Are Oil Royalties Considered Passive Income?
Finance and wealth experts emphasize creating passive income. But what passive income is and what can legally qualify as passive income varies a lot. Those who earn oil and gas royalties may consider royalties passive income. Even though it fits the definition, it’s not passive income for tax purposes.
In the US, many oil and gas royalties generate a significant portion of income. Understanding whether it’s passive income can help you plan your financial strategy and pay taxes according to the applicable laws.
What is Passive Income?
Passive income comprises earnings from a source other than employment or business. In simpler words, income comes from a source you’re not actively involved with or do not work for.
Rental income, profits from a limited partnership, and other such investments where you don’t actively work to produce money.
There are many ways to generate passive income these days, especially in the online world, as even a website can be considered passive income that earns revenue from displaying advertisements.
Passive income is typically the extra income on top of an active income (for example, employment). However, many people only have passive income as their sole earning.
Are Oil and Gas Royalties Passive Income?
In the US, mineral rights owners can earn royalties by leasing those rights to another party, typically an oil and gas company. As a royalty interest holder, the mineral owner is not liable for any effort or cost for exploring, extracting, and producing minerals in their land. So they get royalties without putting in the work, which qualifies oil royalties as passive income.
However, if a person also has a working interest defined in the lease, their royalties are not considered passive income. That’s because, with a working interest, they are involved in extraction and production. So their earnings from both interests would be active income.
The Internal Revenue Service (IRS) also considers oil and gas royalties as passive income. However, it’s taxed as regular income you get from your business or employment.
Are Oil and Gas Royalties Taxed as Ordinary or Passive Income?
While the IRS says that oil and gas royalties are passive-type income, it taxes it as a regular income. This means that this income would be taxed at the rate your other non-passive income is taxed depending on the tax bracket you fall in.
As royalties are like regular income for taxation in the eyes of the IRS, it’s possible to deduct net losses from other active incomes. But that’s not the only deduction you can benefit from for this passive income type. You may also be able to benefit from a depletion deduction, which can be as high as 15 percent.
Depletion deduction is based on the fact that oil and gas deposits are finite sources and would eventually deplete. So the IRS allows a depletion deduction for earnings from the extraction of minerals for all parties with an economic interest in the well or field.
You will receive Form 1099 from the lessee, who pays you the royalties to report your earnings from the extraction of minerals from your land. For those who only have a royalty interest in a well or field, the royalty income goes on Schedule E of Form 1040.
If you have a working interest, your income from the production operations goes on Schedule C of Form 1040, which is for reporting self-employment (sole proprietor).
The same rules apply to those with a royalty interest who don’t own the mineral rights or are the lessor. For example, parties with an overriding royalty interest would also need to pay tax on their royalties based on ordinary income tax rates. Similarly, those earning royalty interest through unitization also need to report their royalties as ordinary income in Schedule E.
At the end of the day, the percentage of tax you pay on royalties depends on your income and how you file your taxes (for example, as a single individual or couple).
How Much Can You Earn from Oil and Gas Royalties?
Oil and gas royalties are based on a percentage of the revenue from the production and sale of minerals from the mineral owner’s property. Usually, oil royalties range between 12 to 25 percent.
This percentage is paid from the revenue and not the net profit. The lessee adjusts its costs for extraction and production after paying the royalties.
Other than the percentage of revenue share, royalty payments also depend on production rate and commodity prices. If there’s no production, there won’t be any royalty payments. Similarly, if the oil/gas prices are high, royalties would be higher, and the payment would also be low if the prices are low.
Lessors receive royalties every month. They would also receive all the details, such as the amount of mineral extracted, measured at the wellhead, and the price of it (price per bbl for crude oil and per mcf for natural gas).
Depending on production and market price trends, royalties for oil and gas can range from a few thousand to hundreds of thousands of dollars per month.
It’s possible to negotiate royalty interest and get a higher rate. You should consult with a professional before signing the lease. They might be able to help you get a better deal, which would drastically improve your passive income from the mineral lease.
Oil and gas royalties are passive income and are taxed as regular income. Most passive income in the US is taxed based on ordinary rates, except for some long-term passive incomes where the returns kick in after years.
Regardless of the taxation rules for oil royalties, their passive nature makes them an ideal source of income and creating wealth. You can receive a regular check without investing money or doing any work.
For individuals and corporations, it’s only possible in the US to receive royalties for minerals as the US is the only country where private ownership of minerals is allowed. In most of the world, the state owns the minerals and receives royalties from companies.