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Taxation of Mineral Lease Sales
You are selling a lease that you have had in your possession for over one year. What are the tax consequences? What type of tax do you pay? That depends ...
We know you do not like "that depends" as an answer, but the sale of a lease is usually treated three different ways depending on the facts and circumstances of your holding. A different tax treatment will result for each of the following categories of lease holdings:
- Buying and selling leases is your business.
- Holding leases is an investment.
- You are in the trade or business of exploring, developing and producing oil and gas.
Buying and Selling Leases is Your Business
If you are a landman and buy leases, put together packages and then sell the lease package, your lease is inventory to you. You are considered a dealer in real estate according to IRC Sec. 1221. A dealer of real estate buys and sells inventory to customers in the ordinary course of business. As an integral part of your business, the sale of that lease is ordinary income subject to regular tax rates.
To be considered in the trade or business of buying and selling leases, some factors are the number of lease sales, the frequency of those lease sales, the substantiality of those sales and the percentage of time spent on the lease sales versus the time spent on other business ventures. If your business is primarily buying and selling leases, most likely your gain from the sale will be ordinary income to you.
Lease as Investment Property
You inherit a lease and sell it to an oil and gas producer. If this is a one-time deal, you held the lease as an investment. You are not in the trade or business of selling leases. In this case, your income is taxed at capital gain rates - 0% - 20%, depending on your ordinary income tax rates. Because it is inherited, it is automatically long term capital gain. If you had purchased the lease as an investment and held it less than 12 months, the tax would be subject to the short term capital gain rules.
Investment income is also subject to the new Net Investment Income (NII) tax. This is an additional tax of 3.8% on investment income over certain thresholds.
Sale of Lease Used in Trade or Business
You own an oil and gas lease and drill a gas well on the property. The well is producing, but prices are so low, that it is uneconomical for you to continue operating the well. You decided to sell the well, the equipment and the lease to someone who thinks they can make money on the property. This lease was used in your business of exploration and production.
The sale of a lease "used," not considered inventory, in your trade or business is an IRC Section 1231 asset. Provided it is held over 12 months, any net Sec. 1231gain on sale receives long-term capital gain treatment. A net Sec. 1231 loss on the sale is an ordinary loss. However, to the extent that any depletion was deducted against the cost basis of the lease, the depletion taken may be recaptured as ordinary income under IRC Section 1254. Where multiple assets are sold, the allocation of purchase price becomes an important part of the transaction, which could lower the negative effect of depletion recapture.
Sublease Caution
However, a word of caution - If you sell a lease and retain any ongoing benefit from the sold lease (retain an override - ORR), you will create the potential of a sublease arrangement. The negative tax consequences of a sublease are typically unexpected and catch many a lease seller by surprise. When any ongoing benefit is retained, make sure you understand the ordinary income tax treatment that can come with the transaction.
Segregate Your Leases
The purpose and use of your mineral lease determines the tax treatment of selling that lease. It is possible to have all three types of leases held by a single owner. Precautions should be taken to separately distinguish each type of holding to maximize your tax benefit and reduce the tax burden on the sale of a lease. This may mean segregating the leases in accounting records, keeping detailed records about the purchase and its purpose or holding the lease in separate entities to distinguish whether a lease is -
- Inventory sold in the ordinary course of trade or business subject to ordinary tax rates.
- Investment property subject to capital asset treatment.
- Property used for exploration and development and subject to Sec. 1231 gain treatment.
An oil and gas tax specialist with Eide Bailly LLP can give you additional guidance in structuring sales, categorizing leases and provide tax advice to optimize your tax consequences for sales of your oil and gas leases. | 
