Let’s say that about 1990 I purchased 160 acres of farm/ranch land in Fisher County for $1,000 an acre. Because the area was assumed to be marginal for oil and gas and pretty much “drilled out”, and the seller was elderly, the seller did not choose to reserve any minerals, so I received 100%. Now due to horizontal activity I have received offers to purchase my minerals for, let’s say, $3,000 per acre. Obviously, if I sell I will have a capital gain and will pay taxes on the gain, but for tax purposes how is a cost basis established? There was nothing in the sales contract to separate the value of the surface from that of the minerals, so if the two are now separated, how is the basis of each determined?
Hi Stonecreek,
I believe our CPA who’s also a Tax Attorney, would tell us if we were in your shoes, that you’re stuck with the cost basis of both surface and minerals. So you’re 160K investment will be the cost basis for selling the minerals. You’ll pay capital gains on anything over 160K. This is what our CPA would tell us in regards to your tax liability in selling.
It would seem quite advantageous to attribute 100% of the cost basis to the minerals if selling the minerals, but that leaves a zero basis in the surface which seems as if it wouldn’t pass muster. However, since I would not contemplate selling the surface in the foreseeable future, applying the entire cost basis to the minerals would be preferable from my perspective.
Let’s say that I sold the minerals for $3000/acre and used the $1,000 purchase price as the basis; that would mean a $2,000 taxable gain. If I later sold the surface for $2,500/acre then the taxable gain on that sale would be the entire $2,500 since the surface would have a zero remaining basis, correct?
I would be hesitant to use advice from an open forum to make financial decisions such as these. Instead, I would rely on an attorney and a CPA. Depending on where your land is in Fisher County if you’re getting large offers for the minerals, you may see drilling soon, especially if you’ve been approached and signed drilling leases.
Where’s the property? I can map it.
Not looking for financial advice, and regarding the question I asked it is irrelevant as to where the property is located. It might even be in another county or even hypothetical.
I’m sure that someone on the forum has sold mineral rights and I am curious as to how they determined the basis for tax purposes. Since the basis reduces the taxable income it is a somewhat important factor in determining if a sale of minerals is financially advantageous compared to speculatively holding those minerals in anticipation of collecting royalties.
Everyone’s situation is different in regard to personal finances, timelines, tax considerations, etc., so no one-size-fits-all advice as to “sell” or “hold” at a given price is of usefulness. What is useful is to understand the tax consequences of selling vs. holding.
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If you have been receiving royalties, then any mineral basis must be reduced by the depletion deducted on your tax returns.
That makes sense, although I hadn’t thought about it. In this case there has been no production since I became the owner of the property, therefore no depletion to subtract from the basis. But thanks for pointing that out.
Calculating the break-even between selling and holding, is, of course, impossible since there is no way to know how much petroleum an acre might produce, much less what the price might be if and when produced.
However, selling as opposed to holding for royalties, has some advantages many people overlook. For one, revenue from sales is (generally speaking) taxed at the lower capital gains rate, whereas royalties are taxed as ordinary income (depletion allowance notwithstanding). Also, there is the time value of money, which is greater now that interest rates have more than doubled. That time value can’t be computed, but it is certain that if no drilling activity is taking place at the moment, that it will be a minimum of substantially more than a year before a well can be drilled, oil produced, and the royalty owner get paid. Even then, it may take many more months or years (or maybe never) for the royalties to equal the price that the minerals could have been sold for. In the meantime, the value of the revenue from selling keeps growing from either interest or investment – or the income has been enjoyed through the purchase of whatever indulgences the seller chooses. Such indulgences have to wait (maybe forever) on royalties, by which time the royalty owner may be beyond the capacity to indulge himself, or is even in the grave.
Another advantage of selling is that the seller never has to worry about whether he is being paid on all of the production that he is owed. I know some larger royalty owners who keep an attorney on retainer and are seemingly forever filing suit to get paid. Not that anyone in the oil production business is less than honest, but sometimes a tank or two of crude gets overlooked – and gas meters can go “on the blink”.
On the other hand, people who offer to buy at a given price aren’t fools or idiots (well, mostly not). They only offer to purchase if they believe the purchase will ultimately pay dividends. And on average they are nearly always “winners”. However, such buyers also have the financial capacity to speculate, so the acreage they buy from you doesn’t have to pay out if similar acreage they bought in the next county pays double.
Individual mineral owners typically have only one shot, which is either hit or miss. So, does the individual take the “sure bet” (sell) or does he roll the dice (hold) and hope to hit a string of sevens? Again, every individual’s circumstances are different. If you’re younger, have a good income, and want to see if that lottery ticket you’re holding is a winner, then you might hold for big-time royalties. If you’re older, have seen dusters drilled too many times in the past, could use the cash for financial security, and don’t have any place to spend those big-time royalties even if they hit, then you might be a candidate to sell.
As for me, at least I have the luxury (assuming I should get an attractive offer) of figuring out which category I’m closer to, where the advantages to me lie, and acting accordingly.
So, does anyone know for certain what my basis is in any minerals I might choose to sell?
You need to consult a professional appraiser who is experienced with surface and minerals in Fisher County. The valuation with depend on the exact location and surrounding properties and historical data.
I suppose an appraiser’s letter with his opinion of the value of minerals in 1990 would be of some use if the basis used for tax purposes were challenged by the IRS.
Appraisals are based on either cost, comparables, or income. The “cost” is fairly simple in that it has to be somewhere between zero and $1,000, which doesn’t help much. No record of sales would exist for severed minerals in this area in 1990 to establish comparables. The income method can’t be used since no income existed and it is unknown if any income could be reasonably expected. Considering that cost, comparables, and income are the only ways to appraise property, it would seem that even the most experienced appraiser’s estimate could vary by an order of magnitude.
Probably the best way to find out what the IRS accepts would be to examine how the basis was treated in other sales of severed minerals. Perhaps some tax court cases exist which would shed some light on this issue?
If I had offer of $3,000/acre, I would hang on to those mineral interests!
I agree with Mr. Farwell. Every Time filings are made with the Oklahoma Corporation Commission regarding a proposed new well, we receive a flurry of unsolicited offers to buy our minerals, surely in the hopes that owners are uninformed. So I would check with the Texas Railroad Commission–or whoever oversees Texas minerals–for activity in your section. Your solicitation surely didn’t occur on a random basis.
The price and location of the land and the dollar figure for the minerals are intended to both be hypothetical. I just want to know how the cost basis of minerals which were obtained with the purchase of the surface is established. This is essential to evaluating an offer to purchase minerals, just as volume, price, ad valorem taxes, severance taxes, and income tax rates are essential to evaluating potential income from royalties.
Once again, has anyone had any experience in establishing the cost basis of previously un-severed minerals?
I would use the appraised value of the land at date of purchase. Which would $1000 for surface and zero for minerals. I know that wouldn’t lead to an audit. If you could find an pro appraiser to write a letter stating a value use it.
I’ve never sold minerals. I’ve taken a working interest on a number of wells. I had 64 acres in one section. Could have taking a 10% deal. instead I leased 48 acres and used part of that bonus to drill 2.5% of the well. I got the royalty on the whole 64 acres. I got back my investment and lost lease bonus in less than 3 years. I’m still making money 10 years later. I’ve got a cousin who leased 160 acres of his farm. But he held out of the other 1760 acres. Four good wells were drilled. He then hired a drilling company and drilled his own 42 wells over the next five years. He borrowed the money for the first 4 and they cash flowed the rest. He also bought 100’s of used broken farm equipment. Used some for parts and created a fleet of rentals. He is one hard working man. The kind that built this country. Dream big take risks and reap the reward of hard but wise work.
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