Thursday, March 9, 2017
Normally, land improvements constitute capital expenditures the cost of which would have to be added to the basis of the land. But, a farmer can currently deduct the cost of certain improvements and soil and water conservation expenses in the first year in which the farmer incurs the expenditures. I.R.C. §175. If the deduction is not taken in that first year, the result is that the taxpayer has elected not to deduct which is binding in subsequent years. In that case, the expenditures increase the basis of the property to which they relate. Once a method of reporting such expenses is adopted, it must be followed in subsequent years unless the IRS agrees to a change.
So, what expenditures are eligible to be currently deducted under I.R.C. §175? How is the deduction claimed? If there a possibility of recapture if the associated land is sold? These are the issues today’s post examines.
Soil and water conservation expenses that qualify under the I.R.C. §175 provision must be paid or incurred for soil or water conservation purposes with respect to land used in farming, or for the prevention of erosion on farmland. I.R.C. §175(a). Qualified expenses include various types of earth moving on farmland using in the business of farming. Expenses for leveling, conditioning, grading, terracing and contour furrowing are all eligible as are costs associated with the control and protection of diversion channels, drainage ditches, irrigation ditches, earthen dams, water courses, outlets and ponds. Even the cost of eradicating brush and the planting of windbreaks is eligible. I.R.C. §175(c)(1). Also included are drainage district assessments (and soil and water conservation district assessments) if such assessments would have been a deductible expense if the taxpayer had paid them directly. I.R.C. §175 (c)(1)(B).
Taxpayer engaged in farming. Several requirements must be met before soil and water conservation expenditures can be deducted. As noted above, the taxpayer must be engaged in the business of farming. A farm operator or landowner receiving rental income under a material participation crop share or livestock share lease satisfies the test. Treas. Reg. §1.175-3. Under that type of lease, the landlord bears the risk of production and the risk of price change. A share lease where the landlord’s report the income from it on Form 4835 also satisfies the test. However, a cash lease doesn’t meet the test. That’s a rental activity.
Land used in farming. The expenditures must pertain to land used in farming - to produce crops or sustain livestock. Specifically, the term “land used in farming” means land “used by the taxpayer or his tenant for the production of crops, fruits, or other agricultural products or for the sustenance of livestock.” I.R.C. §175(c)(2).
Improvements that are made to land that hasn’t been previously used in farming are not eligible. But, prior farming activity by a different taxpayer counts as does a different type of agricultural use. Treas. Reg. §1.175-4(a). In addition, expenses associated with assets that qualify as deductible as soil and water conservation expenses are not necessarily precluded from being depreciated by a subsequent purchaser of the real estate on which qualifying property has been placed. For example, in Rudolph Investment Corp. v. Comm’r, T.C. Memo. 1972-129, the court allowed the taxpayer to depreciate earthen dams and earthen water storage tanks located on ranchland even though the structures qualified for a current deduction under I.R.C. § 175.
NRCS plan and ineligible expenditures. The expenditures must be consistent with a conservation plan approved by the Natural Resources Conservation Service (NRCS) or, if there are no NRCS plans for the area, a state (or local) plan. I.R.C. §175(c)(3). See also 2016 IRS Pub. 225 (Ch. 5). On this point, expenditures for draining or filling of wetlands or land preparation for center-pivot irrigation are not deductible as soil and water conservation expenses. I.R.C. §(c)(3)(B). Similarly, expenses to clear land so that it can be farmed are not eligible and must be added to basis. IRS Pub. 225, Chapter 5, also points out that ineligible expenditures include those for various structures such as tanks, reservoirs, pipes, culverts, canals, dams, wells, or pumps composed of masonry, concrete, tile (including drainage tile), metal or wood. The costs associated with these items are recovered through depreciation. Similarly, costs associated with clearing land to prepare it for farming are not eligible and must be added to basis. Likewise, expenses that are currently deductible as repairs or are otherwise currently deductible under I.R.C. §162 as an ordinary and necessary business expense are not claimed under I.R.C. §175. Treas. Reg. §1.175-2(b)(2).
Deduction limit. The deduction may not exceed 25 percent of the taxpayer's “gross income derived from farming” in any taxable year. I.R.C. §175(b). The term “gross income derived from farming” includes gain from the sale of draft, dairy, breeding or sporting purpose livestock, but not gains from the sale of machinery or land. Excess amounts may be carried over to the succeeding years subject to the same 25 percent limit.
Note: It is possible that qualified expenditures could be subject to the 25 percent limitation if the farm taxpayer defers a sufficient amount of grain sales, for example, such that gross farm income is decreased.
How to Claim the Deduction
Line 12 of the 2016 Schedule F (Form 1040) is where soil and water conservation expenses can be reported. As noted above, if they are not claimed they are to be added to the land’s basis. In addition, as noted above, the decision to either currently deduct or capitalize soil and water conservation expenses is made in the first year in which the expenses are incurred and establishes a method of accounting. To change that method of accounting requires IRS approval.
If a deduction is taken for soil and water conservation expenses on farmland or ranchland and the land is disposed of within ten years of its acquisition, part or all of the deductions taken are recaptured as ordinary income up to the amount of gain on the disposition or the amount deducted multiplied by a percentage (as noted below), whichever is lower. I.R.C. §1252. The amount of recapture depends upon how long the land was held before disposition. For land held five years or less, all of the deductions are subject to recapture. For land held more than five years but less than ten, a sliding scale applies. A sale or disposition in the sixth year recaptures 80 percent, within the seventh year 60 percent, within the eighth year 40 percent, and within the ninth year 20 percent, of the deductions. If the land was held for more than nine years, there is no recapture of soil and water conservation deductions.
To restate, in the event recapture applies, the recaptured amount cannot exceed the amount of gain on the land. Also, if only a portion of the land is disposed of, the deductions attributable to the entire parcel are allocated to each part in proportion to the fair market value of each at the time of disposition. If disposition of the land is by gift, tax-free exchange or transfer at death, no gain is recognized from recapture.
The current deduction for soil and water conservation expenses can be a helpful provision for numerous farmers. When a farmer has qualifying expenses it’s a helpful tool to include in the tax planning arsenal.