Oil and gas Lease

[AJsTax]

There is a lot of activity in our area right now on the new style of drilling for deep gas. Of course there are a lot of ideas floating around on how to avoid income taxes on that money. The up front signing bonus can be a very significant sum for many landowners. One theory going around is that this rent money can be capital gains. Could anyone please explain to me how a payment for a five year lease for the right to drill can be anything other than ordinary rent income on a Sch E? It is reported as rent on a 1099-Misc in box 1. I do not see where you have sold anything at this point that would create capital gains.

Has anyone seen an explanation of how this can be done within the law?

I have already had a few clients that this affected and there will be many more in the next couple of years, including our own farm.

[jimmcg]

There is a lot of activity in our area right now on the new style of drilling for deep gas. Of course there are a lot of ideas floating around on how to avoid income taxes on that money. The up front signing bonus can be a very significant sum for many landowners. One theory going around is that this rent money can be capital gains. Could anyone please explain to me how a payment for a five year lease for the right to drill can be anything other than ordinary rent income on a Sch E? It is reported as rent on a 1099-Misc in box 1. I do not see where you have sold anything at this point that would create capital gains.

Has anyone seen an explanation of how this can be done within the law?

I have already had a few clients that this affected and there will be many more in the next couple of years, including our own farm.

The contractual agreement should specify what the consideration for the signing bonus is for. If it is as you say "for the right to drill for a specified period of time" then it most certainly is rental income. The consideration would have to be contractually specified as for the sale of some sort of a capital asset for capital gains to apply. The contractual agreement will always tell you what the considerataion in the agreement is.

[AJsTax]

Ok,

None of the leases that I have read say anything about selling part of the property. I would like to see the wording of one that does.
Also, I found a ruling that kinda throws that out, Supreme Court, Anderson VS Commissioner: "Lease bonuses are regarded as advance royalties and are given the same tax consequences."

[Burke]

Lease of Mineral Rights
"If the transaction is a lease, the income is treated as ordinary income as it is received. The economic interest retained by the landowner is normally referred to as a "royalty interest." The ecomomic interest retained by the lessee is refered to as a "working interest." Royality income received is normally reported to the taxpayer on Form 1099-MISC. He in turn reports that income on Form 1040, Sche E, Line 4. Because a royalty owner is deemed to have retained an economic interest in the mineral rights, he may be eligible for a percentage depletion deduction. Percentage depletion is entered on Line 20 on Schedule E.

If the transaction provides for payment for use of the surface land, that payment is rent. Rent of the land as a separate payment not associated with the mineral rights is non-depletable and would need to be identified separately on Schedule E as rental income."

Sale of the mineral rights and/or the sale of the surface land would generally be afforded capital gains treatment. For this to occur, the contract must be worded properly. Basis of the mineral rights will be zero unless a basis was determined when the land was purchased. See article in NATP TaxPro Monthly, August 2008.

[AJsTax]

What you are saying

agrees with what I understood and have been able to research.
I do not understand yet how you could get to capital gains on a bonus payment reported as rent? I know it is reported as rent on the 1099-misc. I have several in my archives. How are these "advisers" and "lawyers" turning that income into capital gains as they claim?

[Burke]

Darned if I know, but it could be either rent or advance royalties as you referred to above. The article goes on to say, "Both the Supreme Court and the IRS have adopted an "economic interest" test to determine if the contract is either a sale or a lease of the mineral interest. If the payment to the land owner of the mineral rights is sourced only from the sale of the mineral, then an ecomomic interest has been retained by that owner and the transaction is a lease. If the payment is made regardless of the amount, if any, of the mineral extraction, and the landowner agrees that he has made a complete disposition of his mineral rights, then the landowner has not retained an economic interest, and the transaction is a sale." Only if it can be deemed a sale per the contract wording would capital gains come into play.