Naro looking for stories on impacts of proposed tax changes

NARO has been visiting with congressmen about the impact of the proposed tax changes on mineral and royalty owners and is looking for good examples to present on the effect these changes will have on particularly smaller owners.

If you you would have a good story to tell on the following topics, please contact me through this website or Jack Fleet at the National Office:

  1. What would be the effect of losing your 15% percentage depletion allowance deduction against your royalties?

  2. What would be the effect if your heirs have to pay capital gains tax on your minerals even if the property has not sold?

  3. How difficult would it be to find out what was paid for the minerals you own?

  4. Would your heirs have to sell part of your minerals to pay this new proposed capital gains?

  5. How has your royalty income improved the finances of you and your family?

Stepping Back By Not Stepping Up By Wade Caldwell, President of NARO - National Email:

One of the most concerning of the tax proposals being floated in Congress this year, among many, is the proposed elimination of the step-up in basis upon death and requiring the payment of capital gains taxes upon death. The NARO Executive Committee recently voted unanimously to oppose elimination of the step-up in basis, especially if it triggered the automatic payment of capital gains on property that had not been sold.

First, a brief primer on estate taxes. When you die, your estate gets valued, and your financial advisor will decide whether your heirs need to file an estate tax return. If your estate is worth more than $11.5 million, after exemptions and credits, you must pay estate taxes on the net taxable estate in excess of $11.5 million. The tax rate at this level is 40%. If your estate does not have the cash to pay the taxes, your heirs must sell assets or borrow money to pay them. Among the current tax proposals, one is to reduce this cap from $11.5 million back to $3 million, which it has not been seen since 2008.

Another thing happens when you die, which is your heirs receive your assets with a free “step-up” in basis. This means that if you decide to file an estate tax return, even though your estate is worth less than $11.5 million, and put values on the estate return, your heirs inherit that property with the higher basis on the date of death. This means that if the heirs ever sell the property, the capital gains they pay is the difference between what they sell it for and the stepped-up basis at your death, not the basis that you bought the property for or inherited it at. This step-up can result in a substantial capital gains savings and encourages people to file estate tax returns so they can take advantage of the free step-up in basis. It also encourages taxpayers to put a fair value on estate tax returns because of the tradeoff. If you put too conservative a value on the estate tax return to stay below the $11.5 million cap, you are also lowering the basis that your heirs will have to use to calculate capital gains if the property ever sells. In other words, the system has some checks and balances.

Next a brief history lesson. In the 1950s and 1960s, when the estate cap was around $60,000, many family farms, and ranches, particularly those that owned minerals, got caught and had to pay substantial estate taxes due to lack of estate planning. Considered “land rich but cash poor”, the heirs had to sell land to pay the estate taxes. In fact, it was such a common thing that it is not unusual to see in chains of title from this era proof that estate taxes had been paid to make sure someone was not buying land or minerals that owed estate taxes.

The startling proposal out of the Biden administration is to eliminate the step-up in basis and require heirs to go ahead and pay the capital gains owed at the time of your death, even if the property has not sold. This would be a disastrous outcome for people that hold family ranches, farms, and family mineral holdings.

So, in other words, if you are passing down minerals you inherited, which means that the cost basis is probably very low, then your heirs will owe up to 20% of the value on the date of your death as a long term capital gain. That amount rises to 23.8% with net investment taxes under current law and will rise to 39.6% if you are making over $1 million per year and if other parts of these tax proposals pass.

As a rough rule of thumb, the IRS may challenge any valuation of producing minerals that is less than three times your annual royalty revenue. If you have land that is currently under lease, but not yet producing, then anything less than the bonus paid is subject to being challenged. These are very rough rules of thumb only.

Further, the automatic triggering of a capital gains tax would put many families in the unenviable position of trying to find out what their basis was. For inherited minerals, or for minerals or land that was purchased decades ago, this can be almost impossible unless you have excellent recordkeeping.

Further, it completely obliterates the incentive to put a fair value on an estate tax return to take advantage of the automatic step-up in basis. If passed, all of the incentive will be to put values as low as possible to minimize the capital gains tax.

Already, groups are clamoring about the impact on family ranches and farms. However, even if credits or exemptions get put into the final bill for these groups, expect much less sympathy for family mineral holdings and increased documentation and recordkeeping.

Further, there is, yet no proposal to limit this proposal only to people that are making more than $400,000 a year, which is President Biden’s stated threshold in which he has promised not to raise taxes.

And what is the general justification for these tax proposals, other than raising additional revenue? The frequently cited reason is income inequality. But who benefits if your heirs are required to sell part of your mineral holdings to pay estate taxes? Are your less fortunate neighbors and friends going to be the buyers of these minerals? No. It will be the hedge funds and other large mineral buying companies that have raised billions of dollars to buy minerals across this country. In other words, this proposal, ostensibly to fight income equality, will actually concentrate mineral holdings in the hands of those who have more means than you do.

The proposal would also have arbitrary and disproportionate impacts. If you own minerals on a limited number of acres but have the good fortune of recently having had one of the new, large horizontal wells drilled on it, the current income may be a true blessing. However, as we know, it can also decline quickly, especially with the decline curves on shale wells. So, a person who has recently had wells drilled on them, and then dies before the decline curve sets in, the heirs will have to hire valuation experts to show the true value was much lower than the recent income indicates. You may be faced with a large capital gains bill, to be paid with rapidly declining royalty checks.

The other side effect of this proposal would be a guaranteed full employment act for all estate planning lawyers. Any radical shift in tax policy like this will cause a huge surge in redone estate plans, gifting, and other mechanisms for trying to minimize expected estate taxes.

Finally, and most discouraging, is the extreme double taxation aspect of it all. These properties were purchased by someone in your family with after-tax money that they already paid income tax on. You paid income taxes on the royalty that was generated also. Keep in mind your minerals are not “income producing” assets. They are assets being depleted by oil production, and therefore declining in value while the production is going on. Now, if you die, your heirs get the pleasure of forking over another 20% to 39.6% of your minerals’ values in taxes to the U.S. government even if they have not sold and generated the cash to pay the tax bill. Somewhere along the way I suspect that that adds up to more than 100%.

Eliminating the step-up in basis? It is a major step backwards.

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Following up on Wade’s discussion regarding the current tax proposals to eliminate fair market value basis( which can be either a step-up or step-down from the cost basis) for assets that are not income in respect of a decedent such as IRAs and qualified retirement plans, one argument to help defeat the proposal is to emphasize it repeats prior, failed tax policy.

The Tax Reform Act of 1976 contained a new Section 1023 of the Internal Revenue Code, which would have provided for carryover basis rules to apply to the assets of a decedent dying after December 31, 1976. This provision was retroactively repealed in 1980 and never took effect. Why was it repealed? Congress finally listened to tax professionals who had strongly advocated the law was unworkable due to the nature of the records that most taxpayers had regarding assets received from others and it was going to get tax administration problems for the IRS.

The clean slate afforded by a fair market value basis for inherited assets based on IRC Section 1014 facilitates tax compliance by taxpayers and efficient tax administration by the Internal Revenue Service. Carryover over basis does not. If you have every had to go through the records of a decedent to locate all of their assets, you know what a difficult task that can be–let alone find the records to show the cost of an asset.

The various tax proposals dealing with the proposed carryover basis differ regarding what is a realization event that would trigger the capital gains tax. Death is clearly a triggering event for the capital gains tax and what is not getting as much press are certain lifetime gifts. Also, there are proposals to cause a realization event to occur every 21 years for property transferred to grantor trusts that are not included in the grantor’s estate for federal estate tax purposes.

There are tax proposals that would carve out exemptions for family farms and ranches and family businesses so that the beneficiaries and heirs would not have to pay the capital gains tax until the assets were actually sold. I have not seen similar discussions concerning passive assets such royalties, which have been inherited. Thus, if the exemptions described above become law, entity planning will need to be done to try and convert passive mineral ownership into an active trade or business, which may require the ownership or working interests too.

Under current law, the fair market value at death basis rule applies to large estates as well as small estates. An executor’s fiduciary duty includes the obligation to determine the fair market value of the assets and this duty applies were or not a federal estate tax return is required to be filed because a probate inventory requires the executor to list the probate assets at their fair market value. The decedent’s eligible assets receive a fair market value basis whether of not a federal estate tax return is required to be filed. With the current federal estate tax exemption at $11,700,000 for decedent’s dying in 2021, the number of estates required to file a federal estate tax return is small. However, many estate tax returns are filed so the executor can make the portability exemption to allow the surviving spouse to use the deceased spouse’s unused federal estate tax exemption.

It should be noted that there is a proposal to limit the federal gift tax exemption to $1,000,000 and the federal estate tax exemption to $3,500,000, neither of which would be indexed for inflation. Current law provides that on January 1, 2026, both of these exemptions would be reduced to $5,000,000 and would be indexed for inflation.

It should be noted that politically there are about 5 Democratic senators up for reelection in 2022 who are located in “red” or “purple” states and if political pressure is brought to bear on them in the “tax reform” area, they are not necessarily going to support major estate and gift tax proposals or the repeal of fair market value basis.

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Excellent points and background Steve. Thank you!

Thank you for being proactive here.

The loss of the 15% is unconscionable…it will hurt alot. I need the deduction!!

Some have this as their only subsistence financially.

Do not let this be low hanging fruit to pick.

Let me know if I can help!

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