Is Oil and Gas Royalty Income Passive or Portfolio?

Oil and gas royalty income is not passive income under federal tax law. The IRS treats standard royalty checks as portfolio income, a separate category that sits outside the passive activity rules entirely.¹ That classification decides which losses can offset your royalties, whether the 3.8 percent Net Investment Income Tax applies, and how you report the income on your return.

Why the IRS Calls Royalties Portfolio Income

Most royalty owners do nothing to earn their checks. They inherited mineral rights, bought them as an investment, or leased land to an operator. The intuition that this must be “passive” is reasonable, but the tax code draws the line somewhere else.

Section 469(e)(1)(A)(i)(I) specifically excludes royalties not earned in the ordinary course of a trade or business from the passive activity calculation.¹ Instead, they land in the portfolio category alongside interest, dividends, and annuities.² The Schedule E instructions state it plainly: “Royalty income not derived in the ordinary course of a trade or business reported on Schedule E in most cases is not considered income from a passive activity.”³

Royalty checks are neither passive income nor active earned income. They occupy their own tax bucket.

What the Portfolio Label Means for Your Taxes

The classification has two practical effects, and they cut in opposite directions.

First, passive losses from other investments cannot shelter your royalty income. If you own a rental property that generated a $10,000 passive loss and you also received $15,000 in royalty income, you cannot net them. Passive activity losses only offset passive activity income under Section 469, and royalties are not passive.¹ The rental loss stays suspended on Form 8582 until you have passive income to absorb it or you dispose of the rental entirely.⁴

Second, the portfolio label works in your favor on the deduction side. If depletion and other allowable deductions on a royalty property exceed the income it produces, the resulting loss is a portfolio loss, not a passive one. Portfolio losses are not caged by the Section 469 limitations, so they can reduce your other taxable income.

The Narrow Exceptions

A handful of taxpayers earn royalties in the ordinary course of a trade or business, such as someone who deals in royalty interests. Their income may be treated as active business income rather than portfolio income, which can affect eligibility for deductions like the qualified business income deduction. Qualifying generally requires being in the trade or business of dealing in royalties or obtaining a private letter ruling from the IRS.² Neither describes the typical mineral rights owner.

Working Interests Are a Different Animal

A working interest in an oil or gas property is not a royalty interest, and the tax treatment differs completely. Section 469(c)(3)(A) excludes a working interest from the definition of a passive activity regardless of whether you materially participate in the operation.¹ This is one of the few automatic exceptions in the passive activity rules.

How you hold the interest determines whether the exception applies. You must own it directly or through an entity that does not limit your personal liability, such as a general partnership. Hold the working interest through an LLC or limited partnership that caps your exposure and the exception is lost.² The logic tracks the risk: if you are on the hook for drilling costs, environmental cleanup, and operating expenses, the IRS treats the income as non-passive.

Because working interest income is non-passive, losses on a working interest can offset wages, interest, business profits, and other ordinary income. A royalty owner with a net Schedule E loss on a royalty interest cannot use that loss against wages. A working interest owner reporting a Schedule C loss can. That makes working interests attractive to higher-bracket investors looking to deploy drilling-year losses against other income.

The at-risk rules under Section 465 still cap the deduction. Oil and gas exploration is one of the activities the statute specifically lists.⁵ You can only deduct losses up to the amount you have personally at risk, generally your cash investment plus amounts you have borrowed and are personally liable to repay. If a third party or insurance covers your potential losses, the IRS can reduce or deny the deduction.

The Net Investment Income Tax Still Applies

Portfolio classification does not shield royalties from the 3.8 percent Net Investment Income Tax. The regulations include royalties in net investment income unless they are derived in the ordinary course of a non-passive trade or business.⁶

The surtax applies to the lesser of your net investment income or the amount your modified adjusted gross income exceeds the threshold for your filing status:⁷

Married filing jointly or qualifying surviving spouse: $250,000
Single or head of household: $200,000
Married filing separately: $125,000

Those thresholds are set by statute and do not adjust for inflation. Working interest income may escape the NIIT if the activity qualifies as a non-passive trade or business, though it will then face self-employment tax instead.

Percentage Depletion: The Offset Royalty Owners Actually Get

Because passive losses cannot reach your royalty income, the depletion deduction becomes the main tool for reducing the tax on it. Percentage depletion lets you deduct a fixed portion of gross royalty income to reflect the gradual exhaustion of the mineral resource. For independent producers and royalty owners, the rate is 15 percent of gross income from the property.⁸

Two caps apply. Percentage depletion is limited to the first 1,000 barrels of average daily production, or the natural gas equivalent. Total depletion for the year cannot exceed 65 percent of your taxable income, calculated before the depletion deduction and certain other items.⁸ Anything disallowed under the 65 percent cap carries forward to the next year.

Section 613A specifies that these rules apply to independent producers and royalty owners rather than large integrated oil companies. As long as production stays below the daily limit and depletion stays under the income cap, you can claim the 15 percent deduction each year, even if the cumulative depletion eventually exceeds your original cost basis in the property.

How to Report It

The operator or purchaser paying your royalties issues a Form 1099-MISC after year-end, with gross royalties in Box 2. That figure is your royalties before any reduction for severance taxes or other deductions.⁹ Working interest payments come on Form 1099-NEC in Box 1 instead.

Standard royalty income belongs on Schedule E (Supplemental Income and Loss), where you list gross income and subtract allowable deductions such as percentage depletion and state severance taxes.¹⁰ Working interest income goes on Schedule C because the IRS treats it as a trade or business, which also triggers self-employment tax at a combined 15.3 percent (12.4 percent Social Security and 2.9 percent Medicare).¹¹

If you carry suspended passive losses from other activities, report them on Form 8582 to see how much you can use for the year.⁴ Those losses will not reach your royalty income, but they may offset other passive income you report.

1
Office of the Law Revision Counsel. 26 USC 469 – Passive Activity Losses and Credits Limited
2
Internal Revenue Service. Publication 925, Passive Activity and At-Risk Rules
3
Internal Revenue Service. 2025 Instructions for Schedule E (Form 1040)
4
Internal Revenue Service. 2025 Instructions for Form 8582, Passive Activity Loss Limitations
5
Office of the Law Revision Counsel. 26 USC 465 – Deductions Limited to Amount at Risk
6
eCFR. 26 CFR 1.1411-4 – Definition of Net Investment Income
7
Internal Revenue Service. Topic No. 559, Net Investment Income Tax
8
Office of the Law Revision Counsel. 26 USC 613A – Limitations on Percentage Depletion in Case of Oil and Gas Wells
9
Internal Revenue Service. Instructions for Forms 1099-MISC and 1099-NEC
10
Internal Revenue Service. About Schedule E (Form 1040), Supplemental Income and Loss
11
Internal Revenue Service. Self-Employment Tax (Social Security and Medicare Taxes)