Thursday, November 29, 2018
The tax law is structured to tax income less the cost of producing the income. Over time, assets wear out or cease to be useful with their cost, in effect, being consumed during their period of usefulness in the farming or ranching business. In recognition of this cost, the tax law allows an annual deduction for depreciation. In addition, in some instances the total allowable depreciation for the asset can be claimed entirely in the first year that the taxpayer places the asset in service.
In general, depreciation is allowable on all tangible and intangible property with a limited useful life of more than one year that is used in the trade or business of farming or ranching or held for the production of income. Property that is depreciable includes business machinery and equipment, buildings, patents, purchased livestock and property held for rental. Property that is generally not depreciable includes inventories or stock in trade, a building used only as a residence and an automobile used only for pleasure. Land is not depreciable because it doesn’t have a determinable useful life.
Farmers and ranchers do encounter some unique situations that raise the question of whether an allowance for depreciation is available. Assets that are sufficiently similar to land may be non-depreciable because they don’t have a determinable useful life.
Non-depreciable farm assets due to the lack of a determinable useful life – that’s the topic of today’s post.
Agricultural operations can have several unique assets that aren’t depreciable because they don’t have a determinable useful life.
Grazing preferences. In general, grazing preferences are not be depreciable or amortizable. In Uecker v. Comr., 81 T.C. 783 (1983), aff’d, 766 F.2d 909 (5th Cir. 1985), the court held that grazing privileges had an indeterminant life because the taxpayers had preferential application and renewal privileges under state and federal law. They weren’t depreciable under I.R.C. §178 because of the taxpayers' ability to renew them indefinitely.
The same result was reached in Shufflebarger v. Comr., 24 T.C. No. 90 (1955). Under the facts of the case, the taxpayers acquired a portion of a summer allotment of grazing privileges in a national forest. They amortized the cost of acquiring the grazing privileges deducted it. The IRS disallowed the deduction on the basis that the rights had an indefinite duration. The Tax Court agreed. The same result was reached in Central Arizona Ranching Company v. Comr., T.C. Memo. 1964-217, a case involving state and federal land leases. Also, in Priv. Ltr. Rul. 8327003 (Mar. 17, 1983), the IRS determined that a taxpayer’s interest in a state grazing rights lease did not qualify as real property for purposes of a tax deferred exchange under I.R.C. §1031, but it was not subject to depreciation or amortization deductions under I.R.C. 167. The IRS noted that the terms of the lease were of indefinite duration.
But, a change in the facts could lead to a different conclusion if those facts reveal that the life of the grazing privilege has a certain end point, such as when the rights are dependent on the supply of a natural resource that will eventually be depleted.
Earthen irrigation ditches and levees. In Rev. Rul. 69-606, 1969-2 C.B. 33, the IRS ruled that the cost allocated to earthen watering tanks or "ponds" that were constructed by a prior owner on land that the buyer leased to ranchers was not recoverable through depreciation because it didn’t have a determinable useful life. The IRS also ruled that the buyer couldn’t recover the allocated cost as a soil and water conservation expense. The Tax Court concluded similarly in Wolfsen Land & Cattle Co. v. Comr., 72 T.C. 1(1979). In that case, the taxpayer bought a ranch that had an extensive irrigation system on over 17,000 acres. The Tax Court upheld the IRS determination that the system was not depreciable because it had an indeterminant useful life. The Tax Court noted that the evidence revealed that consistently repairing the system would result in the system lasting indefinitely.
However, some cases have held dams and ponds to be depreciable if a definite useful life can be demonstrated. For example, In Rudolph Investment Corp. v. Comr., T.C. Memo. 1972-129, earthen water tanks and dams were determined to have a ten-year useful life. In Rev. Rul. 75-151, 1975-1 C.B. 88, the IRS pointed out that the question of whether dams, ponds, canals and similar structures are depreciable depends on a factual determination that the asset is actually exhausting and that such exhaustion is susceptible of measurement. But, for farmers and ranchers, a current deduction under I.R.C. §175 is available for expenditures incurred for earthen terraces and dams which are non-depreciable. Of course, the qualifications for I.R.C. §175 must be satisfied.
Permanent Pastures. Permanent pasture is generally defined as land that is used to grow grasses or other forage naturally or through cultivation and is not included in a crop rotation for five years or longer. Permanent pastures have been held to be depreciable. For example, in Johnson v. Westover, 55-1 USTC ¶9,421 (S.D. Cal. 1955), the taxpayer purchased a ranch that included 200 acres of permanent pasture that had been planted with various grasses about five years earlier. The court determined, based on the evidence, that the pasture should be replanted at the end of 10 years to maintain its economic usefulness. At the time of purchase, the evidence showed that the pasture had a remaining life of five years.
Government Allotments or Quotas. Many farmers participate in federal farm programs. Particularly under prior farm bills, farmers were required to participate in acreage allotments. An acreage allotment is a particular farm’s share, based on its historic production, of the national acreage needed to produce sufficient supplies of a particular crop. In essence, an allotment represents the federal government’s attempt to micro-manage production of certain types of crops. These allotments have been held to not be depreciable due to a lack of a determinable useful life. For example, in Wenzel v. Comr., T.C. Memo. 1991-166, the Tax Court addressed the peanut base acreage allotment as part of the federal farm programs was depreciable. The Tax Court noted that wule the program had been controversial for some time, it continued to be reauthorized by subsequent farm bills. Thus, the Tax Court determined that the peanut program was a stable program that would continue unless the Congress took action to terminate it. Because the actions of Congress were completely unpredictable, the Tax Court held that the peanut program base acreage allotment was indeterminant and the associated cost to the taxpayer was not depreciable. Later, in C.C.A. 200429001 (Jul. 16, 2004), the IRS noted that three additional farm bills had become law since the Tax Court’s ruling in Wenzel and the peanut program continued. That lead the IRS to conclude that the duration of the peanut program could not be determined with reasonable certainty or accuracy. Consequently, the IRS determined, the peanut base acreage allotment did not have a determinable useful life and could not be depreciated.
But a transferable right to receive a premium price for a fixed quantity of milk in accordance with a regional milk marketing order has been held to be amortizable (e.g., the cost could be spread over the useful life – 15 years) when it has a statutory expiration date and is not expected to be renewed. For example, in Van de Steeg v. Comr., 60 T.C. 17 (1973), aff’d., 510 F2d 961 (9th Cir. 1975), the taxpayers were dairy farmers who marketed their milk production subject to a Federal Milk Marketing Order. On several occasions they purchased an intangible asset (referred to as a "class I milk base") which they used in their dairy business. They claimed depreciation for the milk base and IRS disallowed the deduction on the basis that the asset had an indeterminable useful life – it depended on the will of the Congress whether or not to extend the program. The Tax Court (affirmed by the Ninth Circuit) held that the program that created the class I milk base always contained an express termination date and the existence of two extensions did not change the fact that a termination date always existed, even though the date had changed. While the IRS disagrees with the Van de Steeg opinion, it did announce that it would follow it. Rev. Rul. 75-466, 1975-2 C.B. 74.
Drilling Costs for Wells. Drilling costs for wells are not depreciable, but parts of wells, such as piping and casings are. See, e.g., Rev. Rul. 56-599, 1956-2 C.B. 122. However, there is language in a Treasury Regulation that indicates that wells might be depreciable. See, e.g., Treas. Reg. §1.175-2(b)(1). In addition, the fact that the IRS has previously ruled that water wells were eligible for the investment tax credit (when it was available), bolsters the argument that water wells are depreciable. To be eligible for the investment tax credit, the property at issue had to be depreciable property. See, e.g., Rev. Rul. 72-222, 1972-1 C.B. 17; Rev. Rul. 81-120, 1981-1 C.B. 20.
Landscaping and Land Modification Costs. If a farmer or rancher incurs costs associated with landscaping or modifying the land (dirt moving) to construct a building that will be used in the farming business, the costs are likely depreciable. Support for this position can be found in Rev. Rul. 74-265, 1974-1 C.B. 56. Under the facts of the ruling, the taxpayer constructed and operated a garden-type apartment complex on several acres. The surrounding area was landscaped according to an architect's plan to conform it to the general design of the apartment complex. The expenditures for landscaping included the cost of top soil, seeding, clearing and grading, and planting of perennial shrubbery and ornamental trees around the perimeter of the tract of land and immediately adjacent to the buildings. The replacement of the apartment buildings after the expiration of their useful lives would destroy the immediately adjacent landscaping, consisting of perennial shrubbery and ornamental trees. The IRS ruled that the perennial shrubbery and ornamental trees immediately adjacent to the apartment buildings were depreciable because the replacement of the buildings would destroy the landscaping. That meant that the land preparatory costs could be recovered through depreciation deductions over the established useful life of the apartment buildings.
Logging Roads, Bridges and Culverts. Logging roads, bridges and culverts are depreciable if the taxpayer can establish that the roads have a determinable life. In one instance, the IRS ruled that a road did have a determinable useful life that could be determined by the amount of time it took to harvest trees that were reachable by the road. Rev. Rul. 88-99, 1988-2 C.B. 33. Under the facts of the ruling, the taxpayer built roads in order to harvest timber, to transport the logs cut from the timber to its facilities for processing, and to carry out general management activities. The taxpayer wanted to depreciate two of the roads. One road was to be maintained so that the taxpayer could use it for an indefinite period of time to manage and harvest timber. The IRS ruled that the roadbed could not be depreciated, but that the associated surface, bridges and culverts could be because they each had determinable useful lives. The other road was to be abandoned after four years, and the useful lives of all parts of the road (roadbed, surface, bridges, culverts, etc.) would terminate when the timber harvest and reforestation work was completed that the road was associated with. Thus, this road could be depreciated.
In a Tax Court case, the taxpayers were allowed to depreciate paved lots that were used in a cattle operation. Eldridge v. Comr., T.C. Memo. 1995-384. The court based its determination on the fact that the taxpayers maintained the horse barn and associated paved areas primarily for use in their cattle-raising activity. The horses housed in the barn were used by the taxpayers to move cattle from one pasture to another, and the Tax Court determined that the horse barn was maintained primarily for use in the cattle-raising activity which was engaged in for profit.
There are many unique items on a farm or ranch that present tricky issues with respect to depreciation because they don’t clearly have a determinable useful life. But, if a determinable useful life can be determined, a deduction for depreciation is available if the asset is used in the taxpayer’s trade or business or for the production of income.