Taxation of Dispositions of Oil and Gas Interests

Energy & Resources

By Gordon Snyder

The current interest of investors and/or developers in gaining access to the Marcellus Shale has provided numerous landowners with formal offers to either lease, or in some cases purchase, the rights to access and develop the minerals underlying the surface of their property. The “Marcellus Shale” is the name given to a geologic formation located some 5,000 to 8,000 feet below the surface of up to three-quarters of the land areas in Pennsylvania and in parts of New York, Ohio, Maryland and West Virginia. Those knowledgeable in the field estimate that the Marcellus Shale holds sufficient recoverable natural gas deposits to meet the United States’ projected natural gas needs for 10 to 15 years.

In Pennsylvania, solid minerals, and/or oil and natural gas are owned by the surface owner unless there has been a prior severance of the surface estate from the mineral estate. Furthermore, in Pennsylvania, a grant or reservation of “minerals” does not include oil and/or natural gas unless there is evidence that the parties intended oil and/or natural gas to be included in that description (Dunham v. Kirkpatrick, 101 PA. 36 (1882)).

Although we are beginning to see some increase in investors’ desire to purchase the mineral interests, specifically including the oil and natural gas rights, leasing of the desired rights has been the most frequently used medium to effect the transfer of those rights. The lease will generally be for an initial period of 2 to 5 years with provisions for extensions (including automatic extensions) if drilling has been initiated, whether or not mineral production is being obtained from the property. The legal aspects of either a lease or a sale of the oil, gas or other mineral interest in the property is beyond the scope of this discussion.

Any lease conveying to the lessee the right to do exploratory and development work on the lessor’s property results in the receipt of ordinary rental income taxable to the lessor at ordinary income tax rates. If the lessor receives a lease bonus payment at the inception of the lease, it too is considered to be rental income taxable at ordinary income tax rates.

Taxpayers leasing their property for oil and/or gas exploration often receive the right to royalty payments connected with the income received by the lessee from the sale of the oil and/or gas production from the property. Under the Pennsylvania Oil and Gas Act (58P. § 33 et sq), any lease or agreement conveying the right to remove oil and/or natural gas is invalid if it does not guarantee the mineral owner a royalty of at least 12.5% of the production. Although many of the Marcellus Shale leases provide for royalties higher than the referenced minimum, the allocation of certain post-production expenses against the gross royalty tend to decrease the actual amount of the royalty received. Under current federal tax law, oil and gas royalties received by the lessor representing a share of the sale proceeds from production may qualify for an offsetting percentage depletion deduction (Internal Revenue Code Section 613A). The statutory depletion rate is currently 15% for those who qualify to claim the deduction.

In some situations, the landowner might decide to sell the mineral interests (including the hard minerals, natural gas and/or oil rights to any of those elements underlying the surface of the property). Such a transaction would normally involve a deeded transfer of the therein described mineral(s) and might further designate the specific geologic formation and/or subsurface depth to which the deed relates. For example, the deed might describe the transferred property to the area beginning 1,000 feet below the surface and extending to 10,000 feet below the surface. Alternatively, such a deed might be restricted to the Marcellus Shale formation or several consecutive formations. Provisions might also be included in the deed or in a companion document providing access to the surface area so the purchaser could access the subsurface area purchased.

An outright sale of the mineral rights with no retained interest therein, such as an overriding royalty interest, should result in capital gain treatment for federal income tax purposes. The gain would be measured by the difference between the total proceeds received or to be received and the tax basis of the property sold, including selling expenses incurred in connection with the transaction (legal fees, consulting fees, etc.). Under current law, if the property has been held for more than one year, the gain may be treated as long-term capital gain subject to a maximum federal income tax rate of 15%. If held for less than a year, the gain would be taxable at the taxpayer’s marginal income tax rate as determined by the taxpayer’s other items of income and deduction reflected in the annual tax return for the year of sale.

For Pennsylvania personal income tax purposes, a landowner receiving royalty income attributable to receipt of a lease bonus type payment or a royalty related to production income would have taxable income classified as “net gains or income from rents, royalties, patents, and copyrights” for tax-reporting purposes. Under current state law, this income would be subject to Pennsylvania personal income tax at the statutory rate of 3.07%. Similarly, any net gain from a sale of the mineral interest(s) would be classified as net gains or income from disposition of property and would be subject to the same rate of tax. Although Pennsylvania does not recognize percentage depletion, cost depletion could be a deduction against the royalty income if the tax basis of the minerals could be determined along with the estimated productive life of the property.


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This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax-related matter.

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