Oil and gas royalties are an excellent source of passive income for self-directed IRA (SDIRA) holders.
While they may sound complicated at first, oil and gas royalties are generally easy to invest in and are one of many mineral rights assets that can lead to long-term gains. Here’s how to invest in oil and gas royalties using a SDIRA and what you need to know before you get started.
How Oil and Gas Royalties Work
Oil and gas royalties refer to payments made to mineral rights owners when resources are extracted from their land. To receive royalties, you typically lease your land to drilling companies and earn a percentage of the revenue received.
Royalties often yield 12.5% or more of revenue. However, the exact amount received will depend on a variety of factors, including the lease agreement, the amount of gas or oil extracted, and the market demand.
Oil and gas royalties can produce passive income for investors, including those who hold old oil and gas royalties in eligible retirement accounts, such as self-directed IRAs (SDIRAs)
Why Oil and Gas Royalties Are a Smart Investment Strategy
Oil and gas royalties are an excellent and fairly straightforward investment. Investing in oil and gas royalties can offer several benefits, including:
- Passive Income: When you invest in royalties, you earn income without actively managing the property or the operations.
- Diversification: Investing in gas and oil royalties allows you to diversify your portfolio and limit your reliance on a specific type of investment, such as stocks and bonds or a specific industry or sector.
- Inflation Hedge: Commodity prices, including oil and gas, often rise during inflationary periods, making royalties a potential hedge against inflation.
- Tax Advantages: Depending on how you invest in royalties, your earnings may earn tax advantages. For instance, royalties held in eligible retirement accounts can grow tax-free. If you want to add gas and oil royalties to your retirement portfolio, you need to open a self-directed IRA.
What Types of Mineral Royalties Can You Invest in an SDIRA
Self-directed IRAs allow you to hold a number of different mineral royalties with very few additional regulations attached, including:
- Oil and Gas Royalties: As specified above, these mineral rights are based on revenue generated from the extraction and sale of oil and gas from leased properties. Payments are typically made based on production output and market prices.
- Mining Royalties: Similar to oil and gas royalties, mining royalties involve receiving a share of the revenue generated from mining activities, such as those for gold, copper, and iron. Royalties can be based on either the volume of resources extracted or the value of the minerals sold.
- Timber Royalties: These royalties stem from timber harvesting on a property. Investors earn a percentage of the proceeds from timber sales.
- Water Rights Royalties: In some regions, water rights can be leased, and royalty payments are made to the owner for the use of water resources.
Are Oil and Gas Royalties Subject to UBIT?
Oil and gas royalties held in an SDIRA are generally not subject to unrelated business income tax (UBIT). However, there are two circumstances that may result in UBIT obligations:
- Debt-Financed Income: If the SDIRA uses borrowed funds to acquire oil and gas royalty interests, a portion of the income generated may be subject to Unrelated Debt-Financed Income (UDFI), which triggers UBIT.
- Active Business Operations: If the SDIRA engages in active business operations rather than simply earning passive royalties, the income could be subject to UBIT.
Steps to Invest in Oil and Gas Royalties in an SDIRA
If you want to invest in oil and gas royalties using an SDIRA, follow the steps below.
1. Research SDIRA Custodians
SDIRAs must be opened with IRS-approved custodians. As you research and compare custodians, look for those who have experience with oil and gas royalties, as they will be familiar with the documents and permits required for this type of investment.
It’s also helpful to review and compare custodian fees. Reputable custodians should be able to provide a transparent list of fees and answer any questions you may have.
2. Open an SDIRA
Once you find the right custodian, you can open your SDIRA. Though the process varies by company, it’s typically straightforward and requires minimal paperwork.
As part of this process, you’ll need to fund your account. You do so in one of the following ways:
- Transfer funds from an existing IRA account.
- Rollover funds from an employer-sponsored retirement plan, such as a 401(k).
Though you can fund your SDIRA account with money from a checking or savings account, those types of transactions count towards your annual contribution limit, whereas transfers and rollovers do not. The current contribution limit for IRAs is $7,000, with an additional $1,000 catch-up contribution if you are 50 or over.
3. Research Investment Opportunities
In an SDIRA, the account holder is responsible for all investment decisions. The custodian does not offer investment advice.
As such, you need to complete due diligence for each investment, and thoroughly research each aspect of the investment, including the asset, market/industry, and the company or organization with which you will do business.
4. Purchase Royalties Through Your IRA
After you complete due diligence, you can purchase the royalties. In general, you must coordinate asset trades with your custodian. However, SDIRA owners can also choose to establish an SDIRA LLC, resulting in “checkbook control.” In this case, investors can bypass the custodian to purchase the asset directly.
Learn how it works: Self-directed IRAs with checkbook control.
5. Monitor Gains and Tax Implications
Track your investment’s performance, including royalty payments, market trends, and potential risks. While royalties are typically exempt from UBIT, monitor for scenarios like debt-financed income. Speaking to a financial advisor can help you determine if your investment earnings result in any tax obligations.
Investing in oil and gas royalties with a self-directed IRA is easy and profitable. To get started, contact Horizon Trust today to open an account or discuss your investment options.
FAQs
What are the potential benefits of investing in oil and gas royalties through an SDIRA?
Investing in oil and gas royalties with your SDIRA allows you to diversify your portfolio while securing passive earnings that grow tax-free while in your account. It also makes it easy to invest in profitable industries without worrying about direct costs, such as operational expenses.
Are there risks involved in investing in oil and gas royalties?
Yes, investing in oil and gas royalties comes with risks. Common risks include market volatility, potential production issues, and any additional costs stipulated in the land lease terms. As such, it’s important to approach each oil and gas royalty investment with due diligence to assess potential risks.
How does taxation work for oil and gas royalty income within an SDIRA?
Oil and gas royalty earnings held in an SDIRA are typically tax-advantaged. If you have a traditional SDIRA, taxes are deducted when you make withdrawals during retirement. If you have a Roth IRA, you won’t need to pay taxes on qualified withdrawals.
However, taxes may apply if you financed the purchase of royalties. In that case, earnings would be subject to unrelated business income tax (UBIT). You may also owe taxes if your royalties are earned as part of an active business engagement held by your SDIRA.
