Selling Texas Mineral Rights: Capital Gain, Basis, and What the IRS Asks For

If you own minerals anywhere in Texas, you get the letters. A company wants to buy your royalty interest for a lump sum. Sometimes the offer is good. Sometimes it is not. Either way, the tax treatment of the deal can change what you actually keep by a wide margin.

This guide covers the federal income tax side of selling mineral rights. Title, conveyance documents, and Texas property law questions belong with a Texas attorney who practices in that area. The IRS cares about three things: is it really a sale, what is your basis, and how long have you held it.

A sale versus a lease: the line that decides everything

When you sell your entire interest in minerals, or your entire royalty interest, and keep no continuing economic interest in the production, you have generally sold property. For most individual owners, that property is a capital asset or Section 1231 property, and gain on property held more than a year is long-term.

When you lease your minerals to an operator, you have not sold anything. You granted the right to develop them while keeping a royalty. The lease bonus you receive is ordinary income, not capital gain. Royalties are ordinary income too, reduced by depletion.

The gray area is a transfer where you keep something back, such as an overriding royalty or a production payment. Keeping a continuing interest in production can turn what looks like a sale into a lease or sublease for tax purposes, with ordinary income treatment. If the buyer's paperwork keeps any slice of production for you, ask how that affects the character of the payment before signing.

Holding period

Long-term capital gain rates generally require holding the property more than one year. If you bought the minerals, your holding period starts on the purchase date.

If you inherited them, IRC 1223(9) generally treats the holding period as long-term automatically, regardless of how soon after the death you sell. Many Texas mineral interests are inherited, often through several generations, which makes this rule important.

Basis: the number most sellers do not have

Gain is the amount realized minus your adjusted basis. Basis is where mineral sales go wrong.

If you bought the minerals, basis starts with what you paid. If you inherited them, IRC 1014 generally sets basis at fair market value on the date of death. For producing minerals, that value may have been significant. For minerals inherited decades ago, nobody may have valued them separately from the surface.

Either way, basis is reduced by depletion. IRC 1016(a)(2) reduces basis by depletion allowed or allowable, but not below zero. Percentage depletion can exceed basis over time, so long-producing minerals may have little or no basis left even if they were valuable when inherited. Cost depletion reduces basis dollar for dollar.

If you cannot document basis, the IRS can treat it as zero. That turns the entire sale price into gain. A retrospective appraisal of value at the date of death is often the best evidence when the estate never valued the minerals. The guide to the community property basis step-up covers a related rule that can increase basis for surviving spouses.

Reporting the sale

Report the sale on Form 8949 and Schedule D, or on Form 4797 if the minerals were used in a trade or business. The buyer or closing agent may issue a Form 1099-S or other information return. Even if no form arrives, the sale is reportable.

Selling part of your interest, such as half of your royalty in a particular tract, requires allocating basis between the part sold and the part kept. That allocation should be reasonable and documented.

Higher-income sellers should also account for the net investment income tax under IRC 1411, which can add 3.8 percent on gain from the sale of investment property.

Installment sales

If the buyer pays over time, IRC 453 may let you report gain as payments are received instead of all at once. You report it on Form 6252. That can spread income over several tax years and may keep more of the gain in lower brackets.

Installment treatment has limits. It does not apply to a sale at a loss, and certain sales to related parties have special rules. And if the buyer defaults, you still have to deal with the tax consequences of the payments you did receive. Weigh the tax benefit against the credit risk of the buyer.

What to keep for the IRS

• The purchase and sale agreement and the deed or assignment.
• Closing statement showing gross price, fees, and net proceeds.
• Proof of basis: your purchase documents, or the estate inventory, appraisal, or a retrospective valuation at the date of death.
• Depletion schedules from prior returns, to show how much basis was used up.
• Division orders and recent revenue statements describing exactly what interest you owned.
• Any correspondence showing whether you kept an overriding royalty or other interest.

When the IRS gets involved

The common IRS problem with mineral sales is a sale reported with no basis, or not reported at all because the seller assumed inheritance made it tax free. Inheritance gives you a basis. It does not make the sale tax free. The proceeds are reported to the IRS, and a matching notice follows when the return is silent.

The second problem is a large lump sum with no estimated tax payment. A big mineral sale can produce a big balance due and an IRC 6654 penalty. Make an estimated payment in the quarter you close, or increase withholding elsewhere.

If a notice is proposing tax on a mineral sale, or you sold and could not pay the tax, the solution starts with documents: basis, holding period, and the actual terms of the deal. My oil and gas audit guide covers the royalty and depletion side, and if a balance is already owed, the IRS relief options guide covers your choices. Let's talk: 813-229-7100.