OFFICE OF THE ATTORNEY GENERAL . STATE OF TEXAS

   JOHN      CORNYN




                                                November 26,200l



The Honorable Pat Phelan                                     Opinion No. JC-0436
Hockley County Attorney
802 Houston, Suite 211                                       Re: The ad valorem taxation of mineral interests
Levelland, Texas 79336                                       that extend across the boundary between two
                                                             counties (RQ-03 89- JC)
The Honorable G. Dwayne Pruitt
Terry County Attorney
500 West Main, Room 208E
Brownfield, Texas 793 16-4335


Gentlemen:

         You ask about the proper method for allocating the taxable value of mineral interests that
straddle the boundary between your two counties.’ While the Tax Code does not address this
situation directly, we conclude on the basis of the Tax Code and prior judicial and attorney general
opinions that each county must separately determine the market value of a mineral interest as it
appertains to surface land located within that county’s boundaries according to generally accepted
appraisal methods.

         You each present us with various facts relating to oil and gas leases that extend across your
counties’ common border. This office does not make findings of fact or resolve disputed questions
of fact. See, e.g., Tex. Att’y Gen. Op. Nos. JC-0020 (1999) at 2 (stating that investigation and
resolution of fact questions cannot be done in opinion process); M-l 87 (1968) at 3 (“[Tlhis office
is without authority to make . . . factual determinations.“); O-29 11 (1940) at 2 (“[Tlhis . . . presents
a fact question which we are unable to answer.“). However, based on the descriptions in your letters,
we present the following facts as background to your legal question.

        Your query involves the ad valorem taxation of a working interest in an oil and gas lease.
A working interest in an oil and gas lease is the interest owned by the operator of the lease who has
the exclusive right to exploit the minerals and is usually responsible for all direct operating costs.
See HOWARD R. WILLIAMS & CHARLES J. MYERS, OIL AND GAS TERMS: ANNOTATED MANUAL OF



          ‘Letter from Honorable Pat Phelan, Hockley County Attorney, to Honorable John Comyn, Texas Attorney
General, at l-2 (received Jun. 7,200l) (on tile with Opinion Committee) [hereinafter Hockley County Request Letter];
Letter from Honorable G. Dwayne Pruitt, Terry County Attorney, to Honorable John Comyn, Texas Attorney General,
at 1 (Jun. 20,200l)   (on file with Opinion Committee)   [hereinafter   Terry County Request Letter].
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The Honorable G. Dwayne Pruitt




LEGAL ENGINEERINGTAX            WORDS AND PHRASES 979 (6th ed. 1984) (defining                 working   interest)
[hereinafter    OIL AND GAS TERMS];         TEX.   COMPTROLLER,     GENERAL     APPRAISAL      MANUAL, LEGAL
REQUIREMENTS,OPERATIONS,VALUATION PROCEDURES,at               M-l 8 (1985) (Appraisal of Minerals) (on
file with Opinion Committee) [hereinafter MANUAL]. By contrast, the owner of a royalty interest is
entitled to a share of production, generally free of the costs of production. See OIL AND GAS TERMS
775 (defining royalty interest).

         You state that eighty-four percent of the surface estate associated with the working interest
is located in Hockley County; sixteen percent of the surface estate is located in Terry County. Two
producing wells are located in Hockley County; five are located in Terry County. The two sets of
wells produce at the same rate. In addition, Terry County asserts that the underlying minerals are
not evenly distributed and that the underlying reservoir is more heavily concentrated in Terry
County. See Terry County Brief, at 1,3 (attached to Terry County Request Letter, supra note 1).

          The Hockley County Appraisal District (HCAD) has appraised eighty-four percent of the
value of the mineral interest because eighty-four percent of the surface estate associated with the
mineral interest is located in Hockley County. On the other hand, the Terry County Appraisal
District (TCAD) has appraised fifty percent of the value of the mineral interest because the district’s
analysis of the present production rates and geological data indicate that fifty percent of the
remaining recoverable reserves are located in Terry County. Hockley County cites “a fundamental
difference” between the appraisal districts with respect to what they are appraising: “HCAD believes
that it is valuing the mineral interests created by interests in real property, while TCAD is apparently
appraising the minerals that are under the ground.” Hockley County Request Letter, supra note 1,
at 1.

        Because the appraisal districts cannot agree on the proper method of allocating the taxable
value of the mineral interest, you ask whether the allocation of the mineral interest should “be based:
(1) on the ratio of surface acreage covered under the lease attributable to each county, or (2) on an
engineering analysis of the reservoir, the production of minerals, and the remaining recoverable
reserves present in each county.” Hockley County Request Letter, supra note 1, at 1-2; Terry
County Request Letter, supra note 1, at 1. It is not clear from your queries whether you are asking
only about the valuation of the working interest in the oil and gas lease or if you are also concerned
about other interests, such as royalty interests. In addition, Terry County has recently asked about
a second oil and gas lease.* We answer your questions generally, without regard to any particular
mineral interest or type of mineral interest.

         We begin with a brief review of the ad valorem taxation of mineral interests. The                   Texas
Constitution provides that “[a]11property . . . shall be assessed for taxation, and the taxes paid           in the
county where situated.” TEX. CONST. art. VIII, 8 11. Under the Tax Code, an estate or interest               in oil,
gas, or other minerals is taxable as real property. See TEX. TAX CODEANN. 9 1.04(2) (Vernon                  Supp.


           2See Letter from Honorable G. Dwayne Pmitt, Terry County Attorney,   to Honorable   John Comyn,    Texas
Attorney    General (Sept. 4,200O) (on file with Opinion Committee).
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2001) (defining “real property” to include both “a mineral in place” or “an estate or interest . . . in
property”); see also Electra Indep. Sch. Dist. v. Waggoner Estate, 168 S.W.2d 645,650 (Tex. 1943)
(treating a working interest in mineral as an interest in real property taxable as real property);
Sheffield v. Hogg, 77 S.W.2d 1021, 1030 (Tex. 1934) (holding mineral royalty interest taxable as
real estate). Under the Tax Code provisions governing the taxable situs of property, real property
is taxable by a taxing unit if located in the unit on January 1 of the tax year at issue. See TEX. TAX
CODE ANN. 8 21 .Ol (Vernon Supp. 2001). As this office noted in Attorney General Opinion DM-
490, “Courts have held that because a royalty interest is taxable as an interest in land, it is taxable
as real estate in the county where the land to which it appertains is located, rather than in the county
where the owner of the interest resides.” Tex. Att’y Gen. Op. No. DM-490 (1998) at 2 (citing Jett
v. Kahn, 273 S.W.2d 43 1, 433 (Tex. Civ. App.-Beaumont           1954, writ ref d n.r.e.) (“royalties are
‘rights and privileges belonging or . . .     appertaining’ to the  land leased . . . and are therefore
assessable as real property by the defendant county and school district . . . .“); Wilcox v. Hull-
Daisetta Indep. Sch. Dist., 95 S.W.2d 490, 493 (Tex. Civ. App.-Beaumont                1936, writ ref d)
(concluding that “said 3 per cent royalty or interest is an interest in the 300 acres of land and so
taxable as real estate in the county where the land is located” and rejecting argument that royalty
interest payable only in money was interest in personal property taxable only in interest owner’s
county of residence). Thus, the taxable situs of a working or royalty interest in an oil and gas lease
is the location of the surface estate to which the interest appertains. See id.

         Chapter 25 of the Tax Code, governing the appraisal of taxable property, requires the chief
appraiser of each taxing unit to prepare appraisal records listing all property that is taxable in the
district and stating the appraised value of each. See TEX. TAX CODE ANN. 5 25.01 (Vernon 1992).
When different persons own land and improvements in separate estates or interests, each separately
owned estate or interest shall be listed separately. See id. 9 25.04. Unless the owners of separate
mineral interests request joint taxation, “each separate interest in minerals in place shall be listed
separately from other interests in the minerals in place.” Id. 8 25.12 (Vernon Supp. 2001). If the
owners request joint taxation, then the separate interests are listed jointly, usually in the name of a
designated operator. See id. In addition, chapter 25 specifically requires that “[i]f real property is
located partially outside and partially inside a taxing unit’s boundaries, the portion inside the unit’s
boundaries shall be listed separately from the remaining portion.” Id. 8 25.17 (Vernon 1992).

        All taxable property is appraised at its market value of as January 1 of any given tax year.
See id. § 23.01(a) (Vernon Supp. 2001). “Market value” is defined by the Tax Code to mean:

                the price at which a property would transfer for cash or its equivalent
                under prevailing market conditions if:

                    (A) exposed for sale in the open market with a reasonable time for
                the seller to find a purchaser;

                    (B) both the seller and the purchaser know of all the uses and
                purposes to which the property is adapted and for which it is capable
                of being used and of the enforceable restrictions on its use; and
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                      (C) both the seller and purchaser seek to maximize their gains and
                 neither is in a position to take advantage of the exigencies of the
                 other.

Id. 8 1.04(7).

        The Tax Code provides the following general directive regarding          appraisal methods   for
determining the market value of taxable property:

                      The market value of property shall be determined by the
                 application of generally accepted appraisal methods and techniques.
                 If the appraisal district determines the appraised value of a property
                 using mass appraisal standards, the mass appraisal standards must
                 comply with the Uniform Standards of Professional Appraisal
                 Practice. The same or similar appraisal methods and techniques shall
                 be used in appraising the same or similar kinds of property.
                 However, each property shall be appraised based upon the individual
                 characteristics that affect the property’s market value.

Id. 5 23.01(b). A taxing unit’s chief appraiser, in determining the market value of property, “shall
consider the cost, income, and market data comparison methods of appraisal and use the most
appropriate method.” Id. 5 23.0101.

          The income approach is generally the most appropriate method for appraising oil and gas
interests. As one court has explained:

                 [The] ‘comparable sales’ method of valuing property becomes less
                 accurate when applied to property interests such as an overriding
                 royalty interest [in a mineral] because of the absence of an open
                 market and because the value of the interest lies primarily in its
                 income-producing    potential. For this reason, taxing authorities and
                 appraisers commonly turn to the ‘income approach’ to value when
                 assessing a property interest of this nature.

Destec Properties, Ltd. v. Freestone Cent. App. Dist., 6 S.W. 3d 601,605 (Tex. App.-Waco 1999,
pet. denied) (citation omitted); see also MANUAL supra, at M-l (income approach generally only
feasible method for appraising interests in oil and gas). Under section 23.012 of the Tax Code, a
chief appraiser who uses the income method of appraisal is required to:

                      (1) use rental income and expense data pertaining to the property
                 if possible and applicable;

                     (2) make any projections of future rental income and expenses
                 only from clear and appropriate evidence;
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The Honorable G. Dwayne Pruitt




                    (3) use data from generally accepted sources in determining      an
                appropriate capitalization rate; and

                    (4) determine a capitalization rate for income-producing property
                that includes a reasonable return on investment, taking into account
                the risk associated with the investment.

TEX.  TAX CODE ANN. 8 23.012 (Vernon Supp. 2001). In the case of an oil and gas lease, an analysis
of the income to be produced from the mineral interest would take into account not just economic
data but also geological and engineering information, such as the productivity of the wells, reservoir
characteristics, remaining recoverable reserves, and the likelihood of recovery. See, e.g., MANUAL
supra, at M-1-15.

         Section 23.175 of the Tax Code provides special rules for the appraisal of a real property
interest in oil or gas in place when the appraisal takes into account the future income from the sale
of oil or gas to be produced from the interest. See TEX. TAX CODEANN. 8 23.175(a) (Vernon Supp.
2001) (“If a real property interest in oil or gas in place is appraised by a method that takes into
account the future income from the sale of oil or gas to be produced from the interest, the method
must use the average price of the oil or gas from the interest for the preceding year as the price at
which the oil or gas produced from the interest is projected to be sold in the current year of the
appraisal.“). This provision also requires the Comptroller by rule to develop and distribute to each
appraisal office appraisal manuals that specify methods and procedures to discount future income
from the sale of oil or gas from the interest to present value and requires each appraisal office to use
the methods and procedures specified by these appraisal manuals. See id. 9 23.175(b), (c). The
Comptroller has complied with this legislative directive by promulgating            a lengthy rule on
discounting oil and gas income. See 34 TEX. ADMIN. CODE 5 9.4031 (2001) (Tex. Comptroller of
Public Accounts, Manual for Discounting Oil and Gas Income). We also note that section 23.17 of
the Tax Code establishes a special rule for the appraisal of certain types of mineral interests that are
not in production, but is not applicable here. See TEX. TAX CODE ANN. 5 23.17 (Vernon 1992).

         We have located only one other provision in the Tax Code that deals with the appraisal of
mineral interests for purposes of ad valorem taxation. Section 41.455 of the Tax Code addresses a
tax protest involving a pooled or unitized mineral interest that is being produced in more than one
appraisal district. Subsection (b) of this provision specifically addresses protests involving pooled
or unitized mineral interests that are being produced at two or more production sites located in more
than one county:

                     (b) If a property owner files protests relating to a pooled or
                unitized mineral interest that is being produced at two or more
                production sites located in more than one county with the appraisal
                review boards of more than one appraisal district and at least
                two-thirds of the surface area of the mineral interest is located in the
                county for which one of the appraisal districts is established, the
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                appraisal review board for that appraisal district must determine the
                protest filed with that board and make its decision before another
                appraisal review board may hold a hearing to determine the protest
                filed with that other board.

Id. fj 41.455(b) (V emon Supp. 2001). We note, however, that this provision deals with the proper
procedures to follow when a property owner files a protest rather than how a mineral interest that
extends across a county line should be appraised in the first place.

         Again, you ask about the proper valuation of a mineral interest that appertains to surface
property that extends across a county line. The Tax Code does not directly address this situation.
Attorney General Opinion DM-490, which you both cite, is relevant to your query, but does not
resolve it. See Tex. Att’y Gen. Op. No. DM-490 (1998). That opinion considered the taxation of
royalty interests in a pooled gas unit sharing income from a well located in one school district, but
which appertained to surface property located in both that school district and another. See id. at 1.
Only the school district where the well was located had been taxing the royalty interests. This office
was asked whether a taxing unit is entitled to tax royalty interests based upon the location of the well
or based upon the location of surface property to which the royalty interests appertain. See id.
Based upon case law establishing that the taxable situs of a royalty interest is the location of the
surface property to which it appertains, see id. at 2; see also cases cited supra page 3, we concluded
that a taxing unit is entitled to assess ad valorem taxes against a royalty interest based upon the
location of the surface property to which the royalty interest appertains.

         Here, the question is not whether each county is entitled to tax the mineral interest at issue
but rather how the mineral interest should be valued in each county. Under the Tax Code and our
prior opinion, we conclude that each county is limited to valuing the mineral interest only as it
appertains to surface property located in the county. See Tex. Att’y Gen. Op. No. DM-490 (1998)
(taxable situs of mineral interest is location of surface property to which it appertains); TEX. TAX
CODEANN. $5 25.01 (appraisal records must list and state appraised value of taxable property), 25.17
(“If real property is located partially outside and partially inside a taxing unit’s boundaries, the
portion inside the unit’s boundaries shall be listed separately from the remaining portion.“) (Vernon
1992); see also TEX. CONST. art. VIII, 9 11 (“All property. . . shall be assessed for taxation, and the
taxes paid in the county where situated”). Furthermore, each county must appraise the mineral
interest as it appertains to surface property located in the county at its market value as of January 1,
using generally accepted appraisal methods and techniques.          See TEX. TAX CODE ANN. 8 23.01
(Vernon Supp. 2001). “The same or similar appraisal methods and techniques shall be used in
appraising the same or similar kinds of property. However, each property shall be appraised based
upon the individual characteristics that affect the property’s market value.” Id. Special rules and
considerations must be taken into account in the appraisal of mineral interests, see, e.g., id. 8 23.175;
34 TEX. ADMIN. CODE 5 9.403 1 (2001); MANUAL, supra; the income approach is generally the most
appropriate method, see Destec, 6 SW. 3d at 60; MANUAL, at M-l 5.
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The Honorable G. Dwayne Pruitt




         You specifically ask whether the counties should allocate the mineral interest “based: (1) on
the ratio of surface acreage covered under the lease attributable to each county, or (2) on an
engineering analysis of the reservoir, the production of minerals, and the remaining recoverable
reserves present in each county.” Hockley County Request Letter, supra note 1, at 1-2; Terry
County Request Letter, supra note 1, at 1. The Tax Code requires each county to separately
determine the market value of the mineral interest only as it pertains to surface estate located in the
county according to generally accepted appraisal methods. See TEX. TAX CODEANN. 8 5 23 .O1-.O13,
.175 (Vernon 1992 & Supp. 2001); 34 TEX. ADMIN. CODE 5 9.4031 (2001). This will generally
involve entirely separate appraisals. In the event, however, that the market value of the mineral
interest is uniform across the surface estate, then simply determining the market value of the entire
mineral interest and allocating that value according to the ratio of surface acreage located in each
county may be an appropriate method of appraising the market value of the mineral interest. This
may be the case, for example, if the mineral interest owners have entered into a pooling agreement
or some other kind of contractual arrangement that allocates production revenue based on surface
acreage, or if the mineral itself is evenly distributed across the surface estate.

          If, on the other hand, the market value is not uniform across the surface estate, then simply
allocating the value of the entire mineral interest based on surface acreage is not appropriate. The
appropriate method in that case is to appraise the mineral interest in each county based upon
generally accepted appraisal methods. These methods would normally include an analysis of the
income to be produced from the mineral interest in the county, which would take into account
geological and engineering information such as the productivity of the wells located in the county,
reservoir characteristics, remaining recoverable reserves and the likelihood of recovery. See, e.g.,
MANUAL, supra, at M- 1- 15. In this case, the actual location of the mineral is important to the extent
it affects the market value of the mineral interest in each county.

         Hockley County asserts with respect to one oil and gas lease that the mineral interest owners
share in the revenues from all seven wells “dependent only on the relative contribution of the interest
owner’s land to the lease as a whole,” Hockley County Brief, at 2 (attached to Hockley County
Request Letter, supra note l), suggesting that, under the income method of appraisal, the market
value of at least some of the mineral interests in the oil and gas lease may be uniform across the
surface estate. This, however, is not an issue that we can resolve in an attorney general opinion. The
valuation of mineral interests is both fact-bound and highly technical. See, e.g., MANUAL, supra at
M-l (“The appraisal of mineral properties is a highly technical field normally requiring extensive        ,
knowledge and training on the part of the appraiser.“) As this office does not make findings of fact3
and has no particular expertise in the accounting and geological issues involved in appraisal of
mineral interests, we cannot ultimately determine the market value of a mineral interest as it pertains
to the surface estate in each of your counties.




       3See attorney general opinions   cited supra page 1.
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The Honorable G. Dwayne Pruitt




                                        SUMMARY

                       When a mineral interest appertains to surface property that
               crosses a county line, each county must separately determine the
               market value of the mineral interest only as it pertains to surface
               property located in the county according to generally accepted
               appraisal methods. See TEX. TAX CODE ANN. $3 23.01-.013, .175
               (Vernon 1992 & Supp. 2001); 34 TEX. ADMIN. CODE 8 9.403 1
               (2001). If the market value of the mineral interest is uniform across
               the surface estate, simply determining the market value of the entire
               mineral interest and allocating that value according to the ratio of
               surface acreage located in each county may be an appropriate method
               of appraising the market value of the mineral interest. If, on the other
               hand, the market value is not uniform across the surface estate,
               simply allocating the value of the entire mineral interest based on
               surface acreage is not appropriate.




                                               JOHN     CORNYN
                                               Attorney General of Texas



HOWARD G. BALDWIN, JR.
First Assistant Attorney General

NANCY FULLER
Deputy Attorney General - General Counsel

SUSAN D. GUSKY
Chair, Opinion Committee

Mary R. Crouter
Assistant Attorney General, Opinion Committee