In this guide
Why three layers exist
Minerals are unusual property: they are income-producing, they are physically consumed as they pay, and three levels of government have historically claimed a piece. The federal government (plus most states) taxes the income; the producing state taxes the act of extraction through a severance or production tax; and in many states the county taxes the property value of the reserves still in the ground. None of these replaces the others by default — though several states, like Oklahoma and North Dakota, deliberately structured their severance tax to be "in lieu of" the county layer, and a few, like Colorado and Kansas, let you credit part of one layer against another.
If you invest through a drilling partnership, own mineral rights, or collect royalties, all three layers show up in your economics whether you notice them or not. Layers 2 and 3 arrive pre-deducted on revenue statements; Layer 1 arrives every April.
Layer 1: income tax — where the write-offs live
Your share of production income is ordinary income, federally and in most states. What makes oil & gas unusual is the set of deductions Congress attached to it, and they are worth knowing at least by name:
- Intangible drilling costs (IDCs), IRC §263(c). Typically 60–85% of the cost of drilling a well — labor, fuel, mud, rig services, everything with no salvage value — deductible in full in the year incurred. This is the engine of every year-end drilling program pitch.
- Tangible costs. The equipment balance (casing, pumps, tanks) is capitalized and depreciated over seven years under MACRS.
- Percentage depletion, IRC §613A. Independent producers and royalty owners deduct 15% of gross production income each year — even after recovering their full basis — subject to the 1,000-barrel-per-day, 100%-of-property-income, and 65%-of-taxable-income limits.
- The working-interest exception, IRC §469(c)(3). A working interest held without limited liability is not a passive activity, so drilling deductions can offset wages and business income — the rarest feature in the code, and the reason investor-general-partner structures exist.
Each of these carries real limits: prepayment timing rules on IDCs, an AMT preference for large IDC deductions, recapture as ordinary income under §1254 when you sell, and state-by-state differences in whether your state honors the federal treatment. The full mechanics — what qualifies, GP vs. LP timing, the 90-day spud rule, a worked $100,000 example — are in the dedicated guide.
The honest frame, stated once: write-offs defer and reduce tax on capital you have genuinely put at risk. A deduction never rescues a bad well, and production income is fully taxable later. If a deal only pencils because of the deduction, it doesn't pencil.
Layer 2: severance taxes — the state's cut at the wellhead
Every major producing state except Pennsylvania and California levies a severance tax (sometimes called a production or gross production tax): a percentage of the value — or a fixed amount per barrel or mcf — of everything that comes out of the ground. In 2025–26 the headline rates run from Texas's 4.6% on oil and 7.5% on gas, through Oklahoma's 5% then 7%, to North Dakota's 10% combined on oil and roughly 12% all-in in Wyoming once the county layer is added. Pennsylvania charges a flat per-well "impact fee" instead; California charges only a small regulatory assessment.
Two things matter for investors. First, everyone pays: the operator remits the tax on gross production and deducts each owner's proportionate share — severance tax comes out of royalty checks and working-interest revenue alike, usually as a line item you never see unless you read the check detail. Second, exemptions are everywhere: stripper wells, high-cost gas, enhanced recovery, new-well holidays. On marginal properties the incentive rate can be the difference between a well that keeps pumping and one that gets plugged.
Layer 3: ad valorem taxes — the county's annual bill
In Texas, Colorado, Wyoming, Kansas, California, and several other states, producing minerals are also taxable property. The county appraises the value of the remaining reserves — usually a discounted-cash-flow estimate of future production — and taxes it every year at local rates. In Texas that typically works out to roughly 2–3% of the interest's appraised value per year, billed to royalty owners directly and charged to working-interest owners through the operator. Other states went the opposite way: Oklahoma, North Dakota, and Montana made their production tax expressly in lieu of county property tax, so there is no separate county bill on production; Colorado and Kansas split the difference by crediting part of the ad valorem bill against severance tax.
This is the layer investors most often fail to model, because it isn't tied to a transaction — it's an annual levy that continues as long as the appraisal district thinks your interest has value, and it's the one you can actually protest.
Worked example: $100 of production revenue in Texas
Take one working-interest owner's $100 share of gross oil revenue from a Texas well in 2026, an investor in the 37% federal bracket (Texas has no personal income tax, which flatters this example):
| Line | Amount |
|---|---|
| Gross production revenue (your share) | $100.00 |
| Less: Texas severance tax on oil (4.6%, 2025 rate) | −$4.60 |
| Less: county ad valorem tax (illustrative ~2.5% of value) | −$2.50 |
| Less: lease operating expenses (illustrative 20%) | −$20.00 |
| Pre-tax cash to you | $72.90 |
| Percentage depletion (15% of $100 gross) | −$15.00 (deduction) |
| Taxable income | $57.90 |
| Federal income tax (37%) | −$21.42 |
| After-tax cash from $100 of revenue | $51.48 |
Read the shape of it: severance and ad valorem together took about 7 cents of every gross dollar before income tax entered the picture — but both were deductible, and depletion sheltered another 15 cents of the gross from income tax entirely. The effective all-in tax rate on the pre-expense dollar came to roughly 28.5% instead of the 44%+ you'd get by naively adding 37% + 4.6% + 2.5%. The layers stack, but deductibility and depletion keep them from compounding. (Rates and percentages here are illustrative and rounded; ad valorem varies by county and appraisal, and a royalty owner's version of this table has no LOE line.)
How the stack differs: working interest vs. royalty owner
| Layer | Working interest | Royalty owner |
|---|---|---|
| Income tax write-offs | IDC deduction, 7-yr depreciation, 15% depletion, §469(c)(3) exception if GP | 15% depletion only |
| Severance tax | Pays share via operator; deductible | Deducted from royalty checks; deductible |
| Ad valorem tax | Charged through operator (JIBs); deductible | Billed by county directly (in stacking states); deductible |
| Also pays | Drilling costs, LOE, plugging liability | Nothing — no cost obligations |
The pattern: Layers 2 and 3 are ownership-blind — the state and county tax the production and the property, not the owner's role. Layer 1 is where the roles diverge sharply: the working interest funds the well and gets the write-offs; the royalty owner risks nothing and gets only depletion. That trade is the heart of choosing between the ways to invest.
What this means for planning
- Model all three layers before you buy. A 20% royalty in Wyoming and a 20% royalty in Oklahoma are different assets: one carries a ~12% combined state/county load, the other ~7% with no county bill. Location is a tax term.
- Read a revenue check detail once. You'll see severance and (in some states) ad valorem withheld line by line. Our royalty calculator can help you back into what a check implies about the underlying well.
- The write-offs are a Layer 1 story only. If you're being pitched "oil and gas tax benefits" on a royalty or mineral purchase, the honest version is 15% depletion — useful, modest. The dramatic year-one deductions require a working interest, with everything that entails, and can pair with strategies like the Roth conversion IDC offset.
- Get state-specific advice. Rates, exemptions, and credits change with legislative sessions — Louisiana cut its oil severance rate nearly in half for new wells in 2025. This page is education, not advice; verify current rates with the state and your CPA.