Royalty trusts could have reduced the pain for income seeking investors in the latest financial crisis. If the past few years have taught those income investors anything at all, it is that there is no such thing as a guaranteed dividend, at least not among common stocks.

Fortunately, that glum situation has changed somewhat, as dividends have been coming back over the past two years. Still, not all dividend stocks are created equal. Moreover, not all sectors known for their dividend payouts are created equal either.

Simply put, some opportunities are better than others. We like the energy sector, and more specifically, royalty trusts. Let’s take a deeper look at this unique investment vehicle and how income investors can integrate royalty trusts into their portfolios.

Defining Royalty Trusts

Royalty trusts are typically involved in crude oil or natural gas production, although there are several mining royalty trusts for investors to pick from. For the most part, royalty trusts hail from Canada or the U.S., but regardless of home domicile, royalty trusts are known for their fat dividends.

Since royalty trusts are not structured like a typical corporation, they can pass on more of their net income to shareholders. In fact, royalty trusts are like MLPs in that both distribute up to 90% of their net income to shareholders in the form of dividends. However, MLPs generally have more consistent cash flows. Royalty trust cash flows are subject to swings in commodity prices and production levels, which can cause them to be inconsistent from year to year.

Unique Structure… according to Morningstar “the trusts have no physical operations of their own and have no management or employees. Rather, they are merely financing vehicles that are run by banks and trustees, and they trade like stocks.

“Other companies mine the resources and pay royalties on those resources to the trust. For example, Burlington Resources, an oil exploration and production company, is the operator for the assets that the largest U.S. royalty trust, San Juan Basin Royalty Trust (SJT), owns the royalties on.”

Royalty trusts are good ideas for investors that want energy exposure with minimal risk because these trusts engage in oil and gas exploration in areas with proven reserves and with wells that are closer to the end of production life, rather than at the beginning. Exploration costs are kept to a minimum, meaning more cash is made available to shareholders.

Additionally, since royalty trusts primarily focus on areas with proven reserves, the risk profile for investors is fairly low.

Tax Treatments and Other Things to Consider

When it comes to paying the tax man for your dividends from royalty trusts, they are not treated as regular dividends. U.S. royalty trusts are classified as pass-through entities that avoid the double taxation suffered by regular corporations and also benefit from a “depletion allowance” which treats the cash received by unit-holders as a reduction of cost basis rather than taxable income. The owner uses the non-income distributions to reduce his costs basis in the stock and pays a lower rate of capital gains when the investment is sold.

If you own shares in a royalty trust, you may even qualify for a tax credit. There is some scuttlebutt that this law may change in the near future, so consult with your CPA or tax advisor regarding your eligibility for a royalty trust tax credit.

Also, evaluate the interest rate environment. The Fed has proven extremely dovish of late, when it comes to interest rates and that works in favor of royalty trust investors given the high yields these investments provide. Typically in the range of 10%-15%, royalty trust share prices have an inverse relationship to interest. Meaning the shares rise when interest rates are low and fall when interest rates are on the rise.

Finally, consider inflation. Royalty trusts, like many energy-related investments, are a great place to park your money when inflation is on the rise. Commodities are sound bets when inflation is scaring the market, and royalty trusts are a great way to integrate commodities into your portfolio.

Should You Consider Royalty Trusts?

Royalty Trusts have been around since 1979 when T. Boone Pickens created the first oil royalty trust. According to Wikipedia, the Oklahoma businessman created the structure in response to the difficulty that Mesa Petroleum was having in replenishing its oil reserves. Through royalty trusts, he was able to substantially decrease his amount of effective reserves and avoid the difficulty of replenishing them.

Since the performance of a royalty trust is highly correlated to the price fluctuations of an underlying commodity like oil or natural gas, the income generated by the trust can be inconsistent so the dividend yields need to be eye-catching (like 10% to 15%) to keep investors interested in the asset class.

However, many investors still aren’t familiar with this method of generating portfolio income. With the long-term trends for commodities decidedly bullish and dividends not fully back to historic levels, we are still bullish on royalty trusts at this time.

Interesting Differentiation

There is a significant difference between U.S. and Canadian royalty trysts. U.S.-based royalty trusts cannot acquire new businesses or additional oil and gas wells or mineral fields. Canadian royalty trusts can and this makes them look more like a regular corporation than a trust.

For that reason, the chance exists that the IRS may extend more punitive tax treatment to Americans owning shares of Canadian royalty trusts in the future; so if you own shares of a Canadian royalty trust, make sure your accountant keeps you up to date on this situation.

More Pros than Cons

Royalty trusts seem to have more advantages than disadvantages and in the world of investing, we’re frequently thinking more about what we can get out of the investment, not the tax implications. Fortunately, royalty trusts don’t compound that situation, because the tax benefits are just too good to ignore.

Major Benefits and Downsides for Royalty Trusts according to Morningstar:

High Yield… Trusts are required to pay out essentially all of their cash flow as distributions. Because of this, nearly all royalty trusts have above-average yields, many wildly above average.

Tax-Advantaged Yield… Due to depreciation and depletion, distributions from most trusts are not considered income in the eyes of the IRS. Rather, these non-income distributions are used to reduce an owner’s cost basis in the stock, which is then taxed at the lower capital gains rate and is deferred until an owner sells.

No Corporate Income Tax… Trusts are merely “pass-through” investment vehicles. The issues surrounding double taxation of dividends do not apply.

Peculiar Tax Credits… Have you ever received a tax credit for producing fuels from nonconventional sources? If you own a royalty trust, you might qualify for such credits. The laws on this issue are in flux, and the credits are generally small, but it’s still a nice potential perk.

“Pure” Bets on Commodities.. Want to bet on the future price appreciation of natural gas but don’t want to get involved with the futures market? An excellent way to do that would be to buy a royalty trust that owns gas.

The value of any given trust and the distributions it pays are directly tied to the prices of the underlying commodity. Just remember the sword cuts both ways here. The trust’s income (and therefore probably the trust’s stock price) could end up falling if commodity prices go down instead of up.

Downsides Include the Following:

Depletion, Depletion, Depletion… Royalty trusts own royalties on a finite amount of resources. Once those resources are gone, they’re gone. As the resources deplete, royalties and distributions will fall and will, eventually, go to zero. In financial terms, there is no terminal value.

Granted, most trusts won’t hit this point for two or three decades (or more), but it’s still incredibly important to consider that distributions will eventually contract and disappear.

Volatile Distributions… Trusts typically pay out their distributions on a quarterly or monthly basis. If royalties fall in that period due to the underlying commodity price tanking, distributions will also fall. It’s entirely conceivable that a trust that yielded 15% in the last 12 months could yield 3% in the next 12.

Tax-Filing Complexity… Owners of royalty trusts are required to 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.

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.

The Bottom Line

Though they require a bit of work to understand and may increase tax complexity, investing in royalty trusts can boost the income-producing power of most portfolios.

Research and Editorial Staff
Mike Casson
Executive Editor
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