Mineral rights owners are often confused whether to sell or lease their ownership. Leasing seems to be pretty luring as it is assumed by many to be a steady income-generating option. But, in reality, leasing is not as simple and beneficial as it is perceived.
Below are 6 common potential risks when leasing mineral rights:
1. Unsteady Royalty Payments
A royalty payment is the compensation received by the mineral rights owner in return for giving the mining company the right to extract oil and gas from his property. Although there are different methods in calculating this payment, the most basic form would be an up-front lease bonus payment plus a royalty percentage of the value of production.
It is clear that royalty depends on the value of the production. If you are leasing the rights for the first time, the production will be substantial in the first few months. As the drilling goes on, the producing potential of the well decreases and will affect your royalty payments. Unless, you have a good producing well, leasing generally leaves you with an unsteady income. Also, there is a chance the leasing company does not intend to drill at all during the lease period leaving you with no income and tying your property up.
2. Risk of Depleting Assets
It is very difficult to predict the producing life of a well. Sometimes a newly drilled well which produces a substantial amount may suddenly stop producing and become depleted. Once it's depleted, your mineral rights become worthless. You neither receive royalties nor can you sell rights to other companies.
3. Negative Impact on Property's Value
One of the biggest drawbacks of leasing is not knowing the right terms and clauses to include in a lease. This can potentially greatly decrease your income on a property. If you sign a lease but leave in negative or operator friendly lease language you can impact the overall property value. Also in many cases, it's best not to lease to get the greatest value for your rights. In any case it's best to look into this before executing a lease. If you own severed mineral rights, many times the surface owner can be a big messy problem to deal with. Many clauses that deal with surface ownership should be taken very seriously and left to those that know it best.
4. Complicated Legal Procedures
Once two parties agree on the mineral rights lease, both parties have to sign an agreement which is generally prepared and drafted by the leasing company. All legal procedures and documentation with regard to leasing is complicated and can lead to disputes and disagreements during the extraction and production. If you disagree with any of the operations after the drilling commences, as per the agreement, you will be bound by the lease that was executed in in most cases cannot stop the operator from drilling.
5. Heavy Tax Burdens
While most income from a mineral rights sale is taxed at 15% (Capital Gains), the income from royalty and bonus payments from a lease payment is charged for ordinary income rates which can be very high! (Check with your tax professional). It is usually very beneficial to sell the mineral rights over leasing them due to the much lower potential tax rate of the income and sale.
6. Accounting Hassles
Receiving a royalty payment may seem exciting, but the accounting and records maintenance is a challenging task. One has to monitor the drilling process, payment process and pending payments. In addition and more importantly, in order to check the accuracy of the accounting, professional audits will be necessary.
The only way to avoid all of the above-mentioned hassles is to sell the mineral rights. By selling your mineral rights, you will receive a lump sum cash payment that you can put to use on other investments like real estate or payment of bills or payments that are due.