Royalty trusts usually hold oil and gas properties. Instead of paying dividends, they pass through royalty income to unit owners on a Form 1099-MISC report each year and provide a grantor trust tax information letter. The royalty income is taxed only once, at the unit owner level.
Some examples of publicly-traded royalty trusts (and stock symbols) are: BP Prudhoe Bay Royalty Trust - BPT Cross Timbers Royalty Trust - CRT Hugoton Royalty Trust - HGT North European Royalty Trust - NRT Permian Basin Royal Trust - PBT Sabine Royalty Trust - SBR San Juan Basin Royalty Trust-SJT
The cost basis for a royalty trust is NOT the acquisition cost. Ignore what appears on your brokerage firm statement--only you know your own cost basis because it depends on how much depletion you were eligible to claim. The cost basis must be adjusted each year for the depletion expense that is claimable on the unit owner's individual income tax return. The royalty trust will issue instructions on how to compute the depletion deduction each year. The depletion can be calculated by one of two available methods--"cost depletion" or "percentage depletion," whichever is more.
Click on the image below to access the depletion calculator.
The important thing here is that you must reduce your cost basis each year for the depletion deduction. Your cost basis changes every year.
The cost depletion method allows a depletion deduction based on this year's units of production divided by the estimated total remaining unit reserves of the property times your adjusted cost basis at the beginning of each year. The percentage depletion method for oil and gas allows 15% (22% for eligible regulated natural gas, 10% for geopressurized methane gas) of the gross income from the property (before expenses) to be deducted (limited to net income from the trust.) You claim a depletion deduction using the method that results in a higher deduction.
The accounting is a hassle, but it's well worth it because royalty trusts offer generous yields which are partially tax-sheltered by depletion deductions. Also, unlike private oil and gas limited partnerships, publicly-traded royalty trusts are completely liquid and you can sell whenever you want.
A nice extra added benefit you can get for gas royalty trusts is a direct dollar-for-dollar U.S. tax credit called "FNS" which you enter on line 54(c) of your Form 1040 and on Form 8907. It stands for "Fuel from Non-conventional Sources" and is based on Section 29 (now Section 45K) of the Internal Revenue Code. The trust sponsor will calculate this for you and tell you the amounts on your tax information statement.
The percentage depletion method is subject to an overall limitation equal to the lesser of: (1) 65% of your taxable income from all sources before depletion, carrybacks, and domestic production activities deductions; or (2) 100% of the net taxable income from the particular oil and gas property after expenses but before depletion. Any excess under the 65% test can be carried over to future tax years.
If the royalty trust is sold at a gain, past depletion deductions which reduced adjusted cost basis must be recaptured as ordinary income. The remaining gain is eligible for capital gains treatment.
There are special depletion rules for marginal oil and gas production royalties when the reference price of crude oil is less than $20 per barrel.
Each property in the royalty trust must be depleted separately. In most trusts there is only one property, but some have multiple properties, such as Williams Coal Seam (2), Hugoton Royalty Trust (3), Permian Basin (3), and Cross Timbers (5!)
Investors who own a lot of royalty trusts also need to be aware of the IRS limits for claiming percentage depletion. The percentage depletion is only available for average daily production up to 1,000 barrels of oil and 6 million cubic feet of gas. You must compute your own share of the average daily production based on the number of units you own in each royalty trust. This is problematical because many royalty trusts do not include production volume in their tax information letters. You can usually find it if you hunt through the Form 10-K or Annual Report.
Investors subject to AMT (Alternative Minimum Tax) should also be aware that deductions for percentage depletion in excess of the adjusted cost basis are tax preference items and must be added back to income for AMT purposes.
For state income taxes, if the royalty trust does not file a composite return on behalf of all unit-holders, each individual unit owner is required to file a state individual income tax return in each state in which the royalty trust operates. This is not as bad as it sounds because: (1) the net income allocable to that state is usually below the state filing limits for normal retail investment quantities; (2) some royalty trusts do file composite returns (Dominion Resources Black Warrior since at least 2004 for Alabama); and (3) many royalty trusts operate solely in states which levy no state income tax on individuals, such as Texas (Permian Basin, San Juan Basin) and Alaska (BP Prudhoe Bay).