Personal Investment Notes

Summary

Royalty trusts (RT) purchase the rights to royalties from the cash flow and sale of a natural resource company, generally oil or gas. They provide a higher than normal (stocks and bonds) yield. Popular ones are Canadian royalty trusts (canroys) and U.S. royalty trusts (usroys). Each have their advantages.

Pros

Above average income

Royalty trusts generate above average income compared to stocks and bonds.

Depreciation and depletion can be written off

Since the RT is a depreciating asset, a portion of the income is considered a distribution can be written off, i.e. the cost basis is reduced.

Once the depreciation write-off reaches zero, you must start paying taxes.

Possible tax credit

Some RTs use energy from unconventional resources and may qualify for a fuel tax credit.

Cons

No principal returned at the end of the trust

The original investment is generally never returned at the end of a trust. It is returned as ‘return of capital’ and can be deducted on income tax returns. This is because a RT is a depleting asset that eventually turns into nothing.

Income varies

The income generated varies and is not fixed, like a bond or preferred stock. So a 10% yield may go higher or lower over time. The price of the commodity, generally oil or gas, can vary which impacts the income. Income is usually distributed on a quarterly or monthly basis.

The income is not a dividend

The income generated is not a dividend so it is taxed ordinary income.

Part of the income is considered “return of capital”

Owners are required to file report the pro rata portion of a trust’s total income and expenses on their tax returns. This typically means filing Schedules E and B as well as having additional work with Form 1040.
You can purchase a mutual fund specializing in RTs which generate a 1099 form
instead a slew of K-1 forms.

State income taxes

Owners of trusts are liable for paying income taxes in the states in which the trust generates its royalties. Different states have different thresholds for when taxes have to actually be filed and paid, and the likelihood of owing income tax in multiple states increases with the size of a given ownership position.

Check the website for details on which states are involved.

U.S. royalty trusts have a finite life

U.S. royalty trusts cannot buy and sell assets (unlike Canadian trusts) thus they have a finite life.

Canadian Royalty Trusts

Canroys are open-ended royalty trusts, meaning they can add assets anytime. Canroy owners pay a 15% foreign tax which is put on the U.S. tax return as a nonrefundable tax credit (i.e reduces your tax payment).

U.S. Royalty Trusts

usroys are closed-end royalty trusts, meaning they have fixed assets. Most usroys are oil and gas related so they are depleting assets and have a finite lifetime.

Details

Look for the expected life left of the trust.