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The Tax Benefits Of Investing In Royalty Trusts

We've talked a lot about the advantages of investing in royalty trusts, especially for income investors. Royalty trusts are typically involved in the extraction and exploration of commodities such as minerals, crude oil and natural gas and can be solid options for conservative investors seeking exposure to energy and commodities. Royalty trusts are most frequently found in the U.S. and Canada and the biggest source of their allure to income investors is the robust dividend yields they offer.

Yields at royalty trusts typically hover around 10%, if not higher, and the pay outs in dollar terms are nothing to scoff at either. 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 to keep investors interested in the asset class.

As an income investor and with the April 18th tax deadline rapidly approaching, you must be aware of the tax benefits and implications of all of your income-generating investments and royalty trusts are no different. We're going to explain some of the tax benefits and consequences of royalty trusts here.

What You Need To Know And What Your CPA Should Know Already

Trusts pay no corporate income tax, which is great news for investors because that means there is more cash to pass through to shareholders in the form of dividends. When it comes to the shareholder's tax obligation, dividends from royalty trusts are NOT considered taxable income by the IRS. This is the case because depletion and distribution costs associated with operating the trust are passed along to shareholder and that enables the shareholder to reduce his cost basis when he sells his stake in the trust.

One more tip: If you own a Canadian royalty trust, be sure to make this clear to your tax professional, simply in the essence of being cautious. The Canadian government applies a 25% non-withholding tax on distributions to non-Canadians. Fortunately for us in the States, that tax is 15% and you might be able to apply to the IRS for a foreign tax credit for a part of what was withheld.

A Tax Credit?

Who doesn't like a tax credit? The U.S. government extends tax credits to companies that generate fuel from non-traditional sources and royalty trusts qualify and that makes shareholders eligible for small tax credits. Again, there has been some scuttlebutt that this law may change in the near future, so consult with your CPA regarding your eligibility for a royalty trust tax credit.

More Pros Than Cons

Royalty trusts certainly have more advantages than disadvantages and those dividend yields are even more powerful during favorable interest rate environments. In the world of investing, we're frequently thinking about what we can get out of the investment, not the tax implications. Fortunately, royalty trusts don't force us choose between the two because the tax benefits AND the dividends are just too good to ignore.

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