Quick answer: When an oil and gas company leases your mineral rights and produces from your land (or a pooled unit), you receive a royalty — a percentage of gross production revenue — every month. Standard negotiated royalty rates range from 12.5% (1/8) to 25% (1/4). You bear zero production costs. Royalty income is taxed as ordinary income.
Surface Rights vs. Mineral Rights in Texas
In Texas, mineral rights can be severed from surface rights — meaning the person who owns the land you see and farm may not own the oil and gas below it. When a previous owner sold the land but reserved the minerals, or when minerals were inherited separately from the surface, you may be surface owner only. This is extremely common in the Texas Panhandle and Permian Basin. When you buy farmland, always confirm whether minerals are included or severed, and get a title opinion on the mineral estate if you plan to factor mineral value into your purchase price.
If you own minerals, an oil company may approach you to sign an oil and gas lease. The lease grants them the right to drill in exchange for a bonus payment (up-front per-acre payment) and a royalty on production. The lease term, royalty rate, and surface use provisions are all negotiable — get an oil and gas attorney to review any lease before signing.
How Royalty Checks Are Calculated
Your monthly royalty = (your royalty fraction) × (your net acreage / total unit acreage) × (gross production revenue). If you own 160 acres in a 640-acre drilling unit with a 1/5 (20%) royalty, and the well produces $100,000 in gross revenue that month, your check is: 20% × (160/640) × $100,000 = $5,000. Operators deduct severance taxes (4.6% for oil in Texas, 7.5% for gas) before cutting your check. Some leases allow deduction of post-production costs (transportation, compression) — negotiate a "no deductions" clause if possible.
Tax Treatment of Royalty Income
Mineral royalty income is ordinary income, reported on Schedule E (not Schedule F). You may take a percentage depletion deduction — for oil and gas, independent producers can deduct 15% of gross income from the property (limited to 100% of net income). Keep records of all royalty checks and any depletion calculations. If you sell mineral rights, the gain is typically capital gains. Inherited mineral rights receive a stepped-up basis at death — potentially eliminating all capital gains on appreciation during the decedent's lifetime. Given the volatility of royalty income, plan for taxes in high-production years and work with a CPA familiar with oil and gas taxation.
Questions About Your Ranch or Farm Situation?
Kyle Ellison is a fourth-generation Texas Panhandle rancher and licensed financial professional in TX, CA, NV, MT, UT, NM.