When gas or oil production is started on a plot of land, the owner of the land is entitled to royalties, or a percentage of the lease minus production costs. While oil and gas leasing can generate substantial revenue for a landowner, there are tax implications. Depending on the state, there may be state and local taxes in addition to federal taxes.

Here is how compensation works for oil and gas leasing and how it’s reported on a tax return.

1. Typical Compensation for Mineral Rights

In most cases, landowners receive two types of compensation for leasing mineral rights: a signing bonus per acre and the percentage of the money generated by the gas and oil from the property. The bonus is most often $200 to $500 per acre. The standard royalty for oil and gas production is 12.5%, but it can be as high as 18% to 25%, according to Blackbeard Data Services. Sometimes the bonus is the only money the landowner receives if no gas or oil is found or the company abandons the prospect.

2. Taxation on Oil and Gas Royalties

The IRS treats royalty payments as regular income. They are subject to the landowner’s marginal or highest income tax rate. Anyone who receives oil and gas royalties should receive a 1099 form if they received more than $600.

Most states also consider royalty payments as income, and they are taxed like other forms of income. There are a few states that are exempt, such as Texas and Wyoming. In most states, mineral income is treated at the state level just like the federal level, but not all states follow this rule. In Oklahoma, for example, the lease bonus can be used as part of the basis for depletion for a larger tax deduction.

3. Allowed Expenses for Royalties

The IRS does allow landowners to deduct expenses incurred through ownership of royalties. The most valuable deduction is usually the depletion deduction. Through this, the IRS allows the landowner to deduct the loss of value to the property as the gas and oil wells will run dry over time. A portion of the income earned each year can be written off. It is possible to calculate actual depletion of the well based on the amount taken out and its reserves, but most landowners choose a straight 15% depletion deduction from the gross income.

Landowners can also write off their share of property taxes, production taxes, transportation expenses, marketing costs, accounting fees, and legal fees associated with the royalties.

4. How to Report Income from Royalties

Royalty payments and related expenses are all reported on Schedule E of the landowner’s federal tax return. Royalty income is reported on line 4 before eligible expenses are deducted. The amount reported on the 1040 return is the net profit or loss from Schedule E. Once the royalty payments are carried over to line 17 of 1040, they are included with regular income and subject to income tax.