While the royalties you could earn from your ownership of mineral rights are taxed as ordinary income, the IRS considers the amount gained from selling those rights to be a capital gain. As with the sale of real estate or other capital assets, you report the sale of mineral rights on Form 4797. The calculation and payment of the taxes on that gain will depend on several variables.
The acquisition method for the rights affects the determination of the gain.
For an investor who purchases mineral rights, the amount you paid for them initially is your basis. The gain on a capital asset is the difference between your basis (or adjusted basis, in some cases) and the sales price. If you inherit the rights instead of buying them, you receive them at a stepped-up basis equal to the current market value, regardless of what the owner paid for them.
For example, suppose you sell mineral rights for $500,000. In scenario A, you purchased the rights five years ago for $250,000. In that case, your gain is $250,000, and you would owe capital gains taxes on that amount. Note that capital gains are taxed at a lower rate than ordinary income.
In scenario B, you inherited the rights from your brother, who bought them five years ago for $250,000. If you now sell them for $500,000 at the time of inheritance, you won't have a capital gain because you inherit the rights at the stepped-up basis of current value, or $500,000. However, in scenario B, if you inherit the rights valued at $500,000 and then hold them for a while and sell them for more than the $500,000 value, you will owe capital gains taxes on the amount that the value increased after you acquired them via inheritance.
Is there any way to defer the taxes?
When you sell real property, you can defer the payment of capital gains taxes by executing a 1031 exchange. This term refers to a transaction in which you use the proceeds from the sale of one investment property to reinvest in another “like-kind” property.
Common examples include selling a residential rental property and buying an office building. Still, the IRS is flexible with the definition of like-kind and has allowed a host of investment properties. For example, the IRS allows the use of mineral rights in an exchange as well as farmland, industrial space, retail or hospitality properties, and more.
The owner of mineral rights can swap that asset for another “like-kind” property using the 1031 exchange and defer payment of the capital gains taxes that would otherwise be due. Keep in mind that the 1031 has strict timelines and requires using a Qualified Intermediary to oversee the arrangement. Form 4797 is also used for reporting this transaction to the IRS.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Examples are hypothetical and for illustrative purposes only. Withdrawal strategies should take into account the investment objectives, financial situation and particular needs of the individual.