Wednesday, October 24, 2018
An issue that can be confusing and difficult to understand is the proper classification of items of depreciable real estate for a farm taxpayer. More specifically, how are farm “buildings” and other structures treated for depreciation purposes? The Tax Code (Code) treats “buildings” and “structures” in a special way. But, that treatment is not always intuitive.
So just what is a “farm building”? What is depreciable farm real property? What is the appropriate tax treatment of these items for depreciation purposes? That’s the topic of today’s post.
“Buildings and Structures”
The IRS classifies depreciable farm real property in at least four ways. Land improvements have a cost recovery period of 15 years and are in depreciation class 00.3 (Modified Accelerated Cost Recovery System depreciation class). Single purpose agricultural or horticultural structures are in Class 01.4 and have a cost recovery period of 10 years. The cost recovery period for farm buildings is 20 years, and they are in Class 01.3. What is known as I.R.C. §1245 real property has no class life and a cost recovery period of seven years. The specifications are set forth in Rev. Proc. 87-56, 1987-2 C.B. 674.
In general, depreciable real estate must use straight-line depreciation. I.R.C. §168(b)(3). But, that’s not the case for depreciable real estate that has a recovery period of less than 27.5 years. I.R.C. §168(e)(2)(B). As such, the applicable depreciation method for depreciable farm real estate is the 150 percent declining balance method.
Land improvements. A land improvement is a tangible depreciable item that is added to the underlying land. It is either I.R.C. §1245 or I.R.C. §1250 property. Such items as sidewalks, roads, canals, waterways, wharves, docks, bridges, fences, landscaping, shrubbery and transmission towers all meet the definition of a land improvement. Other land improvements (and similar structures) include such things as silage bunkers, concrete ditches, stock watering pond outlets and wells used for irrigation and livestock watering. See Rev. Proc. 87-56, 1987-2 C.B. 674.
Sometimes farmers and ranchers incur costs for improvements associated with windbreaks, excavation, dredging, and other earth moving activities. The common IRS position on the cost of these types of improvements is that they are not depreciable and must be capitalized into the cost basis of the underlying land. See, e.g., Everson v. United States, 108 F.3d 234 (9th Cir. 1997). However, they might be depreciable if the taxpayer can establish that the improvement will deteriorate over time and ultimately become worthless unless it is maintained (and the exhaustion of the asset can be measured). See, e.g., Ekberg v. United States, No. 711 W.D., 1959 U.S. Dist. LEXIS 4467 (D. S.D. 1959); Rev. Rul. 75-137, 1975-1 C.B. 74; Rudolph Investment Corp. v. Comr., T.C. Memo. 1972-129. Associated maintenance costs would be currently deductible as a repair expense.
Single purpose structures. The definition of a single purpose agricultural or horticultural structure is contained in I.R.C. §48(p), even though that Code section has since been repealed. Under that definition, a single purpose agricultural or horticultural structure is one that is used for the housing, raising and feeding of a particular type of livestock and the associated equipment that is required to properly house, raise and feed the livestock. I.R.C. §48(p)(2)[repealed]. Examples of these structures on a farm include hog houses, poultry barns, livestock sheds, milking parlors and similar structures.
Likewise, a single purpose agricultural or horticultural structure includes a greenhouse that is specifically designed, constructed and used for the commercial production of plants. I.R.C. §48(p)(3)(B)[repealed].
I.R.C. §1245 assets and I.R.C. §38. Assets which have the appearance of a building but qualify as I.R.C. §1245 assets (and not separately classified as single purpose ag or horticultural structures) are not “buildings” Treas. Reg. 1.48-1(e)(1)(i)]. They are, in essence, items of machinery or equipment which are an “integral part of manufacturing [or] production” I.R.C. §1245(a)(3)(B)(i)]. Structures such as storage facilities for potatoes, onions and other cold storage facilities for fruits and vegetables are included in this category. But, if the structure is used for other purposes after the commodities have been removed, the structures are buildings, rather than I.R.C. §1245(a)(3).
Now repealed I.R.C. §48(a)(1)(B)(i) defined property which qualified for the I.R.C. §38 investment tax credit (ITC). The Tax Reform Act of 1986 moved that language into I.R.C. §1245 for depreciation recapture purposes. Thus, property that qualified as pre-1986 investment tax credit property will qualify as property defined under I.R.C. §1245(a)(3).
For property that is easily adaptable to other uses, it is properly classified as a building. For example, a building with a kit installed for commodity storage did not qualify for the ITC. Tamura v. United States, 734 F.2d 470 (9th Cir. 1984); Bundy v. United States, No. CV85-L-575, 1986 U.S. Dist. LEXIS 17497 (D. Neb. 1986). However, if the property is of special design and unsuitable for other uses, it is not a building. See, e.g., Palmer Olson v. Comm., TC Memo 1970-296. Obviously, the proper determination is based on the facts of the particular situation. The key question is whether a particular structure is closely related to the use of the property that it houses based on its design and whether it can be economically used for other purposes. See, e.g., Priv. Ltr. Rul. 200013038 (Dec. 27, 1999).
Farm buildings. Farm buildings are defined by default – they are depreciable structures that don’t fit in any other class. Examples include shops, machine sheds and other general purpose buildings on a farm that are not integral to the manufacturing, production or growing process. “Hoop” structures generally fit in this category as a general purpose farm building. At least that’s the likely IRS position. Granted, a fact-dependent argument can be made that a hoop structure is used as an integral part of production or is akin to a bulk storage facility used in connection with production. If that argument prevails, a hoop structure is I.R.C. §1245 property with no class life and a seven-year recovery period. In that case, a hoop structure would be eligible for I.R.C. §179 depreciation, and would also potentially be eligible for first-year “bonus” depreciation. The key to the determination a hoop structure’s status is determining whether it is easily adaptable to other uses. If it is, it is properly classified as a “building.”
What About I.R.C. §179 Depreciation?
The Tax Cuts and Jobs Act (TCJA) increased the maximum level of expense method (I.R.C. §179) depreciation to $1,000,000 with the phase-out set at $2,500,000 of qualified assets purchased and placed in service during the year. Do the various structures mentioned above qualify for I.R.C. §179? If the structure is a general purpose ag building, it would not qualify for I.R.C. §179 depreciation. However, property that is “other property,” that is not a building or its structural components, used as an integral part of manufacturing or production qualifies for I.R.C. §179. I.R.C. §179(d)(1)(B). That definition includes single purpose ag and horticultural structures. I.R.C. §1245(a)(3)(D)]. Land improvements, such as irrigation and livestock watering wells and silage bunkers, may qualify for I.R.C. §179 if they are used in the manufacturing, production or growing process. I.R.C. §1245(a)(3)(B)(i). Similarly, grain storage in connection with a manufacturing and production activity qualifies for I.R.C. §179 by virtue of I.R.C. §1245(a)(3)(B)(iii).
The TCJA made changes to the Code’s cost recovery provisions. For tax years beginning after 2017, a five-year recovery period applies for machinery or equipment (other than any grain bin, cotton ginning asset, fence, or other land improvement) used in a farming business, the original use of which commences with the taxpayer and is placed in service after December 31, 2017.
The TCJA also repeals the required use of the 150-percent declining balance method for property used in a farming business (i.e., for 3, 5, 7, and 10-year property). But, the 150 percent declining balance method will continue to apply to any 15-year or 20-year property used in the farming business to which the straight-line method does not apply, or to property for which the taxpayer elects the use of the 150-percent declining balance method.
However, those TCJA modifications don’t change the rules for determining what is a “farm building” or depreciable farm real property. Those tricky rules and factual situations remain.