by Tracy Lenz, PE, CMA.
Tracy is a licensed professional engineer (BS & MS in Petroleum Engineering) with over 15 years in the industry working for oil & gas operators. She left that world to assist mineral owners with navigating mineral value, royalty questions, and general help. Ask her your questions at tracy@pecantreeog.com
If you sold minerals in 2022, keep reading. We’re diving into how to reduce capital gains taxes owed after a mineral sale of inherited properties.
DISCLAIMER: I’m not a tax accountant and you should always review YOUR specific situation with a tax professional. I am only an engineer specializing in appraisals and other valuation needs who frequently gets this question!
Introduction to Key Terminology
Before we get in too deep, let’s define some terms:
- Inherited Date: Typically, if you inherited minerals due to the passing of a relative, the date you officially started owning the minerals was the date of that relative’s passing. If you’re wanting to establish a stepped-up cost basis, this is the date to use.
- Cost Basis: the original fair market value or purchase price of your minerals on the day it became yours. If you have no evidence of value at the time of inheritance, the assumption is $0.
- Stepped-Up Basis: The new cost basis if you’re able to later show the asset was worth a higher value on the day it became yours than previously established.
- Capital Gains Tax: mineral owners typically are dealing with Long-Term Capital Gains (if you’ve had it for more than a year), which is a tax levied on the amount your investment has increased from the day it became yours to the day you sold it. The tax rate depends on your tax bracket, and ranges between 0-20% (as of 2021).
- Fair Market Value: The price for which you could actually sell the property. Specifically, the most likely price a purchaser who is willing, but not required to buy, would pay and that a seller who is willing, but not required to sell, would accept, when both are fully aware, competent, and informed of all the circumstances involving the value and use of the property, with the property being exposed to the market for a reasonable time. In addition, this valuation considers that the mineral interest sale would be an “arm’s length” transaction on a cash or cash equivalent basis.
- Undeveloped Minerals: If oil and gas is known to be present on the minerals but a well has not yet been drilled in order to recover it, these quantities are considered undeveloped. Sometimes these undeveloped minerals have value and sometimes they don’t. It all depends on probability, risk, and economics.
The Basic Idea
Now that we got that out of the way, we need to determine how much you could have sold it for on the day you inherited the property, or the fair market value. You then only pay tax on the increase in value between the date of inheritance to the date of sale.
Establishing Value
There’s not exactly a historical county index of property values for minerals, so what are you to do? Historical property value can be estimated a few different ways.
1. Unsolicited Offers (NOT RELIABLE)
Unsolicited offers are typically not indicative of what you could have actually sold it for. If your house if not on the market, someone offering you $200,000 for your house out of the blue doesn’t mean that’s the value of your house. Intuitively, you probably understand that a random stranger offering you $200,000 for your house when it’s not on the market means it’s worth a lot more, right? Or else, why would they care? A similar thing happens with mineral properties.
If you suddenly get a flush of offers for your minerals when you weren’t trying to sell them, most likely there is drilling activity either on your minerals or near it. A property value goes up the most once a new well starts producing because the risk of the well ever being drilled is removed. That well could also attract more drilling to the minerals if it performs to standards. Also, many mineral buying companies are looking to show quick returns for their investors and producing minerals are great ways to do that….if they can buy for the right price. Basically, you get a slew of low offers right before a new well turns on in hopes you aren’t paying attention.
2. Cost Method
The cost it would take to recreate the asset. This rarely a valid approach for oil and gas mineral interest value as exploration costs are not public data, and you can’t very well pay to recreate the oil and gas underground.
3. Comparative Sales Method
What similar properties are selling for. This assumes there are market comps available, that you can prove they were arms-length fair-market-value transactions, and that you can reasonably compare the properties in terms /acre, /reserve, or some other metric. This is a problem for most properties because
-
-
- Most sales data is not public,
- The amount of reserves remaining can vary drastically property to property, making it difficult to determine if the sale is comparative
- Even if you can determine the above, you would then need to determine if the sale was arms-length and truly fair market value. It get’s messy very fast for oil & gas.
-
4. Probate Appraisal
If an estate is involved and you inherited through the probate process, there should have been a value assigned to your minerals at this time. I’ve not seen many of these which are terribly analytical or extensive, but look to see what you have. Generally I’ve seen county averages or royalty multiples applied for small- to mid-sized portfolios.
5. Historical Royalties
If the property is paying royalties, one possible valuation is three to five times the last year of royalties. For example, if the property made $1000 over the last 12 months, the valuation would be $3000-$5000.
Note that producing royalties will reduce the basis each year by at least a minimum amount, depending on your state, equal to the amount deducted for depletion & depreciation. Talk to your tax specialist if your properties were producing on the date of inheritance.
6. Ad Valorem Tax Appraisal
Some states (like Texas) do mass appraisals on all minerals yearly for property tax reasons (called Ad Valorem taxes). These tax appraisals are the value all future production for the producing oil and gas as of January 1st of that year. This may or may not be representative of the fair market value of the minerals, since often undeveloped minerals can hold value as well.
7. Lease-Bonus Method
In conventionally producing areas with active leasing, lease bonus data can be used to ballpark equivalent sales values at the time by using certain multipliers. The Lierle report maintains leasing data from a variety of sources for each county in the US with activity, and has historical reports back into the 1990’s which can help establish trends for your area. County records and public land records of leasing can help narrow down county averages from that report to your specific area, along with local historic drilling trends and known reservoirs to put it all into context for proper appraisal.
8. Income Appraisal (GOLD STANDARD)
The fair market value of the projected income stream. For producing oil and gas properties, this is often the most reliable/credible method to determine a fair market value, especially retrospectively when comps are even harder to establish. This is typically performed by a licensed petroleum engineer.
The point of having an engineer assign value rather than a lawyer/landman/accountant is to use reservoir performance and science-based forecasts to determine future cash flow of the asset, then relate that future cash flow back to a market value with risk and discount rates. It’s this analysis that is the foundation of the offers, which is why offers are not necessary to establish value. These should then be reconciled with offers and other comps and valuation methods, but most of the time the analytical cash flow method is the best for oil and gas properties.
Which one to use?
It’s in the mineral owner’s best interest to determine which method would maximize the value of the property upon inheritance. This may be different for each individual property. In some instances, a generic $/nma might get you a larger taxable value (which for capital gains tax, the larger initial value the better), while in other instances the producing wells and undeveloped acreage could be worth significantly more than average.
More detailed methods will be able to account for more nuance, and this will tend to increase the property value (though obviously not guaranteed; accuracy does not always work in your favor…).
Also, I would caution against blindly using the valuation from probate. Those valuations rarely involved a mineral appraiser/engineer, and could be using very generic valuation methods (or passed down generation to generation). Again, this could possibly be in your favor, but I recently saw one with Reeves County acreage (Permian Basin) valued at under $10/nma when it should have been closer to $500/nma. These probate valuations can be *(I’m not an accountant or tax specialist; this is just what a select few have told me) overruled by a formal mineral appraisal if performed according to IRS standards, so long as there hadn’t already been a value established for tax purposes (for example, if you had it appraised properly upon inheritance due to your state’s estate tax reasons, that appraisal would have set the value).
The IRS prefers a licensed engineer over an accountant’s valuation
My basis for that statement was a combination of information from accountants my clients have worked with in the past, experience from other Certified Mineral Appraisers, and my own research into the matter.
From the IRS Tax Code 4.41.1.3.9.6 (07-31-2002) (4.41.1 Oil and Gas Handbook | Internal Revenue Service)
(7) Valuations of Oil and Gas Producing Properties
1. A valuation of an oil and/or gas property is an engineering issue and, if the tax consequences warrant, should be referred for engineering services.
You are not stuck with a poor-quality valuation if the probate process slapped a low, generic value on the minerals
Probate appraisals and inventories is a separate item from a “disinterested appraisal by approved methods” and just one of many things considered. Approved methods would establish a Fair Market Value, prioritizing cost methods or comparative value methods before an analytical income method could be used (but we’ve already established why those are usually poor methods for mineral owners).
From Treas. Reg. 1.611–2(d) https://www.govinfo.gov/content/pkg/CFR-2012-title26-vol7/pdf/CFR-2012-title26-vol7-sec1-611-2.pdf
(d) Determination of fair market value of mineral properties, and improvements, if any.
(1) If the fair market value of the mineral property and improvements at a specified date is to be determined for the purpose of ascertaining the basis, such value must be determined, subject to approval or revision by the district director, by the owner of such property and improvements in the light of the conditions and circumstances known at that date, regardless of later discoveries or developments or subsequent improvements in methods of extraction and treatment of the mineral product. The district director will give due weight and consideration to any and all factors and evidence having a bearing on the market value, such as cost, actual sales and transfers of similar properties and improvements, bona fide offers, market value of stock or shares, royalties and rentals, valuation for local or State taxation, partnership accountings, records of litigation in which the value of the property and improvements was in question, the amount at which the property and improvements may have been inventoried or appraised in probate or similar proceedings, and disinterested appraisals by approved methods.
(2) If the fair market value must be ascertained as of a certain date, analytical appraisal methods of valuation, such as the present value method will not be used:
(i) If the value of a mineral property and improvements, if any, can be determined upon the basis of cost or comparative values and replacement value of equipment, or
(ii) If the fair market value can reasonably be determined by any other method. (see Green v. United States, 460 F.2d 412)
What are the recognized methods?
-
-
Cost Method
-
Comparative Sales Method
-
Income Method
-
That said, if the probate process has sufficient support that the mineral appraisal really is fair market value (there could have been more effort than just generic county averages applied), then that might take precedent and your tax professional should advise you.
Conclusion
If you’ve sold minerals which were inherited without an established value, it is worth consulting with tax and appraisal experts to discuss potentially reducing your tax bill by only paying on the ACTUAL gains.
As a Professional Engineer and a Certified Mineral Appraiser, Tracy Lenz is uniquely qualified to accurately value your minerals in an ethical, professional manner. E-mail or call today for your free consultation.
