DEFINITION of 'Royalty Income Trust'

A royalty income trust is a type of special-purpose financing (similar to an MLP, or master limited partnership), created to hold investments or their cash flows in operating companies. These trusts are neither stocks nor bonds but separate legal entities. In general, royalty income trusts buy the rights to royalties on the production and sale of natural resource companies. They then pass on the profits on to trust unit-holders.

BREAKING DOWN 'Royalty Income Trust'

Royalty trusts are attractive to investors, because they promise high yields, compared with stocks and bonds. They are also attractive to companies that wish to sell cash-flow producing assets, because they can provide a relatively high sale price.

For example, suppose that ABC oil company has maturing oil wells with well-known rates of production and reserves. The company estimates that it will produce and sell one million barrels per year for the next 20 years at a price of $20 per barrel (thus $20 million per year). ABC wants to sell the wells, but an investment bank suggests that ABC use a royalty trust, so ABC sells all the oil wells to a trust, the XYZ Royalty Fund. ABC receives a payout from the investment bank and will still manage the company for a fee.

One of the largest U.S. royalty trusts, the San Juan Basin Royalty Trust (SJT), owns the royalties on Burlington Resources, an oil exploration and production company.

Additional Benefits of Royalty Income Trusts

Royalty income trusts also offer tax-advantaged yields. Because of the operations’ depreciation and the depletion of natural resources over time, the IRS does not actually consider distributions from the majority of royalty income trusts income. Instead, an investor can use the distributions to reduce their cost basis in the stock. When they liquidate the stock, the IRS taxes the proceeds at a lower capital gains rate and defers the taxes until after the owner sells the shares.

Since royalty income trusts are "pass-through" investment vehicles, they are not subject to double taxation. It is also possible for royalty trust unit-holders to qualify for certain tax credits for the production of fuels from nonconventional sources. 

Risks Associated With Royalty Income Trusts

The cash flows from royalty income trusts are subject to volatility in commodities prices and production levels. This inconsistency (in contrast with MLPs, which provide steady cash flows) poses significant risk for investors. Because these trusts are not standalone companies (i.e., they do not have independent operations, management, or employees), investors have less control and are more removed from their output.

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