The short answer
Royalty income is ordinary income reported on Schedule E and sheltered only by depletion, and it falls as the wells decline and as prices move. Selling a perpetual royalty is a different event: gain on an interest held more than a year is capital gain, and because a perpetual royalty is real property under the regulations, the sale can be run through a section 1031 exchange into leased buildings or a Delaware Statutory Trust interest without paying that tax now. The exchange does not erase section 1254 recapture of past depletion when the replacement is not mineral property, and a royalty that lasts only for the term of a lease cannot be exchanged at all. Royalty proceeds carry no debt, so the replacement that fits is an all-cash traditional DST or a net-leased property bought outright.
At a glance
| How royalties are taxed | Schedule E line 4: royalties from oil, gas or mineral properties are ordinary income |
|---|---|
| Percentage depletion | Section 613A: 15% for independent producers and royalty owners, on up to 1,000 barrels a day |
| Depletion ceiling | Section 613A: the deduction cannot exceed 65% of taxable income |
| Not self-employment income | Section 1402(a)(1): rentals from real estate are excluded from net earnings from self-employment |
| Sale is capital gain | Section 1222: gain on a capital asset held more than one year is long-term |
| Depletion recapture | Section 1254: depletion that reduced basis is ordinary income on disposition, deferred only into other mineral property |
| Like kind | Reg. section 1.1031(a)-3: a perpetual royalty is an interest in unsevered natural deposits, and state law must agree |
The decision is whether to keep an income that declines or convert it into rent that does not deplete
A royalty check is a share of production from a reservoir that gets smaller every month it produces. The payment moves with the commodity price, with the operator's decisions and with the decline curve, and none of those is under the royalty owner's control. The owner's only lever is whether to hold or sell.
Rent from a leased building behaves differently. It is set by a lease, it does not deplete, and the building is depreciated rather than depleted, which matters for the owner's tax return in a way worked through below. The trade carries its own risks: a tenant can default, a building can lose value and a DST interest cannot be sold on demand. It is a trade of one set of risks for another. The companion page on selling mineral rights covers which interests qualify.
What the royalty costs you each year: ordinary rates, a depletion deduction and nothing else
The Schedule E instructions put royalties from oil, gas or mineral properties on line 4, and the income is taxed at ordinary rates. There is no capital-gain rate on a royalty check. Line 18 allows depletion for an owner with an economic interest in the mineral property, and for most royalty owners that means percentage depletion.
section 613A(c) sets percentage depletion for independent producers and royalty owners at 15 percent of gross income from the property, on an average daily production of up to 1,000 barrels of oil or its gas equivalent. Subsection (d)(1) caps the deduction at 65 percent of the taxpayer's taxable income for the year. In plain terms, a royalty owner typically keeps 15 cents of every royalty dollar free of income tax and pays ordinary rates on the other 85.
What the sale costs you: capital gain, section 1254 recapture, and why the exchange reaches one but not the other
A royalty held more than one year is a capital asset, and section 1222(3) makes the gain on its sale long-term capital gain. For an inherited royalty, the basis is the value at the prior owner's death, so the gain is the appreciation since then plus any depletion that has reduced that basis.
section 1254(a) reaches that depletion first: on disposition of oil and gas property, the lesser of the gain or the depletion deductions under section 611 that reduced adjusted basis is treated as ordinary income. The section applies rules similar to section 1245 for exchanges, which means the recapture is deferred only to the extent the replacement property is itself section 1254 property. Exchange a royalty into an apartment building or a net-leased DST and the recapture is recognised up to the value of the non-mineral property received.
The like-kind question for the royalty itself is settled by Reg. section 1.1031(a)-3: mines, wells and other natural deposits are real property while unsevered, easements and similar intangible interests in real property qualify, and the interest must be classified as real property by the state where it sits. A perpetual royalty passes; a royalty that expires with a lease or after a fixed quantity does not, which the mineral rights property page treats in detail.
A worked model: a $40,000-a-year royalty sold for $600,000 and exchanged into rent
Take a hypothetical perpetual royalty on producing wells paying $40,000 a year, inherited six years ago at a value of $350,000, with $30,000 of depletion claimed since, and a buyer offering $600,000, using round numbers throughout. Adjusted basis is $320,000 and the gain is $280,000, of which $30,000 is section 1254 ordinary income and $250,000 is long-term capital gain.
Holding: the owner reports $40,000 of ordinary income a year, deducts $6,000 of percentage depletion, and watches the check decline as the wells do. Selling for cash: the owner pays tax on $250,000 at 20 percent plus 3.8 percent and on $30,000 at ordinary rates, roughly $70,000 of federal tax, and reinvests about $530,000. Exchanging: $600,000 goes to the intermediary and into replacement real property, the $250,000 of capital gain is deferred, and the $30,000 of recapture is recognised because the replacement is not mineral property, costing roughly $11,000 at ordinary rates.
On the replacement side, $600,000 of leased real estate is depreciated over 27.5 or 39 years, so a share of the rent arrives sheltered by depreciation rather than by 15 percent depletion. The rent is not guaranteed and the building can lose value, but it does not deplete. Have your CPA run the depletion history and the recapture before accepting the offer, because that number decides whether the exchange paperwork is worth it.
- Sale price $600,000; adjusted basis $320,000; gain $280,000.
- Section 1254 ordinary income: $30,000, recognised even in an exchange into buildings.
- Long-term capital gain deferred by the exchange: $250,000.
- Annual royalty given up: $40,000 ordinary income, less $6,000 of percentage depletion.
Energy DSTs exist, but they are a niche that keeps you in the decline curve
Some Delaware Statutory Trusts hold royalty interests rather than buildings. For a royalty owner they have one attraction: a royalty exchanged into a trust that owns royalties is an exchange of section 1254 property for section 1254 property, so the depletion recapture is deferred rather than recognised. The DST versus royalty comparison page sets the two side by side.
The cost is that the owner has not left the asset class. A royalty-pool trust depletes, its income moves with commodity prices, and it adds sponsor fees and a sponsor-controlled exit on top of the reservoir risk the owner already had. A royalty program sold as fund or partnership units is not real property at all and cannot be replacement property.
The replacement that fits royalty proceeds is an all-cash DST or a building owned outright
Royalty proceeds have no debt attached, and the seller's purpose is income that is set by a lease rather than by the futures market. An all-cash Delaware Statutory Trust holding leased property with no mortgage matches that purpose; the firm's traditional DST page lists minimums of $100,000 to $250,000 per trust, which allows a $600,000 exchange to be spread over two or three trusts in different property types.
The risks run the other way from a royalty. A DST interest cannot be sold on any exchange, the sponsor decides when the property is sold, distributions may be reduced or suspended, and the investor can lose some or all of the invested principal if a tenant fails or the property sells below cost. A royalty owner used to a check that varies but never stops should read a trust's private placement memorandum with those risks in front of them.
Related questions
Are my royalty checks capital gains?
No. Royalties are ordinary income on Schedule E line 4, reduced by depletion. Only the sale of the royalty interest itself produces capital gain, and only if you held it more than a year.
Will I lose the depletion deduction if I exchange?
Yes, because the replacement property is depreciated rather than depleted. Past depletion that reduced your basis also comes back as ordinary income under section 1254 unless the replacement is itself mineral property.
Can I exchange a royalty that ends when the lease ends?
No. An interest limited to the life of a lease or to a fixed quantity of production is not like kind to a fee interest. A perpetual royalty on the minerals in place is the exchangeable form.
Is a DST that owns royalties a good way to avoid the recapture?
It defers the section 1254 recapture because it is mineral property, but it keeps you in a depleting, price-driven asset with sponsor fees on top. Whether that trade is worth it depends on how large the recapture is and why you are selling.
Does the net investment income tax apply to royalties and to DST rent?
Both are investment income for an owner who is not in the trade or business, so both are subject to the 3.8 percent tax above the thresholds. The exchange defers the tax on the sale; it does not change how the income is taxed each year.
Sources
Checked against these publications on October 8, 2026. Rules and figures change; confirm the current version with your CPA or attorney before you act. This page is general information, not tax or legal advice.
- IRS, 2025 Instructions for Schedule E (Form 1040), royalties (line 4) and depletion (line 18)
- 26 U.S.C. section 613A, Limitations on percentage depletion in case of oil and gas wells
- 26 U.S.C. section 1402(a)(1), Net earnings from self-employment (rental exclusion)
- 26 U.S.C. section 1222, Other terms relating to capital gains and losses
- 26 U.S.C. section 1254, Gain from disposition of interest in oil, gas, geothermal or other mineral properties
- Treas. Reg. section 1.1031(a)-3, Definition of real property
- Treas. Reg. section 1.611-1, Allowance of deduction for depletion (economic interest)
- 26 U.S.C. section 1031, Exchange of real property held for productive use or investment