Thursday, October 14, 2021
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.
Tax issues with easement payment – it’s the topic of today’s post.
Characterizing the Transaction
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.
A sale or exchange triggers gain or loss for income tax purposes. I.R.C. §1001. Is the grant of an easement a taxable event? It depends. In essence, a landowner’s grant of an easement amounts to a sale of the land if after the easement grant the taxpayer has virtually no property right left except bare legal title to the land. For instance, in one case, the grant of an easement to flood the taxpayer’s land was held to be a sale. Scales v. Comr., 10 B.T.A. 1024 (1928), acq., 1928-2 C.B. 35. In another situation, the IRS ruled that the grant of an easement for air rights over property adjoining an air base with the result that the property was rendered useless was a sale. Rev. Rul. 54-575, 1954-2 C.B. 145. The grant of a perpetual easement on a part of unimproved land to the state for a highway, as well as the grant of a permanent right-of-way easement for use as a highway have also been held to be a sale. Rev. Rul. 72-255, 1972-1 C.B. 221; Wickersham v. Comr., T.C. Memo. 2011-178. Also, the IRS has determined that the grant of a perpetual conservation easement on property in exchange for “mitigation banking credits” was held to be a sale or exchange. Priv. Ltr. Rul. 201222004 (Nov. 29, 2011). Under the facts of the ruling, the taxpayer acquired a ranch for development purposes, but did not develop it due to the presence of two endangered species. The taxpayer negotiated a Mitigation Bank Agreement with a government agency pursuant to which the taxpayer would grant a perpetual conservation easement to the government in return for mitigation banking credits to allow the development of other, similarly situated, land. The IRS determined that the transaction constituted a sale or exchange.
If the payments for the grant of an easement are, in effect, rents for land use the characterization of the payments in the hands of the landowner is ordinary income. For example, in Gilbertz v. United States, 574 F. Supp. 177 (D. Wyo. 1983), aff’d., and rev’d. by, 808 F.2d 1374 (10th Cir. 1987), the taxpayers, a married couple, raised cattle on their 6,480-acre ranch. They held title to the surface rights and a fractional interest in the minerals. The federal government reserved most of the mineral rights. In 1976 and 1977, the taxpayers negotiated more than 50 contracts with oil and gas lessees and pipeline companies to receive payments for anticipated drilling activities on the ranch. The taxpayers reported the payments as non-taxable recovery of basis in the entire ranch with any excess amount reported as capital gain. The IRS disagreed, asserting that the payments taxable as ordinary income. The taxpayers paid the asserted deficiency and sued for a refund.
The trial court dissected the types of payments involved concluding that the “Release and Damage Payments” were not rents taxable as ordinary income. The payments from pipeline companies for rights-of-ways and damage to the land involved a sale or exchange and were taxable as capital gain – the pipeline companies had obtained a perpetual right-of-way. On further review, the appellate court held that the “Release and Damage Payments” were not a return of capital to the taxpayers that qualified for capital gain treatment to the extent the amount received exceeded their basis in the land. However, the appellate court affirmed the trial court’s holding that the amounts received from the pipeline companies were properly characterized as the sale of a capital asset and constituted a recovery of basis with any excess taxable as capital gain.
Limited Easements. 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.
Types of Payments
Damage payments. As noted above, an initial payment made to a landowner for acquisition of an easement could result in income to the landowner or a reduction of the landowner’s basis in the land, or both. That means that a lump sum payment for the right to lay a pipeline across a farm may result in income, a reduction in basis of all or part of the land or both. An amount 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 non-material participation crop-share landlord. Any payment for future property damage (e.g., liquidated damages), however, is generally treated as rent.
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.
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.
The IRS has ruled that periodic payments that farmers received under a “lease” agreement that allowed a steel company to discharge fumes without any liability for damage were rent. In Rev. Rul. 60-170, 1960-1 C.B. 357, the payments from the steel company were to compensate the farmers for damages to livestock, crops, trees and other vegetation because of chemical fumes and gases from a nearby plant. The IRS determined that the payments were rent and, as such, were not subject to self-employment tax.
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.
Note: 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.
Involuntary conversion. While a condemnation award that a landowner receives is treated as a sale for tax purposes, it can qualify for non-recognition treatment under the gain deferral rules for involuntary conversions contained in I.R.C. §1033. Rev. Rul. 76-69, 1976-1 C.B. 219; Rev. Rul. 54-575, 1954-2 C.B. 145. 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. See, e.g., Rev. Rul. 72-433, 1972-2 C.B. 470
The election to defer gain under I.R.C. §1033 is made by simply showing details on the return about the involuntary conversion but 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 details is treated as a deemed election.
Note: If the taxpayer designates qualified replacement real estate on a return within the required period and purchases the property at the anticipated price within three years of the end of the gain year, a valid election is complete. If the purchase price of the replacement property is lower than anticipated, the resulting gain should be reported by amending the return for the election year. If qualified replacement property within the required three-year period, the return for the year of the election must be amended to report the gain.
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.