Tax Considerations for Royalty Trusts

Royalty trusts invest in oil and gas production.

Thinkstock Images/Comstock/Getty Images

Royalty trusts are similar to real estate investment trusts, but instead of holding portfolios of investment real estate properties, they hold portfolios of mineral royalty interests, which are frequently oil and gas. Like REITs, they are designed as pass-through entities. Since they pay no corporate income tax, their dividends get treated differently from other dividend income. On the other hand, they pass through their expenses, so you get to claim additional write-offs against the income before you pay regular income tax on it.

Reporting Royalty Trust Income

Royalty trust income needs to be reported in two different places. Interest from the trust goes on your Schedule B like any other interest that you earn, while the bulk of the income gets reported on your Schedule E. In essence, your shares in a royalty trust are a piece of a real estate partnership, so you get to report both income and subtract expenses.

Income and Expenses

Since royalty trusts don't pay taxes on their income, you have to report both your income and expenses. At the end of the year, the royalty trust will send you a tax guide letting you know how to allocate expenses. Generally, you'll report your royalty tax income on Schedule E and subtract three other expenses -- severance tax, depletion and any passed-through administrative costs. Severance tax is the state tax that the mineral operation pays for taking the minerals out of the ground, and depletion is a special allowance.

Depletion Deduction

Mineral production facilities like oil and gas wells have a limited life. The Internal Revenue Service lets you write off a portion of the cost of your investment every year to make up for the fact that it's losing value as its mineral wealth gets pumped out. Since depletion goes on Schedule E as an expense, it comes right off the top and reduces your taxable income. You only pay taxes on your income after the depletion deduction, making some of your income tax-free.

Selling Royalty Trusts

There's a good chance that when you sell your shares in your royalty trust, it'll be at a loss. Over time, the depletion catches up with the investment, and its price reflects the fact that there's less oil in the ground. When you go to sell your shares, though, you might not be able to write off a loss. All of the depletion that you claimed gets subtracted from your cost basis, so if you buy $100,000 worth of shares, claim $50,000 in depletion and sell your investment for $60,000, you actually have a $10,000 gain. Furthermore, you'll pay taxes on that gain as regular income instead of capital gains since you claimed the depletion deduction against regular income.

Photo Credits

  • Thinkstock Images/Comstock/Getty Images

About the Author

Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.

Zacks Investment Research

is an A+ Rated BBB

Accredited Business.