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. 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 Mesa Royalty Trust - MTR North European Royalty Trust - NRT Permian Basin Royal Trust - PBT Sabine Royalty Trust - SBR
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 have claimed. The cost basis must be adjusted 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--"percentage depletion" or "cost depletion."
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 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.
The percentage depletion method for oil and gas allows 15% of the gross income from the property (before expenses) to be deducted. 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. You claim a depletion deduction using the method that results in a higher deduction.
Click on the image below to access the depletion calculator.
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.
When the royalty trust is sold, 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.
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Information provided is intended solely for U.S. individual cash-basis taxpayers and is believed to be accurate for most cases. Always consult your personal tax advisor about your own situation. Suggestions are most welcome. Please e-mail webmaster @ costbasis.com or write to us at P O Box 11022, Chicago IL 60611 with your comments.