Expense Method Depreciation and Leasing - A Potential Trap

Overview

For tangible depreciable personal property (and some types of qualified real estate improvements), all or part of the income tax basis can be deducted currently in the year in which the property is placed in service (defined as when property is in a state of readiness for use in the taxpayer's trade or business), regardless of the time of year the asset was actually placed in service.  This is known as “expense method depreciation” and it is an off-the-top depreciation allowance that may be taken at the taxpayer's election each year.  I.R.C. §179.

For farmers and ranchers, the deduction can apply to a wide array of business assets.  But there is a potential trap that can apply to farm landlords that is often overlooked.  Expense method depreciation and a trap for the unwary – it’s the topic of today’s post.

Basics of Expense Method Depreciation

On a joint return, the aggregate basis amount eligible for the deduction is $1,080,000 at the federal level (for 2022), except for certain types of vehicles.  But, the maximum amount that can be claimed is limited to the taxpayer’s aggregate business taxable income (including I.R.C. §1231 gains and losses and interest from the working capital of the business).  Treas. Reg. §1.179-2(c).  The extent of a taxpayer’s income from the active conduct of a trade or business is determined in accordance with a facts and circumstances test to determine if the taxpayer “meaningfully participates in the management or operations of the trade or business.” Treas. Reg. §1.179-2(c)(6)(ii).  Wages and salaries that the taxpayer receives as an employee are included in the aggregate amount of active business taxable income of the taxpayer.  Moreover, a spouse's W-2 wage income is considered income from an active trade or business for this purpose if the couple files a joint income tax return.

The I.R.C. §179 limitation applies at the entity level for pass-through entities in addition to also applying at the individual taxpayer level.  That’s an important point for farming operations where family members are sharing ownership of equipment.  If a co-ownership arrangement is construed as a partnership, only one I.R.C. §179 limitation would apply to equipment purchases.  If the co-ownership is not a partnership, each taxpayer could count their respective share of equipment purchases for purposes of the I.R.C. §179 limitation.

Here are some other key points about the provision:

• Property that is eligible for expense method depreciation is tangible, depreciable personal property. This includes costs to prepare and plant a vineyard, including labor costs. C.A. 201234024 (May 9, 2012).
• Expense method depreciation is tied to the beginning of the taxpayer’s tax year.
• Qualified leasehold improvement property and qualified retail improvement property are eligible for expense method depreciation as are air conditioning and heating units.
• Certain items of tangible depreciable personal property are not eligible for expense method depreciation. In general, any property that would not be eligible for investment tax credit (under the rules when the investment tax credit was available) is ineligible for expense method depreciation. 
• In addition, property acquired by gift, inheritance, by estates or trusts and property acquired from a spouse, ancestors or lineal descendants is not eligible for expense method depreciation. However, qualifying property held by a grantor trust is eligible for I.R.C. 179, but property held by an irrevocable trust is not. 
• For property traded in, only the cash boot that is paid is eligible for expense method depreciation.
• Expense method depreciation is phased out for taxpayers with cost of qualifying property purchases exceeding $2,700,000 (for 2022). For each dollar of investment in excess of $2,700,000 for the year, the allowable expense amount is reduced by $1. Thus, for 2022, at $2,700,000, the full deduction is available, and at $3,780,000, nothing is available.
• Upon disposition of property on which an expense method depreciation election has been made, special income tax recapture rules may apply.
• For expense method depreciation assets disposed of by installment sale, all payments received under the contract are deemed to have been received in the year of sale to the extent of expense method depreciation claimed on the property.
• The expense method election for eligible property must be made on the first return (or on a timely filed amended return) for the year the elected property is placed in service. However, an expense method depreciation election can be made or revoked on an amended return for an open tax year (generally the most recent three years).

For the farmer or rancher, expense method depreciation can be claimed on machinery and equipment, as well as purchased breeding stock, pickup trucks and business automobiles, it can also be claimed on tile lines, fences, feeding floors, grain bins and silos.  But, of course, the trade-off is that if expense method depreciation is selected for a particular asset, the basis of the asset must be reduced by the amount of the expensing deduction.

Leases and the Non-Corporate Lessor Rule 

Non-corporate taxpayers that lease property to others that contains tangible property on which the landlord seeks to claim expense method depreciation, must satisfy two additional requirements.  I.R.C. §179(d)(5).  

• First, the term of the lease must be less than 50 percent of the class life of the property.

• Second, during the first 12 months of the lease, the deductions of the lessor with respect to the property (other than taxes, interest and depreciation) must exceed 15 percent of the rental income produced by the property. 

Note:  Presumably, the rule does not apply to S corporations. 

The rule makes it difficult for farm landlords to claim expense method depreciation with respect to many real estate improvements, particularly those that don’t require repairs and maintenance in the first 12-month period of the lease.

Note:  A non-corporate lessor is also eligible for I.R.C. §179 if the non-corporate lessor manufactured or produced the leased property.  I.R.C. §179(d)(5)(A). 

A Tax Court case a few years ago illustrates the peril posed to farm landlords by the non-corporate lessor rule.  In Thomann v. Comr., T.C. Memo. 2010-241, the taxpayers were a farm couple that owned and operated a 504-acre farm.  Around 2000, the couple orally leased 124 acres of their farmland along with buildings, grain storage bins and equipment to Circle T Farms, Inc., a hog farrow-to-finish business that the couple owned for $70,000 annual cash rent.  The corporation’s annual minutes for the years at issue, however, failed to specify what property the corporation was “renting” from the petitioners and did not provide details of any changes or additions to the lease. Instead, the minutes for the years at issue merely provided the dollar amounts without describing the property being “leased.” 

The petitioners orally leased the balance of their farmland (380 acres) to C&A, Inc., an unrelated party.  The husband also entered into an oral farming agreement with C&A that was put in writing in 2006 to state that the agreement “covered any future year[‘]s crops, so long as neither party requested a change on or before Sept[ember] 1 of the calendar year.”   

In 2004, 2005 and 2006, the petitioners purchased property that qualified for expense method depreciation.  On their tax return for 2004, they expensed $52,000 for drainage tile and a fence that was installed on the land that they leased to C&A, and $10,000 for material they purchased to remodel their farm office, including furniture and fixtures.  For 2005, they expensed $63,488 for a grain bin.  For 2006, they expensed $8,467 for a pickup truck and $31,000 for a grain bin and grain dryer.  The bin and dryer (and, presumably, the pickup truck) were orally leased to Circle T Farms for the $70,000 annual “cash rent.”  The IRS disallowed all of the expense method depreciation deductions for the farm-related property, citing the non-corporate lessor rule.

As for the office equipment, the court agreed with the IRS that the couple didn’t substantiate the deduction on their return and, as such, the court couldn’t determine whether the office material was eligible for expensing as “other property” under I.R.C. Sec. 1245.  Importantly, the court did not hold that the office materials were not I.R.C. §1245 property, but did hold that the taxpayers failed to present sufficient evidence to allow the court to determine whether the office materials were not “structural components” and would, therefore, be eligible for expense method depreciation.  So, an expense method deduction was denied for those items.  The court did not address the non-corporate lessor rule with respect to the office equipment.  

As for the grain bins, grain dryer, drainage tile, pickup truck and fence, the non-corporate lessor rule was applicable.  The couple claimed that the lease was for a year, renewable annually for another year and was, therefore, less than 50 percent of the class life of the farm-related property.  The Tax Court disagreed.  None of the leases were in writing and the couple didn’t provide any evidence of the actual lease terms.  As a result, the Tax Court concluded that the leases were for an indefinite period of time and did not have a term of less than 50 percent of the class life of the property.  The court also imposed an accuracy-related penalty of $16,209.

Note:  A lessor that merely rents property for the production of income isn’t eligible for expensing because the leased property is not used in the active conduct of the taxpayer’s trade or business.  Thus, cash rent leases also present a problem with respect to I.R.C. §179.  Thus, even if the non-corporate lessor test were satisfied in Thomann, I.R.C. §179 may still have been denied based on the nature of the leases involved. 

Conclusion

When it comes to many improvements on farmland, the non-corporate lessor rule is a major hurdle for farm landlords irrespective of whether the lease is cash rent or crop-share.  But, there is some doubt as to whether material participation share leases are subject to the rule. 

Farm leases may be short term, if they are in writing, but many may not even be in writing.  As Thomann illustrates, an oral lease can end up violating the rule.  Even if the test involving the length of the lease as compared to the class life of the farmland improvements is met, the improvements may not need repair and maintenance sufficient enough to allow the landlord to meet the other part of the non-corporate lessor rule.  That means that satisfaction of the “overhead” test may come down to how operating costs, if any, are allocated between the landlord and the tenant and how those costs relate to the rental amount.

The bottom line is that, for non-corporate farming operations, leases need to be in writing and drafted carefully with the non-corporate lessor rule in mind.