Q: I own mineral rights to land in North Dakota and have been leasing those rights to oil and natural gas prospectors for approximately seven years. In February of this year I began receiving disbursement checks for the oil and gas recovered from two wells. I would like to know how this money is taxed by the federal and CA state governments. Thank you for your assistance. -- Wayne Karlstad, Elk Grove, CA
A: Revenue from oil and gas leases usually consist of royalties or rents. Rent and royalty income is reported on page 1 of the federal Schedule E, Supplemental Income and Loss, of Form 1040. You should receive an information return, IRS Form 1099-MISC, from the payer if the payments exceed $600 reporting the amount and type of income by the end of January 2013 for calendar year 2012.
There may be deductions related to the rent or royalty income that you can deduct. One deduction specific to petroleum, mineral and timber related income is depletion. There are two ways to calculate depletion, the cost method and the percentage method. Cost depletion is based on the property's income tax basis, usually its cost, the number of recoverable units of oil or gas at the beginning of the year and the number of units sold of for which payment is received during the year. The percentage method calculates the deduction by applying specified percentage to the gross income from the property. The specific percentage for oil and gas is 15%. So if you were to receive $10,000 of royalty income, you would be entitled to a depletion deduction of $1,500 (15% times $10,000), based on the percentage method.
You can choose the higher of the deductions calculated by the cost method or the percentage method. You can use the percentage method one year and the cost method the next. Depletion deductions reduce the income tax basis of the related property, so you will have to keep track of them in order to correctly calculate gain or loss should you sell the property.
California taxes the worldwide income received by its residents. So you will have to report the rent or royalty income and related expenses to the state. North Dakota may also tax the income since it is from property located in that state. Check with the North Dakota Department of Revenue. If you do pay tax on the same income to both California and North Dakota, you may be entitled for a credit on your California return for the tax paid to North Dakota.