Tax Treatment of Delay Rentals

Due to the instability of the current economy, companies may find it increasingly difficult to begin production on oil and gas properties currently under lease. The deferral of production might result in the lessee’s requirement to make delay rental payments to lessors in accordance with their lease agreements. It is important to realize the tax implications to both the lessee and lessor of such payments.

Delay rental payments are amounts paid by the lessee for the right to defer development of properties under a lease. Generally, these payments will be treated like other carrying costs and capitalized as leasehold costs. Delay rentals cannot be expensed unless the lessee can establish that the leasehold was acquired for reasons other than development. A lessee’s failure to make the required delay rental payments usually results in the termination of the lease.  As a result, a loss due to worthlessness may be deducted in the year of the lease termination.

Upon receipt of delay rental payments, the lessor must recognize the payments as rental income. The payments are not subject to depletion since the amounts received are not based on the production of the property. This treatment is different than the receipt of a lease bonus payment which often qualifies as depletable income to the lessor.

Many leases were signed prior to the current economic downturn when prices were much higher.  As a result, many leases may not be drilled within the original lease term due to concerns about the economic viability of the lease at today’s prices, forcing a decision on the payment of delay rentals.