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Lev
Lev, Tax Advisor
Category: Tax
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Experience:  Taxes, Immigration, Labor Relations
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What are the sale of mineral rights?

Resolved Question:

Are the sale of mineral rights ordinary income or capital gains?
Does this situation if the owner sells the mineral rights but retains 1% overriding royalty %?
Submitted: 5 years ago.
Category: Tax
Expert:  Lev replied 5 years ago.
Hi and welcome to Just Answer!
Timber rights are the ownership of the marketable trees on a particular property. Similarly – mineral rights (“mineral interest”) – are the ownership of the marketable minerals that are extracted from the land. Both are parts of an estate in real property. The complete private ownership is known as a “free simple estate”. The property owner may sell or transfer partial rights knowns as “surface rights” and “subsurface rights”. For tax purposes – partial rights to a real property are treated the same was as a free simple estate – they may be sold, the seller will recognize a capital gain on the sale, etc.
The term "overriding royalty interests" means partial rights in the proceeds from the sale of minerals, produced from the land, which are usually limited in duration to the terms of an existing lease. That doesn't affect the treatment of the sale of mineral rights.
Let me know if you need any help.
Customer: Can you cite any tax documents or supporting documentation showing that the sale of mineral rights is capital gain, but the overriding royalties are ordinary income?
LEV: I would need some time to find references.
Customer: That is fine, I would really like some references.
LEV: See IRS publication 17 page 91 - www.irs.gov/pub/irs-pdf/p17.pdf
Sale of property interest. If you sell your complete interest in oil, gas, or mineral rights, the amount you receive is considered payment for the sale of section 1231 property, not royalty income. Under certain circumstances, the sale is subject to capital gain or loss treatment on Schedule D (Form 1040).
For more information on selling section 1231 property, see page 28 in Publication 544 - http://www.irs.gov/pub/irs-pdf/p544.pdf .
If you retain a royalty, an overriding royalty, or a net profit interest in a mineral property for the life of the property, you have made a lease or a sublease, and any cash you receive for the assignment of other interests in the property is ordinary income subject to a depletion allowance.
Thus – if you retain the "overriding royalty interests" for the duration of an existing lease – not for the life of the property - that will not affect capital gain treatment.
Lev, Tax Advisor
Category: Tax
Satisfied Customers: 28084
Experience: Taxes, Immigration, Labor Relations
Lev and 3 other Tax Specialists are ready to help you
Expert:  Lane replied 11 months ago.
Landowners who receive income from the sale of their mineral rights must report it as a specific type of property sale. Under IRS Section 1231, such sales are equivalent to the sale of real property that has been used for business or trade purposes. However, the income from such sales can also be classified as a capital gain. The distinction largely depends on the structure of the entity that was used to purchase the pertinent parcel as well as the landowner's intention to use it as an investment.
Expert:  Lane replied 11 months ago.
Section 1231 gains and losses are the taxable gains and losses from section 1231 transactions. Their treatment as ordinary or capital depends on whether you have a net gain or a net loss from all your section 1231 transactions....
Expert:  Lane replied 11 months ago.
Here's an example from IRS (Pub 544)....In 2014, Ben has a $2,000 net section 1231 gain. To figure how much he has to report as ordinary income and long-term capital gain, he must first determine his section 1231 gains and losses from the previous 5-year period. From 2009 through 2013 he had the following section 1231 gains and losses. Year Amount 2009-0-2010-0-2011($2,500)2012-0-2013$1,800 Ben uses this information to figure how to report his net section 1231 gain for 2014 as shown below. 1)Net section 1231 gain (2014)$2,0002)Net section 1231 loss (2011)($2,500) 3)Net section 1231 gain (2013)1,800 4)Remaining net section 1231 loss from prior 5 years($700) 5)Gain treated as ordinary income$7006)Gain treated as long-term capital gain$1,300
Expert:  Lane replied 11 months ago.
And on the second part of your question ... not nothing changes (other than the obligation to continue report the royalties in the future....This type of property will have to go through the 1231 netting process to determine gain vs ordinary income and recapture