Monday, November 7, 2016
Rural landowners often receive payment from utility companies, oil pipeline companies, wind energy companies and others for rights-of-way or easements over their property. The rights acquired might include the right to lay pipeline, construct aerogenerators and associated roads, electric lines and similar access rights. Payments may also be received for the placement of a “negative” easement on adjacent property so that the neighboring landowner is restricted from utilizing their property in a manner that might decrease the value of nearby land.
The receipt of easement payments raises several tax issues. The payments may trigger income recognition or could be offset partially or completely by the recipient’s income tax basis in the land that the easement impacts. Also, a sale of part of the land could be involved. In addition, a separate payment for crop damage could be involved.
Today, I take a brief look at some of the tax issues involved when a farmer or other rural landowner receives easement payments from utilities or other companies. Last year, I wrote a detailed section on this issue for the University of Illinois Tax Workbook and today’s post involves excerpts of that detailed work. So, a big hat-tip to U of I and the tax team of high quality tax pros there. If you haven’t attended a tax seminar that uses the Illinois Workbook or haven’t ever obtained a copy, you are missing a tremendous set of research materials. For those interested in listening in on a webinar taught out of the Illinois workbook, Kansas State University will be holding a tax seminar in in Pittsburg, Kansas on December 14 and 15. That seminar will also be live simulcast over the web. I will be teaching on the second day. You can find more information about that webinar here: http://commerce.cashnet.com/KSUAGECON (click the Kansas Income Tax Institute Webinar link)
The grant of a limited easement is treated as the sale of a portion of the rights in the land impacted by the easement, with the proceeds received first applied to reduce the basis in the land affected. Thus, if the grant of an easement deprives the taxpayer of practically all of the beneficial interest in the land, except for the retention of mere legal title, the transaction is considered to be a sale of the land that the easement covers. That means that gain or loss is computed in the same manner as in the case of a sale of the land itself under I.R.C. §1221 or §1231. In addition, only the basis of the land that is allocable to that portion is reduced by the amount received for the grant of the easement. Any excess amount received is treated as capital gain. The allocation of basis does not require proration based on acreage. Instead, basis allocation is to be “equitably apportioned” based likely on fair market value or assessed value at the time the easement is acquired.
In rare situations where the entire property is impacted by the easement, the entire basis of the property can be used to offset the amount received for the easement. This might be the situation where severance damage payments are received. These types of payments may be made when the easement bisects a landowner’s property with the result that the property not subject to the easement can no longer be put to its highest and best use. This is more likely with commercial property and agricultural land that has the potential to be developed. Severance damages may be paid to compensate the landowner for the resulting lower value for the non-eased property. If severance damages exceed the landowner’s basis in the property not subject to the easement, gain is recognized.
Severance damages. Under I.R.C. §1033, it is possible for the landowner to defer gain resulting from the payment of severance damages by using the severance damages to restore the property that the easement impacts or by investing the damages in a timely manner in other qualified property. There is no requirement that the landowner apply the severance damages to the portion of the property subject to the easement. Also, if the easement so impacts the remainder of the property where the pre-easement use of the property is not possible, the sale of the remainder of the property and use of the sale proceeds (plus the severance damages) to acquire other qualified property can be structured as a deferral transaction under I.R.C. §1033.
Temporary easements. Some easements may involve an additional temporary easement to allow the holder to have space for access, equipment and material storage while conduction construction activities on the property subject to the easement. A separate designation for a temporary easement for these purposes will generate rental income for allocated amounts. As an alternative, it may be advisable to include the temporary space in the perpetual easement which is then reduced after a set amount of time. Under this approach, it is possible to apply the payment attributable to the temporary easement to the tract subject to the permanent easement. Alternatively, it may be possible, based on the facts, to classify any payments for a temporary easement as damage payments.
Damage payments. Upfront payments that are made to a landowner by the easement holder for actual, current damage to the property caused by construction activities on the property subject to the easement may be able to be offset by basis in the affected property. Examples of this type of payment would be payments for damage to the property caused by environmental contamination and soil compaction. A payment for damage to growing crops, however, is treated as a sale of the crop reported on line 2 of Schedule F (landlord or tenant) or line 1 of Form 4835 for a crop-share landlord. Any payment for future property damage (e.g., liquidated damages), however, is generally treated as rent.
Negative easements. A landowner may make a payment to an adjacent or nearby landowner to acquire a negative easement over that other landowner’s tract. A negative easement is a use restriction placed on the tract to prevent the owner from specified uses of the tract that might diminish the value of the payor’s land. For instance, a landowner may fear that their property would lose market value if a pipeline, high-power transmission line or wind aerogenerator were to be placed on adjacent property. Thus, the landowner might seek a negative easement over that adjacent property to prevent that landowner from granting an easement to a utility company for that type of activity from being conducted on the adjacent property. The IRS has reached the conclusion that a negative easement payment is rental income in the hands of the recipient. F.S.A. 20152102F (Feb. 25, 2015). It is not income derived from the taxpayer’s trade or business. In addition, the IRS position taken in the FSA could have application to situations involving the government’s use of a taxpayer’s property to enhance wildlife and conservation.
A right of use that is not an easement generates ordinary income to the landowner and is, potentially, net investment income subject to an additional 3.8 percent tax. Thus, transactions that are a lease or a license generate rental income with no basis offset. For example, when a landowner grants surface rights for oil and gas exploration, the transaction is most likely a lease. Easements for pipelines, roads, surface sites and similar interests that are for a definite term of years are leases. Likewise, if the easement is for “as long as oil and gas is produced in paying quantities,” it is lease.
Some other points on lease payments should be made. A lease is characterized by periodic payments. A lease is also indicated when failure to make a payment triggers default procedures and potential forfeiture. In addition, lease payments are not subject to self-employment tax in the hands of the recipient regardless of the landowner’s participation in the activity. Accordingly, the annual lease payment income would be reported on Schedule E (Form 1040), with the landowner likely having few or no deductible rental expenses.
Proposed easement acquisitions can be contentious for many landowners. Often, landowners may not willingly grant a pipeline company or a wind energy company, for example, the right to use the landowners’ property. In those situations, eminent domain procedures under state law may be invoked which involves a condemnation of the property. The power of eminent domain is the right of the state government (it’s called the “taking power” for the federal government) to acquire private property for public use, subject to the constitutional requirement that “just compensation” be paid. While eminent domain is a power of the government, often developers of pipelines and certain other types of energy companies are often delegated the authority to condemn private property. The condemnation award (the constitutionally required “just compensation”) paid is treated as a sale for tax purposes.
The IRS view is that a condemnation award is solely for the property taken. But, if the condemnation award clearly exceeds the fair market value of the property taken, a court may entertain arguments about the various components of the award. Thus, it’s important for a landowner to preserve any evidence that might support allocating the award to various types of damages.
While a condemnation award that a landowner receives is treated as a sale for tax purposes, I.R.C. §1033 allows a taxpayer to elect to defer gain realized from a condemnation (and sales made under threat of condemnation) by reinvesting the proceeds in qualifying property within three years.
The election to defer gain under I.R.C. §1033 is made by simply not reporting the condemnation gain realized on the return for the tax year the award is received. A disclosure that the taxpayer is deferring gain under I.R.C. §1033, but not disclosing is treated as a deemed election.
Rural landowners are facing easement issues not infrequently. Oil and gas pipelines, wind energy towers, and high voltage power lines are examples of the type of structures that are associated with easements across agricultural land. Seeking good tax counsel can help produce the best tax result possible in dealing with the various types of payments that might be received.