Royalties are income, and the IRS treats them like it. The mechanics aren't complicated once you separate the different taxes that touch your money — some come out before you're ever paid, and others you handle at tax time. Here's the plain-English version.
Royalties are ordinary income
The company that pays you reports your royalties to you and the IRS on Form 1099-MISC, with the amount in Box 2 (Royalties). Individual owners generally report this on Schedule E of their federal return, and it's taxed at your ordinary income rate — not the lower capital-gains rate.
Severance tax (taken before you're paid)
Most states that produce oil and gas charge a severance tax on production. You don't write a separate check for it — the operator withholds it and you'll see it as a deduction on your check stub. Rates and rules vary widely by state and by product.
Property (ad valorem) tax on minerals
In some states and counties, producing minerals are also assessed an annual ad valorem (property) tax based on their value. Depending on where the minerals are, this may be billed to you directly or netted out of your payments.
The depletion deduction — your key break
Because the oil and gas under your land is a finite resource, the tax code lets you deduct some of your income to reflect it being "used up." This is the depletion deduction, and there are two methods:
- Percentage depletion — a flat percentage of gross royalty income (commonly 15% for eligible small owners), subject to IRS limits. Many royalty owners use this because it's simple.
- Cost depletion — based on your actual basis in the minerals and how much has been produced. Sometimes larger, often more paperwork.
Which one applies — and how much you can take — depends on your situation and IRS rules, so this is exactly the kind of thing to hand to a CPA who knows oil and gas.
Don't confuse stub deductions with tax deductions
The post-production costs and taxes you see netted out on your check stub are not the same as the deductions you claim on your tax return. The stub shows what was taken before you were paid; your return is where depletion and expenses are applied. Keep your stubs and 1099s so your preparer can reconcile both.
Withholding and out-of-state wells
If your well is in a state where you don't live, that state often taxes the income earned there, and some require the operator to withhold state tax from nonresident owners. Always provide a current W-9 so you aren't hit with backup withholding, and expect to possibly file in both the producing state and your home state (often with a credit to avoid double taxation).
Frequently asked questions
How is royalty income taxed?
As ordinary income — reported on Form 1099-MISC (Box 2) and usually Schedule E. You may also owe income tax in the producing state.
What is the depletion deduction?
A deduction that lets you exclude a portion of royalty income to account for the resource being used up. Percentage depletion is commonly 15% for eligible owners, subject to IRS limits.
Do I pay tax in the state where the well is?
Often yes — many producing states tax royalty income earned there even if you live elsewhere, and some require withholding. You may get a credit on your home-state return.
Keep going: learn how to read your check stub, see why your check changed, or review how royalties are calculated.
Educational information only. This article is not legal, tax, or financial advice — and tax rules change and vary by state. For your specific situation, consult a licensed CPA or tax professional.