended to provide broad, general information about the law. Before applying this information to a specific legal problem, the OSBA urges readers to seek advice from an attorney.
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