How to Invest in Royalty Income

Investing in royalty income can provide long-term returns to investors seeking to fund retirement or simply diversify their portfolio. Owning royalty rights provides a steady income often insulated from fluctuations in the equity and bond markets. Investors can acquire rights to royalty income by purchasing shares of royalty trusts or bidding on royalty auction exchanges. If you’re looking for an alternative investment with regular income, this is how to invest in royalty income.

A financial advisor can help you build a strategy for steady long-term income. 

Royalty Basics

A royalty is a payment made by one party to another for the use of an asset. Often, the asset consists of intellectual property. For example, a patent owner may receive a royalty payment from the manufacturer of a product for each unit made or sold using that patent.

Other examples of royalties from intellectual property include payments for the use of patents, trademarks and copyrighted materials, such as books, films and musical compositions. In addition to intellectual properties, oil, gas and mining leases generate royalties for the use of natural resources.

The Internal Revenue Service considers royalty income to be passive income. Therefore, it is generally falls under capital gains tax rates. These are usually lower than the rates paid by individuals for earned income, such as wages and salaries.

Types of Royalty Income

Spanning diverse industries and applications, royalties come in various forms, with each tailored to the nature of the asset and its market sector.

Whether earned through artistic endeavors, such as music, literature and film, or through the licensing of patents, trademarks and natural resource leases, royalties offer a passive income opportunity that grows with demand. 

Common Types of Royalties

• Energy. Oil and gas landowners who retain mineral rights can receive royalties. These consist of a percentage of the value of energy resources extracted from their property.
• Mineral. Owners of land with mineral resources, such as gold, silver and precious metals, receive royalties for any minerals removed through mining.
• Invention. An inventor receives royalty payments for licensing the use of the patent to manufacturers of products that use it.
• Trademarks. Owners of valuable trademarks can receive royalties for licensing the use of their logos and brand names.
• Music. Composers of songs can receive royalty payments each time their composition is publicly performed, streamed, downloaded, played on the radio, used for a film or TV score or sold as a CD or record.
• TV and cinema. Movies and TV writers, directors, producers, performers and others with copyrights to films and TV shows receive residuals, as royalties are known in Hollywood. These apply any time the show is streamed, played or sold on a DVD or other media.
• Books. Publishers typically pay authors or other copyright holders a royalty consisting of a percentage of the sale price for each copy of a book sold in hardcover, paperback, electronic or audio formats.
• Business funding. Investors who provide capital to new businesses may receive royalties on revenue from products or services that the business sells.

Investors who receive royalty income will receive payments as long as a copyright, patent, trademark, mine, oil well or other source continues to generate income. This makes royalties a potential source of long-term and relatively stable income. 

The only significant risk with investing in royalty income is the potential opportunity cost of higher returns from riskier investments. Sometimes, royalties can increase sharply, such as a featured song in a popular movie soundtrack or a sudden rise in energy prices.

How Licensing Agreements Work for Royalties

Licensing agreements are essential tools in the world of intellectual property, allowing creators and businesses to monetize their innovations. These agreements grant another party permission to use a product, brand or technology in exchange for royalties.

A well-structured licensing agreement clearly outlines critical details.

• Rights and responsibilities of both parties. It specifies the scope of the license, including the geographical area, duration and exclusivity. 
• Royalty structure. The agreement also details the royalty structure, which can vary widely, depending on the industry and the nature of the licensed material. For instance, a flat fee might be appropriate for some agreements, while others might involve a percentage of sales.
• Partnership specifics. The agreement should address issues such as quality control, reporting requirements and dispute resolution mechanisms to ensure a smooth partnership.

Investing in Royalty Trusts

The easiest way to invest for royalty income is by purchasing shares of a royalty trust.

Royalty trusts are a type of income trust. These publicly traded corporations acquire ownership of rights to leases and deposits of oil, gas and minerals. Shareholders then receive the income from royalties as dividends.

Royalty trusts that distribute 90% of their income as dividends are exempt from the double taxation that burdens most corporations. Instead, investors in royalty trust shares pay taxes on the dividends at their rates. Owners of mines and wells can deduct the costs of operating their property as business expenses.

Royalty trusts do not do any mining or drilling; another company handles that part of the business. This allows investors to participate in the energy and mining industries without owning mines or wells.

Investing in Royalties Through Auction Sites

Royalty auctions offer another opportunity to invest in royalty income.

Several sites conduct online auctions of royalties for music, minerals and many other types.

• Songvest focuses on music royalties. Investors can purchase fractional shares of the royalty streams from popular songs.
• Efficient Markets allows bidders to purchase royalty interests in oil wells, gas wells, logging operations and more.
• Royalty Exchange auctions rights to royalties on a wide range of properties, including music, movies, TV shows, oil and gas.

Risks and Considerations for Royalty Investors

While royalty income can offer long-term cash flow and diversification, it comes with specific risks and considerations that investors should evaluate.

Declining Value

One key risk is the declining value of the underlying asset.

For example, a song may lose popularity, a patent may expire or a mine may become less productive. This would then reduce or even eliminate royalty payments.

Market Demand

Another factor is market demand.

Royalty payments often depend on how frequently a product or asset is used or sold. Economic downturns, competition and shifts in consumer behavior can decrease usage, reducing the associated income.

Additionally, some royalty sources rely on commodities, such as oil and gas, which are subject to price volatility and regulatory changes.

Legal Structure

Legal structure and ownership rights also matter.

Investors should review licensing agreements or trust structures to understand the duration of payments, exclusivity terms and transfer of ownership. Not all royalties are permanent; some may last only for the duration of a copyright or lease.

Before investing, conduct due diligence or seek professional guidance to verify the income history, the terms of the royalty agreement and the risks associated with the asset. While royalties can be a stable source of revenue and can even generate monthly income, they are not risk-free.

Royalty Income and Taxes

Royalty income is generally classifies as ordinary income at your marginal tax rate. This can run anywhere from 10% to 37%, depending on your total annual income.

This applies regardless of whether the royalties come from a book, a song, a patent or an oil and gas lease. Being classified as passive income doesn’t change this. Passive and capital gains are two separate tax concepts, and royalty income being passive doesn’t automatically qualify it for the lower rates that apply to long-term capital gains.

Most royalty income is reported on Schedule E of your tax return. ¹

Capital Gains Exceptions

There is a meaningful exception worth understanding.

Selling Royalty Interests

If you sell your royalty interest outright, rather than continuing to receive periodic payments, the sale can qualify for capital gains treatment. This distinction matters because selling all substantial rights to an asset like a patent or a royalty stream receives different IRS treatment than simply licensing that asset and collecting ongoing royalty income from it.

A patent holder who sells their patent outright, for example, can qualify for long-term capital gains treatment on the proceeds. Meanwhile, a patent holder who licenses the same patent and collects royalty payments year after year pays ordinary income tax on those payments instead.

Depletion

Owners of oil, gas and mineral royalties have access to a specific deduction called depletion. This accounts for the fact that the underlying resource is finite and being used up over time.

This deduction, typically 15% of gross royalty income for oil and gas, reduces the taxable amount. It is one of the more generous, often-overlooked deductions available to royalty owners in this category.

Music Catalogs

Musicians and songwriters also have a notable exception.

Under current tax law, selling a music catalog outright can qualify for capital gains treatment. It replaces the ordinary income rates that apply to royalties received from continued licensing of that same catalog.

This has become an increasingly relevant consideration as more musicians choose to sell their catalogs rather than continue collecting royalties over time.

Your tax treatment can shift significantly depending on whether you’re receiving ongoing royalty payments or selling the underlying rights entirely. Therefore, it’s worth reviewing your specific situation with a tax professional before assuming your royalty income automatically qualifies for a particular rate.

Bottom Line

Knowing how to invest in royalty income can prove to be lucrative for your overall investment portfolio. Royalties can provide steady, long-term income to investors seeking greater stability in their portfolios. Many types of assets can generate this royalties, including musical compositions, oil wells, gold mines, books, movies and TV shows. As passive income, royalties are taxed at lower rates than wages and salaries. Investors can invest in royalty income through auction sites and royalty income trusts.

Investing Tips

• A financial advisor can help you invest in royalty income as part of an overall investment strategy. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, begin now.
• When it comes to investing, it’s a good idea to be prepared. SmartAsset has you covered with several free online resources that can help. Try using our free investment calculator today.

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