In general, the Internal Revenue Service deems income as passive if the taxpayer doesn't actively participate in the business. When it comes to oil, landowners that allow outside parties to extract it receive oil royalties and must report them for tax purposes. Even if the landowner doesn't participate in the business, oil royalties are considered ordinary income, not passive income, for the landowner.
Passive vs Ordinary Income
Although they may seem to meet the definition of passive income, dividends, interest, gains and losses from stock, annuities and royalties are all considered ordinary income. Passive income doesn't have as many tax benefits as ordinary income. For example, a taxpayer with ordinary losses from a business can deduct it against other earned income. In contrast, passive losses can only be deducted against passive income.
The IRS considers royalties from oil and gas leases to be ordinary income even if the taxpayer doesn't participate in the business. Owners should get a Form 1099-MISC early in the year that details total royalties earned the year before. Royalty recipients are also entitled to take a deduction for the oil depleted during the year. Owners with a working interest in extraction operations can also deduct related business expenses such as legal, administrative, transportation costs.
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