Thursday, November 12, 2020

Is it a Farm Lease Or Not? – And Why it Might Matter

Overview

In the agricultural sector, agreements other than leases are sometimes utilized which authorize a person to conduct farming operations on behalf of the landowner.  The status of that person can differ.  The person may be classified as a farm tenant or an employee or a cropper.  What are the differences and why does the classification matter?     

The classification of persons conducting farming operations for a farm landowner – it’s the topic of today’s post.

Status of a Person Conducting Farming Operations

Some farming and ranching operations utilize employees, while other operations hire a farm management company or an individual as an independent contractor with compensation based on a certain number of dollars per acre to prepare, plant, cultivate and harvest. Custom cutters provide combine crews that follow the harvest each year from Texas to Canada. Usually, those who hire custom cutters treat them as independent contractors from a legal perspective.

While the status of a tenant or independent contractor is usually clear, the status of a cropper is less clear. A cropper occupies a legal position somewhere between the status of a tenant and an employee or independent contractor. A person is likely to be a cropper and not a tenant when the landowner supplies land and all the inputs, controls the operation of the farm and pays a portion of the crop to the person who actually raises and harvests the crop.

A cropper, unlike a tenant who has a possessory interest in the leased premises and control over the farming operation, only has permission to be on the land. A cropper does not have any legally enforceable interest in the crops and has only a contract right to be compensated in-kind for the cropper’s labor. This has bearing on whether the farmer is entitled to statutory notice of lease termination under state law.  Under Iowa law, for example, a “cropper” is distinguished from a “tenant.”  The relevant statute defines a person as a cropper rather than a tenant if the landowner supplies the land and the inputs, controls the operation of the farm and pays a portion of the crop to the person raising and harvesting the crop.  In that situation, the farmer has no legally enforceable interest in the crop or land involved, only has a contract right for compensation in-kind for labor provided, and is basically an employee of the landowner (i.e., a wage earner) that is hired to produce a crop. See Henney v. Lambert, 237 Iowa 146, 21 N.W.2d 301 (1946). Therefore, because a cropper does not have any property right in the leased premises, the cropper is not entitled to statutory notice of termination - there is no interest to be terminated.  Instead, a cropper’s “lease” terminates upon harvest of the crop. 

As opposed to a cropper, a farmer operating under a crop-share arrangement with the landowner is a crop-share tenant and not a cropper.  Thus, the statutory notice of termination requirement applies.  For example, in Hoffman v. Estate of Siler, 306 S.W.3d 854 (Mo. Ct. App. 2010), the plaintiff was held to be a year-to-year tenant under an oral farm lease rather than a cropper.  As a result, he was entitled to a statutory 60-day notice of termination of tenancy.  The arrangement was determined to be a typical 50/50 crop-share arrangement. The plaintiff supplied his own farming equipment, made all of the farming decisions, performed unpaid maintenance, applied for government programs and dealt with conservation agents. 

When a question arises with respect to the status of the parties, courts attempt to determine the intent of the parties as evidenced by the terms of the written or oral contract, circumstances surrounding the agreement, the action of the parties and the type of farming operation. Typically, no single factor controls. Instead, an examination of all the factors is necessary in most situations to determine the status of the parties. Indeed, most courts do not find controlling the parties’ characterization of the arrangement. But if a landowner gives exclusive possession of a farm to another party, some courts have held that act to establish a landlord-tenant relationship. As for croppers, a court could find them to be employees instead of independent contractors under a state workers’ compensation law.

Recent Case

The issue of the legal status of a farmer was involved in a recent Arizona case.  In F.S.T. Farms Inc. v. Vanderwey, 2019 Ariz. App. Unpub. LEXIS 1430 (Ariz. Ct. App. 2019), the plaintiff farmed for the defendant. The defendant leased farmland from a company and the plaintiff would farm the land, and both would split the crops produced. The state condemned the land and reached a settlement with the company, causing the defendant to be unable to furnish the land to the plaintiff. Neither the plaintiff nor defendant was a party to the condemnation action, and neither received any part of the settlement.

The plaintiff sued, alleging breach of contract and breach of the implied covenant of good faith and fair dealing. At trial, the main point of contention was whether the sharecrop agreement was a lease giving the plaintiff a property interest or a cropper’s contract creating an employment-like relationship. The plaintiff argued the agreement was a lease entitling him to one-half of the amount allocated to crop loss in settling the condemnation matter – approximately $500,000. While the defendant admitted contractual liability, he argued the agreement was a cropper’s contract, therefore the plaintiff’s damages should be limited to its lost profits totaling $10,000. The trial court jury found the agreement was a cropper’s contract and awarded the plaintiff damages of $207,214.40, equivalent to one-fifth of the settlement allocation.

On appeal, the defendant argued that the jury’s conclusion that the sharecropper agreement was a cropper’s contract necessarily limited the plaintiff’s recovery to $10,000. The appellate court held that as a matter of contract law, the plaintiff’s recovery was limited to the $10,000 in lost profits. The appellate court noted that the agreement provided that the parties would share all crops produced on the property and income received on account of growing and sale of crops from the property, and that while both parties were aware of the condemnation action, neither received any income from the settlement. The appellate court held that contract damages are intended to compensate for what the claimant lost because of the other party’s non-performance, and additional recovery is only available in exceptional circumstances, which were not present in this case. On remand, the trial court must determine the amount of damages on the plaintiff’s claims for breach of contract and breach of the implied covenant of good faith and fair dealing.

Conclusion

It is important that parties to a farming arrangement clearly understand the legal nature of the relationship and the legal implications that flow from that relationship.  Disappointed expectations can lead to litigation, and that’s what farmers and others in rural areas desire to avoid.  

November 12, 2020 in Contracts, Real Property | Permalink | Comments (0)

Friday, November 6, 2020

Ag and Tax In the Courts

Overview

The courts keep issuing rulings of importance to agricultural producers and others involved in agriculture or who own agricultural land.  Also, tax issues of general relevance continue to be resolved in the courts.  In today’s post, I take a look at some recent cases involving farm bankruptcy; the “public trust” doctrine; the proper tax classification of a work relationship; on-farm sales of processed beef; and zoning. 

A potpourri of ag and tax legal issues – these are the topics of today’s post.

Court Denies Proposed Sale of Land by Chapter 12 Debtor

In re Holthaus, No. 20-40065, 2020 Bankr. LEXIS 3001 (Bankr. D. Kan. Oct. 26, 2020)

The debtors (a married couple) owned farmland in two counties. They filed Chapter 12 bankruptcy and sought to sell three tracts of land through two contracts. 11 U.S.C. §363(b)(1) provides that a trustee "after notice and a hearing, may use, sell or lease, other than in the ordinary course of business, property of the estate." In determining whether to approve a proposed sale under 11 U.S.C. §363, courts generally apply standards that, although stated various ways, represent essentially a business judgment test. The debtors had not filed a reorganization plan at the time of the proposed sale of the land.

The first contract consisted of two parcels totaling 200 acres which would be used as prime cropland. The second contract was for 120 acres of cropland in need of erosion remediation and not eligible for participation in government agricultural programs in its current condition. The debtors claimed that there was an oral agreement to lease the purchased properties back to the debtors for $175 per acre per year after the sale, as well as a right of first refusal if the buyer were to sell the properties, so that the debtors could continue to farm the land. Both contracts were silent as to the amount of rent to be paid and whether the right of first refusal applied to all three of the properties. The debtors proposed to sell the prime cropland for $4,000 per acre, based on a recent sale of another property in the county.

The creditors had mortgage liens on the properties and vigorously opposed the sale of the three properties. The creditors argued that the debtors were undervaluing all three tracts of land. Specifically, the creditors argued that the debtors erred in relying on a past sale in the county to arrive at $4,000 per acre. The creditor argued that the recent sale involved land that included a significant portion of pasture and wasteland, and that the debtors’ land was compromised of high-quality tillable land and no waste. As a result, the creditors argued that the sale price of the prime cropland should be $5,000 per acre.

The bankruptcy court agreed with the creditors and held that the debtors had inadequately priced the prime cropland. However, the bankruptcy court held that the second contract did not undervalue the less desirable cropland. The bankruptcy court noted that although the debtors’ sale did not require satisfaction of outstanding liens, there were significant concerns about some aspects of the proposed sale. First, the debtors’ ability to resume farming would be dependent upon the lease of the three tracts after the sale for rent that would be less than the debtor’s present debt service. Additionally, the debtors’ right to lease would only last as long as the proposed buyer owned the properties. Consequently, the bankruptcy court denied the debtors’ proposed sale primarily due to an inadequate sale price for the prime cropland. 

Observation:  Clearly, not having the prime cropland exposed to the market through a listing was a problem.  If that had been done, there likely would have been testimony (and other evidence) to support the price in addition to the debtor's testimony.  Having an appraiser testify could have helped the debtor.

Public Trust Doctrine Inapplicable to Natural Resources Allegedly Harmed by “Climate Change” 

Chernaik v. Brown, 367 Or. 143 (2020)

I wrote recently about attempts to expand the “public trust” doctrine and the impact such an expansion would have on agricultural production and land ownership.  You can read that article here:  https://lawprofessors.typepad.com/agriculturallaw/2020/10/the-public-trust-doctrine-a-camels-nose-under-agricultures-tent.html.  In that article I discussed a Nevada Supreme Court opinion in which the Court refused to expand the doctrine.  Now, the Oregon Supreme Court has likewise refused to expand the doctrine. 

In the Oregon case, the plaintiffs claimed that the public trust doctrine required the State of Oregon to protect various natural resources in the state from harm due to greenhouse gas emissions, “climate change,” and ocean acidification. The public trust doctrine has historically only applied to submerged and submersible lands underlying navigable waters as well as the navigable waters. The trial court rejected the plaintiffs’ arguments. On appeal the state Supreme Court affirmed, rejecting the test for expanding the doctrine the plaintiffs proposed. Under that test, the doctrine would extend to any resource that is not easily held or improved and is of great value to the public. The state Supreme Court held that the plaintiffs’ test was too broad to be adopted. The Supreme Court remanded the case to the lower court. 

Zoning Ordinance Bars Keeping of Farm Animals 

Maffeo v. Winder Borough Zoning Hearing Board, 220 A.3d 1210 (Pa. Commw. Ct. 2019)

The plaintiff owned a two-acre property in an area zoned residential. She kept approximately 50 animals on the property including goats, donkeys, and chickens. The city manager’s office had received numerous noise and odor complaints regarding the animals. The city sent the plaintiff a cease and desist letter giving the plaintiff 20 days to remove the animals. A city ordinance prohibited any person from keeping goats, donkeys, and other farm animals on residentially zoned property. The plaintiff appealed the cease and desist letter to the defendant city, the zoning hearing board. The plaintiff admitted that most of her property was located within a residentially zoned district but argued that a small corner of the property was located in a conservation district allowing for agricultural uses. The zoning board denied the plaintiff’s argument and concluded that although part of the property was zoned for agricultural use, it was undisputed that the plaintiff’s animals were within 200 feet of a residential lot which violated a separate city ordinance.

The trial court affirmed. On appeal, the plaintiff argued the trial court failed to consider evidence that she properly cared for her animals and that her property had not been surveyed. Specifically, the plaintiff argued a letter from the county humane society should have been considered to show she properly cared for her animals. The appellate court held that although the letter was not in the record, both the zoning board and trial court had expressly considered the letter in making their respective rulings. The appellate court noted that the care for the animals was not at issue, but rather whether zoning rules and ordinance permitted the plaintiff to keep farm animals on her property. The appellate court also determined that a zoning survey of the property had been done recently, which showed that most of the property was within a residential district and only a small portion was zoned as conservation. The plaintiff failed to present any evidence to rebut the survey before the hearing board or trial court, therefore the appellate court held that the plaintiff was in violation of the city ordinance. Finally, the plaintiff argued the zoning board was unevenly enforcing its zoning ordinances because a neighbor had testified before the hearing board that he kept chickens on his property and a city officer had told him that doing so did not violate any city ordinance. The appellate court held that this evidence alone was insufficient to establish uneven enforcement without any other evidence presented. 

On-Farm Sales of Processed Beef Subject to Sales Tax 

Priv. Ltr. Rul. 8115 (Mo. Dept. of Rev., Sept. 25, 2020)

The taxpayer sought a ruling from the Missouri Department of Revenue (MDOR) concerning the sale of beef products from his farm. The taxpayer raises cattle, slaughters them, and then sends the beef out to be processed at a local processing plant. The taxpayer pays the processing plant for its services and then the taxpayer sells the resulting beef products to customers at his farm. The taxpayer’s question was whether the beef sales were subject to sales tax. The MDOR issued a ruling stating that the sales are subject to sales tax at the food tax rate of 1 percent. The MDOR noted that 7 U.S.C. §2012, defines “food” as "any food or food product for home consumption." The taxpayer was selling raw beef at retail for home consumption. 

Payments Received By CPA Were Wages and Not S.E. Income; Deductions Disallowed

Thoma v. Comr., T.C. Memo. 2020-67

The petitioner acquired a partial interest in an accounting firm and ultimately became the sole owner of the firm that he operated as a sole proprietorship. The petitioner later went into business with another accountant pursuant to two contracts. One contract purported to be a partnership agreement and the second contract “restated” the first contract. The plaintiff provided accounting services to the firm and also brought his own clients to the firm. He later sold his interest back to the business under an agreement stating that he didn’t retain any management or supervisory role in the business.

During the year of sale of his interest and the following year (2010 and 2011), the business made bi-weekly payments to the petitioner for accounting services. The business issued Schedules K-1 reporting the payments as guaranteed payments to a limited partner with no withholding. The petitioner did not receive any paid sick leave or paid vacation time. The business had a professional liability policy that included the petitioner. The petitioner received a letter from the Department of Justice requesting the records of a client and the petitioner responded to the letter without informing the business. That ultimately resulted in the business locking the petitioner out, barring him from the computer network and placing him on administrative leave and his relationship with the business being terminated.

The petitioner reported his income for 2010 and 2011 as self-employment income allowing him to claim deductions for deposits into his SIMPLE IRA and for health insurance premiums that he paid as well as for one-half of his self-employment tax liability. The IRS disallowed the deductions, recharacterizing the income as wages. That resulted in his expenses being treated as unreimbursed employee expenses deductible only as miscellaneous itemized deductions subject to the two-percent of adjusted gross income floor. Likewise, the petitioner’s health insurance deductions were only deductible as a medical expense deduction and the SIMPLE IRA deduction was disallowed. The IRS also imposed accuracy-related penalties.

The Tax Court agreed with the IRS position, concluding that the petitioner and the other accountant did not intend to carry on a business together or share profit and loss. Thus, they never formed a partnership. The 2010 agreement, the Tax Court determined resulted in an at-will employment arrangement with the petitioner having no management authority. The issuance of the Schedules K-1 were not controlling, but merely a factor in determining the existence of a partnership. The Tax Court also held that the petitioner was not an independent contractor because of the longstanding relationship of the petitioner and the other accountant. The accountant/firm retained the right to fire the petitioner and provided him with professional liability insurance, office space and tax prep software. The firm also retained control over the details of his work and he did not have any opportunity for profit or loss independent of the business. The IRS-imposed penalties were upheld. 

Conclusion

The courts again illustrate the numerous legal and tax issues that are relevant for farmers, ranchers rural landowners and taxpayers in general.  It’s always a good idea to have competent legal and tax counsel within arm’s reach.

November 6, 2020 in Bankruptcy, Income Tax, Real Property, Regulatory Law | Permalink | Comments (0)

Monday, October 12, 2020

Principles of Agricultural Law

PrinciplesForBlog2020Fall-cropped

Overview

The fields of agricultural law and agricultural taxation are dynamic.  Law and tax impacts the daily life of a farmer, rancher, agribusiness and rural landowner practically on a daily basis.  Whether that is good or bad is not really the question.  The point is that it’s the reality.  Lack of familiarity with the basic fundamental and applicable rules and principles can turn out to be very costly.  As a result of these numerous intersections, and the fact that the rules applicable to those engaged in farming are often different from non-farmers, I started out just over 25 years ago to develop a textbook that addressed the major issues that a farmer or rancher and their legal and tax counsel should be aware of.  After three years, the book was complete – Principles of Agricultural Law - and it’s been updated twice annually since that time. 

The 47th edition is now complete, and it’s the topic of today’s post – Principles of Agricultural Law.

Subject Areas

The text is designed to be useful to farmers and ranchers; agribusiness professionals; ag lenders; educational professionals; lawyers, CPAs and other tax preparers; undergraduate and law students; and those that simply want to learn more about legal and tax issues.  The text covers a wide range of topics.  Here’s just a sample of what is covered:

Ag contracts.  Farmers and ranchers engage in many contractual situations, including ag leases, to purchase contracts.  The potential perils of verbal contracts are numerous and can lead to unnecessary litigation. What if a commodity is sold under forward contract and a weather event destroys the crop before it is harvested?  When does the law require a contract to be in writing?  For purchases of goods, do any warranties apply?  What remedies are available upon breach? If a lawsuit needs to be brought to enforce a contract, how soon must it be filed? Is a liability release form necessary?  Is it valid?  What happens when a contract breach occurs?  What is the remedy? 

Ag financing.  Farmers and ranchers are often quite dependent on borrowing money for keeping their operations running.  What are the rules surrounding ag finance?  This is a big issue for lenders also?  What about dealing with an ag cooperative and the issue of liens?  What are the priority rules with respect to the various types of liens that a farmer might have to deal with? 

Ag bankruptcy.  A unique set of rules can apply to farmers that file bankruptcy.  Chapter 12 bankruptcy allows farmers to de-prioritize taxes.  That can be a huge benefit.  Knowing how best to utilize those rules is very beneficial.  That’s especially true with the unsettled issue of whether Payment Protection Program (PPP) funds can be utilized by a farmer in bankruptcy.  The courts are split on that issue.

Income tax.  Tax and tax planning permeate daily life.  Deferral contracts; depreciation; installment sales; like-kind exchanges; credits; losses; income averaging; reporting government payments; etc.  The list could go on and on.  Having a basic understanding of the rules and the opportunities available can add a lot to the bottom line of the farming or ranching operation as well as help minimize the bleeding when times are tough.

Real property.  Of course, land is typically the biggest asset in terms of value for a farming and ranching operation.  But, land ownership brings with it many potential legal issues.  Where is the property line?  How is a dispute over a boundary resolved?  Who is responsible for building and maintaining a fence?  What if there is an easement over part of the farm?  Does an abandoned rail line create an issue?  What if land is bought or sold under an installment contract?  How do the like-kind exchange rules work when farmland is traded? 

Estate planning.  While the federal estate tax is not a concern for most people and the vast majority of farming and ranching operations, when it does apply it’s a major issue that requires planning.  What are the rules governing property passage at death?  Should property be gifted during life?  What happens to property passage at death if there is no will?  How can family conflicts be minimized post-death?  Does the manner in which property is owned matter?  What are the applicable tax rules?  These are all important questions.

Business planning.  One of the biggest issues for many farm and ranch families is how to properly structure the business so that it can be passed on to subsequent generations and remain viable economically.  What’s the best entity choice?  What are the options?  Of course, tax planning is a critical part of the business transition process.

Cooperatives.  Many ag producers are patrons of cooperatives.  That relationship creates unique legal and tax issues.  Of course, the tax law enacted near the end of 2017 modified an existing deduction for patrons of ag cooperatives.  Those rules are very complex.  What are the responsibilities of cooperative board members? 

Civil liabilities.  The legal issues are enormous in this category.  Nuisance law; liability to trespassers and others on the property; rules governing conduct in a multitude of situations; liability for the spread of noxious weeds; liability for an employee’s on-the-job injuries; livestock trespass; and on and on the issues go.  Agritourism is a very big thing for some farmers, but does it increase liability potential?  Nuisance issues are also important in agriculture.  It’s useful to know how the courts handle these various situations.

Criminal liabilities.  This topic is not one that is often thought of, but the implications can be monstrous.  Often, for a farmer or rancher or rural landowner, the possibility of criminal allegations can arise upon (sometimes) inadvertent violation of environmental laws.  Even protecting livestock from predators can give rise to unexpected criminal liability.  Mail fraud can also arise with respect to the participation in federal farm programs.  The areas of life potentially impacted with criminal penalties are worth knowing, as well as knowing how to avoid tripping into them.

Water law.  Of course, water is essential to agricultural production.  Water issues vary across the country, but they tend to focus around being able to have rights to water in the time of shortage and moving the diversion point of water.  Also, water quality issues are important.  In essence, knowing whether a tract of land has a water right associated with it, how to acquire a water right, and the relative strength of that water rights are critical to understand.

Environmental law.  It seems that agricultural and the environment are constantly in the news.  The Clean Water Act, Endangered Species Act and other federal (and state) laws and regulations can have a big impact on a farming or ranching operation.  Just think of the issues with the USDA’s Swampbuster rules that have arisen over the past 30-plus years.  What constitutes a regulatory taking of property that requires the payment of compensation under the Constitution?  It’s good to know where the lines are drawn and how to stay out of (expensive) trouble.

Regulatory law.  Agriculture is a very heavily regulated industry.  Animals and plants, commodities and food products are all subject to a great deal of regulation at both the federal and state level.  Antitrust laws are also important to agriculture because of the highly concentrated markets that farmers buy inputs from and sell commodities into.  Where are the lines drawn?  How can an ag operation best position itself to negotiate the myriad of rules?   

Conclusion

It is always encouraging to me to see students, farmers and ranchers, agribusiness and tax professionals get interested in the subject matter and see the relevance of material to their personal and business lives. Agricultural law and taxation is reality.  It’s not merely academic.  The Principles text is one that can be very helpful to not only those engaged in agriculture, but also for those advising agricultural producers.  It’s also a great reference tool for Extension educators. It’s also a great investment for any farmer – and it’s updated twice annually to keep the reader on top of current developments that impact agriculture.

If you are interested in obtaining a copy, perhaps even as a Christmas gift, you can visit the link here:  http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/principlesofagriculturallaw/index.html.  Instructors that adopt the text for a course are entitled to a free copy.  The book is available in print and CD versions.  Also, for instructors, a complete set of Powerpoint slides is available via separate purchase.  Sample exams and work problems are also available.  You may also contact me directly to obtain a copy.

If you are interested in obtaining a copy, you can visit the link here:  http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/principlesofagriculturallaw/index.html.  You may also contact me directly. 

October 12, 2020 in Bankruptcy, Business Planning, Civil Liabilities, Contracts, Cooperatives, Criminal Liabilities, Environmental Law, Estate Planning, Income Tax, Insurance, Real Property, Regulatory Law, Secured Transactions, Water Law | Permalink | Comments (0)

Saturday, October 3, 2020

Real Estate Concepts Involved In Recent Cases

Overview

Agricultural producers and rural landowners often deal with legal issues involving real estate.  That’s to be expected.  Land is often the major asset of a farming or ranching operation, and it is in the open and the action of third parties is often involved. 

Real estate law has many common, well-established legal principles and concepts.  They are frequently on display in the courts.  Real estate matters of importance to rural landowners – it’s the focus of today’s post.

County Can Exercise Eminent Domain For Purpose of Upgrading Road 

Hickman v. Ringgold County, 941 N.W.2d 38 (Iowa Ct. App. 2019)

Eminent domain is the power of a state or the federal government to take private property for public use while requiring "just" compensation to be given to the original owner.  U.S. Constitution, Fifth Amendment.  In some states, the state legislative body can delegate the power to municipalities, government subdivisions, or even to private persons or corporations for the taking of private property for a “public purpose.”  The exercise of this inherent power of government is a concern to rural landowners, and it came up in a recent Iowa case.

In Hickman, the defendant county served a notice of intent to condemn land the plaintiffs owned. The plaintiffs were informed that part of their land was needed for the construction of a new road for the future location of a new concrete batch plant. The plaintiffs argued the proposed condemnation violated Iowa law because it would be solely for the purpose of facilitating the incidental private use of the concrete batch plant. The trial court disagreed and dismissed the plaintiff’s suit.

On appeal, the plaintiffs again argued that the county’s decision to widen and improve the road was solely for the purpose of facilitating the construction and use of the concrete batch plant.  As a result, the plaintiff claimed that proposed condemnation was illegal under Iowa law because it was solely for the purpose of private economic development.  The appellate court held that the county could not rely on an economic development rationale to support its taking of the plaintiffs’ property because of a prior Iowa Supreme Court opinion in Puntenney v. Iowa Utilitie. Board, 928 N.W.2d 829, 844 (Iowa 2019).   However, the appellate court determined that the county could maintain its eminent domain action if it could show that improving the road served a public purpose. On that point, the appellate court noted that the county was statutorily authorized to upgrade the road. In addition, the county supervisor testified that without the condemnation and improvement of the road, the road would have been a hazard and could not have handled heavy truck traffic. Finally, the appellate court held that the county’s need to upgrade the road was a public purpose that supported its exercise of eminent domain over the plaintiffs’ land. 

Moving Cattle Establishes Boundary by Acquiescence

Brewer v. Plagman, 940 N.W.2d 792 (Iowa Ct. App. 2019)

By assumption, a partition fence is located on the property line. In the event a partition fence is not located on the property line, an erroneously located boundary may become the true boundary after a statutorily specified number of years of acquiescence.  The “doctrine of practical location,” as boundary by acquiescence is known, typically arises where, as a result of a dispute, one party occupies to a fence line and the other party acquiesces in that occupation for the required length of time. Another common scenario that gives rise to application of the doctrine is where adjoining landowners know that a particular fence or line in a field is not the true boundary, but do not know where the true boundary is located. After the statutory period of usage of the adjoining tracts in this manner, the fence or field line can become the legal boundary. Boundaries believed to be in error should be surveyed and, if not correctly located, an objection filed before the statutory time period has elapsed.  A boundary by acquiescence matter was before an Iowa court recently. 

In Brewer, the plaintiffs farmed land that had been in the family for nearly 150 years. Over time, parcels of the property were sold to the defendants. The plaintiffs owned two parcels on the northern and southern ends of the land and the defendants owned parcels in between the plaintiffs’ two parcels and directly adjacent to the west. A fenced corridor connected the plaintiffs’ north and south parcels so the plaintiffs could transport cattle from one property to the other. A boundary dispute arose when the defendants’ obtained a survey revealing the boundary between the farms was in between the fences. The plaintiffs sought to quiet title, alleging a boundary by acquiescence along the western fence line. The plaintiffs argued their family had been moving cattle between the two properties for more than a hundred years before the defendants’ bought their land.

The trial court held that the plaintiffs were able to establish a boundary by acquiescence along the western fence line. On appeal, the defendants argued that the trial court permitted inadmissible hearsay, by allowing the plaintiffs to testify about an oral land agreement a parent made that established the western fence line as the new boundary. The appellate court held that although boundaries are usually proven by reference to deeds, statements made by those in the community can often be the only evidence available concerning land boundaries. Further, the appellate court noted that even if it were to disregard the evidence of the oral land agreement, there was sufficient evidence to find that the plaintiffs had established a boundary by acquiescence. The appellate court held that acquiescence exists when both parties acknowledge and treat the line as the boundary. If the acquiescence persists for ten years (the statutory period of time in Iowa), the line becomes the true boundary even though a survey may show otherwise. The appellate court also noted that the evidence showed that the defendant had acquiesced in the plaintiffs’ use of the lane during the time the defendant owned the land. 

No County Road Without Formal Adoption

Reid v. Donithan, No. 2017-CA-001388-MR, 2019 Ky. App. Unpub. LEXIS 758 (Ky. Ct. App. Oct. 25, 2019)

Counties are responsible for county road maintenance.  Generally speaking, a county must maintain a county road in such a manner that protects public safety.  Issues can arise involving such things as road ditches, tree and brush maintenance, water flowage, abutments, and even fences.  Some road may be designated as low maintenance, and others may become abandoned over time for various reasons.  An abandoned rural road was at issue in a Kentucky case last year.

In Reid v. Donithan, the plaintiffs owned a farm that could only be accessed by a road that crosses defendants’ property. The plaintiffs claimed that the road was a county road and, as such, the defendants were not allowed to erect gates across the road. The plaintiffs further asserted that when they had purchased their farm, there was only one gate on the road and the gate remained open during the day.  The plaintiffs also claimed that the county maintained the road. After the defendants bought the neighboring farm, they added three more gates along the roadway. As a result, the county no longer maintained the road, which led to its deterioration. The defendants claimed that the gates were necessary for the use and protection of their property.

The trial court held that the road was not a county road and that one gate could be placed across the road but could only be locked at night. On appeal, the plaintiffs argued that there was significant evidence that the road at issue was a county road. As proof, the plaintiffs showed that the road was listed as a county road in the county’s own road index and the state Department of Transportation had designated the road as a county road. In addition, the plaintiffs argued that the county had maintained the road in the past until the defendants built three additional gates.

The appellate court found that this evidence was inadequate under state law and held that Kentucky statutory law specified that county roads are only those which have been formally accepted by the fiscal court of the county as a part of the county road system. The appellate court noted the plaintiffs’ evidence failed to show that the road had been formally adopted by the county’s fiscal court as a county road. Thus, the road was treated as an abandoned road for which the county had no maintenance or other responsibility.   

Conclusion

Property law issues abound in agriculture.  Today’s brief article is just a sample of how some of the issues arise and how the courts sort them out.

October 3, 2020 in Real Property | Permalink | Comments (0)

Thursday, September 10, 2020

Ag Law and Tax in the Courtroom

Overview

In today’s post, I take a look at some recent court cases involving agricultural producers and rural landowners.

The next installment of “ag in the courtroom” – it’s the topic of today’s post.

Solar “Farm” Not a Nuisance

Yates v. United States Environmental Protection Agency, No. 6:17-cv-1819-AA, 2019 U.S. Dist. LEXIS 160799 (D. Or. Sept. 20, 2019); Yates v. United States Environmental Protection Agency, No. 6:17-cv-01819-AA, 2020 U.S. Dist. LEXIS 65949 (D. Or. Apr. 14, 2020)

A nuisance is an invasion of an individual's interest in the use and enjoyment of land rather than an interference with the exclusive possession or ownership of the land.  Nuisance law prohibits land uses that unreasonably and substantially interfere with another individual's quiet use and enjoyment of property.  The doctrine is based on two interrelated concepts: (1) landowners have the right to use and enjoy property free of unreasonable interferences by others; and (2) landowners must use property so as not to injure adjacent owners.

The two primary issues at stake in any agricultural nuisance dispute are whether the use alleged to be a nuisance is reasonable for the area and whether the use alleged to be a nuisance substantially interferes with the use and enjoyment of neighboring land.  These concepts played out in a case last year involving the construction of a “solar farm” in Oregon. 

In the Oregon case, the plaintiff owned land zoned as “Exclusive Farm Use.” The plaintiff alleged that construction of a 12-acre collection of solar panels (solar array) built on an adjacent property constituted a nuisance by interfering with her use and enjoyment of her property.  The plaintiff also claimed that the construction during the summer of 2017 caused flooding on her property. The plaintiff’s suit was against the adjacent landowner; a company that held a conditional use permit for the solar array; and the construction company. The plaintiff alleged that all three defendants were responsible for the nuisance and trespass claims. The trial court granted summary judgment to all three defendants, finding that the plaintiff failed to offer any material evidence to establish either her nuisance or trespass claim. The court held that the defendant landowner did not engage in any activity constituting a nuisance or trespass. Landowners are generally not responsible for nuisances occurring after the execution of the lease, unless the landowner knew the activity being carried on would involve an unreasonable risk causing the nuisance or had control over the activities on the land. The trial court also noted that merely because the solar company obtained the permit that ultimately allowed construction to happen did not show they had any control over the construction workers’ actions. As for the actions of the construction company, the trial court held the plaintiff failed to allege evidence of an unreasonable interference with her private use or enjoyment of her land. Although the plaintiff complained of increased traffic and leftover debris, she was unable to establish that she had to adjust any daily habits or the manner in which she enjoyed her property as a result of the construction company’s conduct. The plaintiff alleged that a ditch built between the array and her property caused flooding on her property. However, the trial court noted the plaintiff could not show that the defendant construction company built the ditch or that the ditch directly diverted water onto her property. 

In a later action solely against the county, the trial court granted the county’s motion for summary judgment on the plaintiff’s claims of negligence per se and procedural due process.  The trial court determined that the county did not violate state law (a requirement for a nuisance per se) because state law didn’t require the county to provide actual notice to the plaintiff of its permitting decision, but merely an opportunity to appeal.  The appellate court also determined that the setback requirement of state law was complied with and that the waster runoff or flooding allegedly caused by the ditch did not constitute a trespass by water. 

Recreational Use Statute Provides Landowner Protection

Nolan v. Fishman, 218 A.3d 1034 (Vt. 2019)

Many states have what is known as a recreational use statute.  Under such a statute, an owner or occupier owes no duty of care to keep the premises safe for entry or use by others for recreational purposes, or to give any warning of dangerous conditions, uses, structures, or activities to persons entering the premises for such recreational purposes. Similarly, if an owner, directly or indirectly, invites or permits any person without charge to use the property for recreational purposes, the owner does not extend any assurance the premises are safe for any purpose, confer the status of licensee or invitee on the person using the property, or assume responsibility or incur liability for any injury to persons or property caused by any act or omission of persons who are on the property.  But, if injury to recreational users is caused by the willful or malicious failure to guard or warn against a dangerous condition, use, structure, or activity, the protection of the statute is lost. Likewise, if the owner imposes a charge on the user of the property, the liability protection is lost under many state provisions.  In a 2019 case, the Vermont recreational use statute was at issue.

The facts of the Vermont case revealed that the plaintiff is the administrator of the estate of a three-year-old who drowned in a brook on the defendants’ property. The defendants are the parents of the owners of the daycare facility where the decedent had been attending when the accident occurred. The defendants’ land was connected to the daycare property, and the daycare would regularly use a small area of the defendants’ land to access a brook beach and used the defendants’ land for various outdoor activities. The defendants did not profit from the daycare and were not involved in any of the daycare’s business activities. The defendant’s land was not posted, and they had always held it open to the public for recreational use.

The plaintiff sued the defendants alleging their negligence was the direct and proximate cause of the incident. The state recreational use law encourages owners to make their land and water available to the public for no consideration for recreational uses without increasing liability potential for the owner. Under the statute, a recreational user is treated as an adult trespasser, meaning that the landowner must only avoid willfully or wantonly injuring a recreational entrant. 

The trial court found that the activities engaged in by the daycare on defendants’ land were both recreational and educational, therefore qualifying as a recreational use. However, the trial court dismissed the defendant’s motion for summary judgment because questions remained as to whether the defendants’ property was open and undeveloped land that qualified for protection under the statute. On appeal, the appellate court reversed the trial court and held that the statute applied. The appellate court held that the daycare’s use of the defendants’ property was without consideration, qualified as a recreational use, and  that the land was open and undeveloped - the general public was freely permitted to use defendants’ land, along with the daycare. Although the defendants had placed a sandbox and brook bridge on their land, the appellate court noted that the legislature had expressly stated that the presence of such objects on land would not, by itself, preclude land from being open and undeveloped. Therefore, the defendants were covered under the recreational use statute.

Tract Properly Zoned as “Residential.” 

Miller v. Scott County Board of Review, No. 19-1038, 2020 Iowa App. LEXIS 436 (Iowa Ct. App. Apr. 29, 2020)

The rural-urban fringe provides its own unique set of legal issues.  One of those, is an attempt by landowners who aren’t really farmers to qualify their small tracts as “agriculture” for purposes of achieving a lower property tax assessment.  The issue came up recently in an Iowa case.

The plaintiff, a computer services consultant, bought a 10.2-acre tract in 2008. It consisted of approximately two acres of a home and improvements; five acres of deep mud/bog; and 3.6 acres of cropland. The cropland is in a 100-year floodplain. From 2009-2011 the plaintiff grew hay on the cropland, and in 2012 and 2013 he grew corn on it. No crops were grown in 2014 due to weather, and in 2015 he grew corn and pumpkins. He challenged his 2015 property tax assessment and the 2017 assessment as inequitable and on the basis that it misclassified the property as “residential” rather than “agricultural.”

The county zoning board denied his petition and he appealed to the local trial court. At a trial court hearing the county’s assessor noted that the property had multiple uses, but that the plaintiff’s farming operation was “a secondary use.” The county did adjust the valuation downward by 16 percent and granted a “slough bill” exemption for the 2017 tax year. However, the trial court upheld the county’s designation of the property as “residential” on the basis that the plaintiff was a hobby farmer. As such, the trial court determined that the plaintiff’s property taxes should be based on a valuation amount $100,000 greater than the plaintiff desired.

On appeal, the appellate court affirmed, noting that the burden was on the plaintiff to establish the predominant agricultural use of the property. The court agreed with the trial court’s findings that the ag use of the property had never been profitable, and that if it were sold it would be marketed as a residential property rather than a farm property. Indeed, the plaintiff purchased the property as a residential property, and it is surrounded by residential housing. In addition, the largest valued asset on the property is the residence. The plaintiff also testified that he benefited from tax savings as a result of the cropping activities on his tract. He also testified to spending $90,000 for ag equipment and $55,000 to construct a barn but had farm income never exceeding $1,200 annually. That’s a classic “hobby farm” activity.

Conclusion

The legal issues involving rural landowners keep rolling in.  It’s always best to have a well-trained ag lawyer at the ready when needed. 

September 10, 2020 in Civil Liabilities, Real Property | Permalink | Comments (0)

Monday, August 24, 2020

Court Developments in Agricultural Law and Taxation

Overview

The cases and rulings involving agriculture keep on coming.  In today’s post, I pick out just a few involving some rather common issues.

Ag law in the courts – it’s the topic of today’s post.

Railroad Responsible For Faulty Railroad Fence 

Leslie v. BNSF Railway. Co., No. Civ. 1:16-cv-1208-JCH-JHR, 2019 U.S. Dist. LEXIS 154460 (D. N.M. Sept. 10, 2019)

Railroads are responsible for building and maintaining railroad fences.  But, the nuances of each state’s fence law involving railroads can cause some interesting arguments.  In a New Mexico case last year, the court was faced with addressing a previously unanswered application of the state fence law as applied to a railroad.   

The plaintiffs collided with a cow on a public highway.  The defendant was responsible for building and maintaining the adjacent fence along a ranch that it had a right-of-way through. The plaintiffs alleged that the railroad company negligently maintained the fence, which allowed a cow to escape onto the highway. The defendant claimed that it did not own the cow that escaped, and that the plaintiff’s theory for recovery hinged on the defendant first being found liable in an action against the owner of the livestock. The defendant removed the action from New Mexico state court to federal court and sought a judgment with respect to both of the plaintiffs’ negligence claims.

 The court interpreted the New Mexico legislature’s intent of whether the plaintiffs were a protected class under the state’s fence law and determined that the plaintiff failed to establish a negligence per se claim requiring railroads to build fence lines. The purpose of the railroad fencing portion of the fence law, the court determined, was to protect owners of livestock rather than the motoring public.  The plaintiffs’ second claim was that the defendant was per se negligent by permitting the cow to wander upon the road. The statute at issue stated that it was unlawful for “any person” to “negligently permit” livestock to wander upon any unfenced highway. The defendant argued that the term “permit” required that the negligence of the owner of the livestock must be established before liability would attach. Although the court determined that the phrase “any person” had not been construed to mean persons other than owners of livestock, it concluded that the New Mexico legislature had limited the application of similar statutes and failed to do so in this instance. According to the court, the failure to limit the statute by the state legislature meant the statute was intended to be interpreted broadly in order to protect a broader class of people.  The court held that the plaintiffs had established themselves as members of the class sought to be protected by the fence law and that the defendant had permitted the cow to wander on the road. Upon further consideration, the plaintiff must establish whether the defendant had negligently permitted the cow to wander upon the road.

Paying Principal Amount Within Redemption Period is Insufficient to Redeem Property

Sibley State Bank v. Zylstra, No. 19-0126, 2020 Iowa App. LEXIS 830 (Iowa Ct. App. Aug. 19, 2020)

When farmland is foreclosed upon, the owner is given a period of time to redeem the property by paying the price the property brought at the foreclosure sale plus costs.  But details matter.  In this case, the plaintiff purchased one of two parcels of land at a foreclosure action and another business purchased the other parcel. Under state (Iowa) law, the buyers took the property subject to the prior owner’s one-year right of redemption from the date of the sale. The prior owner assigned its redemption rights to the defendant 364 days after the foreclosure sale. The next day (the final day of the redemption period) the defendant tendered a check to the county court clerk for the principal amount of the two foreclosure bids and received a receipt from the clerk showing a “balance due” of zero.

Two days later, the plaintiff applied for a hearing on the redemption issue to refund the defendant’s check and sought a finding that no redemption had occurred because the amount tendered by the defendant did not include interest and fees. The defendant claimed that the court clerk would not tell him the exact amount that was necessary to redeem both properties upon his asking. The defendant further claimed that the clerk withheld the amount from him, and that he had acted in good faith in trying to redeem the properties by paying the full principal amount (well over $1 million). The trial court found that the defendant failed to inquire with either the bank or the bank’s attorney what the amount due for redemption would be. Additionally, the trial court held that the county clerk had no duty to the defendant to determine the redemption amount. On appeal, the defendant claimed that the trial court erred in not granting him equitable relief, and that he paid a sufficient amount to redeem at least one of the properties. The appellate court affirmed, holding that the mistake in calculating the payoff amount was the defendant’s sole fault. Further, the appellate court noted the defendant could have taken advantage of a safe harbor provision, as the redemption period was about to expire, but failed to do so. As for the defendant’s claim of partial redemption for having tendered an amount exceeding the redemption price of either property, the appellate court held that in order to redeem one tract required the defendant to specify which parcel was being redeemed. The appellate court held that an insufficient payment for redemption of two properties alone cannot result in an after-the-fact redemption of one of the properties.

A Prescriptive Easement May Be Created Over a Ditch or Waterway

Five Forks Hunting Club, LLC v. Nixon Family Partnership, No. CV-18-301, 2019 Ark. App. LEXIS 397 (Ark. Ct. App. Sept. 11, 2019)

Easement issues are frequently encountered with respect to agricultural properties.  But, is an access easement restricted to land, or can it apply to water access?  That was the issue involved in this case.

Here, the parties owned adjoining tracts that they used for duck hunting.  The plaintiff sought a declaratory judgment against the defendant, claiming that the plaintiff had the right to control the use of a ditch that the defendant had been using to gain access to the plaintiff’s land. The plaintiff had built a bridge to block the defendant’s path to their property, and in years past had obstructed the defendant’s path on separate occasions. The plaintiff claimed that the defendant merely had permissive use of the ditch, but the defendant sought a prescriptive easement over the ditch and a road that ran parallel to the ditch. The defendant would use the road to gain access to the land during dry periods and travel by boat in the ditch during times where the road was underwater. The trial court held that the defendant was able to establish an easement by prescription over the ditch by establishing that a preponderance of the evidence showed that the use of the ditch was adverse to the plaintiff and under a claim of right for the seven-year statutory period. On appeal, the appellate court noted that under Arkansas law, any vehicle needed for the operation of the easement could be driven across the servient estate. A boat could be used to access the easement therefore a prescriptive easement could be created over a ditch or waterway. The plaintiff also argued on appeal that the defendant failed to prove the necessary elements of a prescriptive easement. The plaintiff argued that the use of the ditch was not continuous or uninterrupted for the required statutory period because the ditch was not always flooded. The appellate court, however, held that mere temporary absences of a claimant do not interrupt the “continuous” requirement for a prescriptive easement. Also, the plaintiff’s attempts to obstruct the defendant’s use of the ditch occurred after the defendant had met the statutory requirement for establishing a prescriptive easement. Finally, the appellate court noted that the trial court’s decision to not limit the prescriptive easement for the ditch to a shorter route was not in error as it created no additional burden to the plaintiff landowner.

Lack of Proof for Ag Sales Tax Exemption 

Arkansas Dept. of Rev. Legal Counsel Op. No. 20200527 (Jul. 21, 2020)

In many states, personal property used in farming is exempt from sales tax.  That is the case, for example, in Arkansas.  But, it is important to be able to certify that the buyer is engaged in the trade or business of farming and that the item(s) purchased will be used in farming.  Under many state provisions, to be exempt the item(s) purchased must be used directly in farm production activities.  Indirect uses, such as an all-terrain vehicle used to spray weeds on the farm, don’t qualify.

Under the Arkansas procedure, a farmer provides a “Farm Exemption Certificate” to a seller so that the seller knows whether the sale of an item is exempt from sales tax because the buyer was engaged in farming and the item purchased would be used directly and exclusively in farming.  Here, the question was whether livestock shade systems and mower covers qualified for the exemption.  Based on the facts presented, it was determined that the taxpayer (seller) did not provide sufficient facts concerning any specific sale or transaction for a determination of exemption to be made.  However, the seller could rely on the buyer’s Certificate and could accept a certification or other information from the buyer to establish that the sale was exempt.  Alternatively, the taxpayer could accept a certification or other information that the buyer provided to establish that the sale was exempt.  Such, other information could include the buyer certifying in writing on a copy of the invoice or sales ticket that the taxpayer would retain stating that the buyer was a farmer and that the items would be used exclusively and directly in farming as a business. 

More Problems with Donated Permanent Conservation Easements

Belair Woods, LLC v. Comr., T.C. Memo. 2020-112 ; Cottonwood Place, LLC, et al. v. Comr., T.C. Memo. 2020-115

The Tax Court continues to render decisions involving claimed charitable deductions for the donation of “permanent” conservation easements.  At the National Farm Income Tax/Estate and Business Planning Conference last month in Deadwood, SD, U.S. Tax Court Judge Elizabeth Paris stated that many cases remain in the Tax Court’s pipeline yet to decide.  That vast majority of the decision so far have been decided in favor of the IRS.  Don’t expect that trend to change. 

I.R.C. §170(h)(5)(A) requires that an easement donated to a qualified organization to be “protected in perpetuity.”  Treas. Reg. §1.170A-14(g)(6) requires that the easement grant must, upon extinguishment, result in the charity receiving a proportionate part of the proceeds when the property subject to the easement is sold.  In Belair Woods, however, the deed language did not provide the charity with a proportionate part of the gross sales proceeds.  Instead, it specified that the charity would receive the extinguishment proceeds reduced by any increase in value related to improvements that the donor had placed on the property.  The deed language also required a reduction in the proceeds going to the charity by an amount paid to satisfy any and all prior claims regardless of whether a claim arose from the donor’s conduct. 

The Tax Court strictly construed the regulation and denied a charitable deduction for the donation because the grantee was not in all cases absolutely entitled to a proportionate share of the proceeds upon extinguishment sale of the property.  As such, the contribution was not protected in perpetuity.  The Tax Court noted that the improvements were part of the donation rather than the donation being restricted just to the underlying land.  The rights to construct improvements were restricted in meaningful ways by the easement, and also enhanced the property’s value.   The petitioner also claimed that the IRS had accepted deed terms comparable to the petitioner’s deed via a stipulation in a case involving a different petitioner and, as such, should be estopped from disallowing the petitioner’s deduction.  The Tax Court determined that the petitioner had failed to satisfy its burden in establishing that judicial estoppel should apply because the IRS position in the other case was merely a tactical stipulation and the case was settled. 

In Cottonwood Place, LLC, the petitioner donated a conservation easement on land to a land trust (qualified charity), reserving the right to construct limited improvements in the area subject to the easement.  The Tax Court determined that no charitable deduction was allowed because the deed language didn’t entitle the charity to a proportionate share of any easement extinguishment proceeds if a court were to extinguish the easement and order the property sold.  Thus, the language violated Treas. Reg. §1.170A-14(g)(6).  The Tax Court noted that the deed language specified that the charity’s share of such proceeds would be reduced by the value of improvements added to the property after the easement donation.  The Tax Court rejected the petitioner’s substantial compliance argument. 

Conclusion

As you can see, issues involving agricultural land and agricultural producers are prevalent.  Good legal and tax counsel is a must.  That’s what we are training at Washburn Law School in the Rural Law Program.  This week we welcome new students to the program from state across the country!

August 24, 2020 in Civil Liabilities, Income Tax, Real Property | Permalink | Comments (0)

Saturday, June 20, 2020

Are Dinosaur Fossils Minerals?

Overview

In the mid-1950s, my Father was having the first of several ponds dug on farm property in northeastern Indiana that he and my Mother had purchased a few years earlier.  During the excavation Mastodon bones (fossils) were unearthed in the muck and grey/blue clay, including a nearly full set of teeth and jaw bones.  Mastodon bones were also unearthed on nearby farms and when a local branch campus of Purdue and Indiana Universities opened in the fall of 1964 it was given the nickname “Mastodons.” 

An issue that I am certain never crossed my Father’s mind, likely because my parents owned both the surface and subsurface estates of the farm, was whether the fossils were “minerals” that would belong to the owner of the mineral estate.  But, the legal classification of fossils is a very important issue when the fossils are valuable. 

Are fossils “minerals” that are owned by the owner of the mineral estate?  It’s the topic of today’s post.

Surface Estate and Mineral Estate

A fee simple owner of real estate can maintain possession and control of the surface of the property and sell/convey the rights to the “minerals” (such as oil and gas).  Upon such a conveyance, the owner of the mineral rights (known as the mineral estate owner) can economically benefit from the extraction of the minerals.  Depending on the mineral deed that conveys the minerals, the deed language may include all minerals known and unknown or the definition of “minerals” may be limited to specific ones. 

Definition of “Minerals”

A common granting clause in a mineral deed specifies that the grantor either conveys or reserves “the oil, gas and other minerals.”  That language can raise an issue concerning what “other minerals” means.  Does it include such things as gravel, clay granite, sandstone, limestone, coal, carbon dioxide, hot water and steam?  The courts have struggled with this issue and have reached differing conclusions.  Does the phrase mean anything that is in the soil that the surface estate owner doesn’t use for agricultural purposes?  Does is matter how the substance is extracted?  Does it matter if the material is located in the subsoil rather than the topsoil?  Is it material if the substance can be extracted without significant damage to the surface estate? 

In 1949, the Texas Supreme Court issued a significant opinion on the issue of whether the term “minerals” includes substances other than oil and gas.  Heinatz v. Allen, 217 S.W.2d 994 (Tex. 1949).  The court utilized the “common meaning” rule under which all substances ordinarily thought of as minerals at the time the deed was executed are deemed to be minerals conveyed by the deed regardless of whether the parties knew the substances existed.  That would seem to include in the definition of minerals such substances as gold, silver, coal, iron ore, etc..  Substances such as sand, gravel, water, etc. that are ordinarily associated with ownership of the surface estate would not be included in the definition of minerals.  But the test is not a perfect, all-inclusive one and other factors can be relevant – such as exceptional value; surface destruction; and commercial and/or industrial meaning.  In addition, state law may have a specific definition that applies in a particular situation.

What Are Fossils?

The issue of whether dinosaur fossils are “minerals” for the purposes of a mineral reservation clause in a mineral deed was an issue in a recent Montana case.  In Murray v. BEJ Minerals, LLC, No. OP 19-0304, 2020 Mont. LEXIS 1472 (Mont. Sup. Ct. May 20, 2020), the court dealt with the issue in a case with millions of dollars on the line.  Under the facts of the case, the plaintiffs (a married couple), leased farm and ranch land beginning in 1983.  Over a period of years, the owner of the land transferred portions of his interest in the property to his two sons and sold the balance to the plaintiffs.  From 1991 to 2005, the plaintiffs and the sons operated the property as a partnership.  In 2005, the sons severed the surface estate from the mineral estate and sold their remaining interests in the surface estate to the plaintiffs.  A mineral deed was to be executed at closing that apportioned one-third of the mineral rights to each son and one-third to the plaintiffs.  After the transactions were completed, the plaintiffs owned all of the surface estate of the 27,000-acre property and one-third of the mineral (subsurface) estate.  At the time, none of the parties suspected there were valuable dinosaur fossils on the property, and none of them gave any thought to whether dinosaur fossils were part of the mineral estate as defined in the mineral deed.  Likewise, none of the parties expressed any intent about who might own dinosaur fossils that might be found on the property. 

Specifically, the mineral deed stated that the parties would own, as tenants in common, “all right, title and interest in and to all of the oil, gas, hydrocarbons, and minerals in, on and under, and that may be produced from the [Ranch].”  The purchase agreement required the parties “to inform all of the other parties of any material event which may [affect] the mineral interests and [to] share all communications and contracts with all other Parties.” 

In 2006, the plaintiffs gave permission to a trio of fossil hunters to search (and later dig) for fossils on the property.  The hunters ultimately uncovered dinosaur fossils of great value including a nearly intact Tyrannosaurus rex skeleton and two separate dinosaurs that died locked in battle.  The fossils turned out to be extremely rare and quite valuable, with the “Dueling Dinosaurs” valued at between $7 million and $9 million.  In 2014, the plaintiffs sold the Tyrannosaurus rex skeleton to a Dutch museum for several million dollars.  A Triceratops foot was sold for $20,000 and a Triceratops skull was offered for sale for over $200,000.  The proceeds of sale were placed in an escrow account pending the outcome of a lawsuit that the sons filed.  The sons (the defendants in the present action) sued claiming that the fossils were “minerals” and that they were entitled to a portion of any sale proceeds.  The plaintiffs brought a declaratory judgment action in state court claiming that the fossils were theirs as owners of the surface estate.  The defendants removed the action to federal court and asserted a counterclaim on the basis that the fossils should be included in the mineral estate.  The trial court granted summary judgment for the plaintiffs on the basis that, under Montana law, fossils are not included in the ordinary and natural meaning of “mineral” and are thus not part of the mineral estate.  Murray v. Billings Garfield Land Co., 187 F. Supp. 3d 1203 (D. Mont. 2016)

On appeal, the appellate court reversed.  Murray v. BEJ Minerals, LLC, 908 F.3d 437 (9th Cir. 2018).  The appellate court determined that the term “fossil” fit within the dictionary definition of “mineral.” Specifically, the appellate court noted that Black’s Law Dictionary defined “mineral” in terms of the “use” of a substance, but that defining “mineral” in that fashion did not exclude fossils.  The appellate court also noted that an earlier version of Black’s Law Dictionary defined “mineral” as including “all fossil bodies or matters dug out of mines or quarries, whence anything may be dug, such as beds of stone which may be quarried.”  Thus, the appellate court disagreed with the trial court that the deed did not encompass dinosaur fossils.  Turning to state court interpretations of the term “mineral”, the appellate court noted that the Montana Supreme Court had held certain substances other than oil and gas can be minerals if they are rare and exceptional.  Thus, the appellate court determined that to be a mineral under Montana law, the substance would have to meet the scientific definition of a “mineral” and be rare and exceptional.  The appellate court held that those standards had been met.  The plaintiffs sought a rehearing by the full Ninth Circuit and their request was granted.  Murray v. BEJ Minerals, LLC, 920 F.3d 583 (9th Cir. 2019).  The appellate court then determined that the issue was one of first impression under Montana law and certified the question of whether dinosaur fossils constitute “minerals” for the purpose of a mineral reservation under Montana law to the Montana Supreme Court.  Murray v. BEJ Minerals, 924 F.3d 1070 (9th Cir. 2019)

The Montana Supreme Court answered the certified question in the negative – dinosaur fossils are not “minerals” for the purpose of the mineral reservation at issue because they were not included in the expression, “oil, gas and hydrocarbons,” and could not be implied in the deed’s general grant of all other minerals.  “Fossils” and “minerals” were mutually exclusive terms as the parties used those terms in the mineral deed.   Murray v. BEJ Minerals, LLC, No. OP 19-0304, 2020 Mont. LEXIS 1472 (Mont. Sup. Ct. May 20, 2020). 

In making its determination, the Montana Supreme Court reasoned that whether a substance or material is a “mineral” is based on whether it is rare and valuable for its mineral properties, whether the conveying instrument expressed an intent to use the scientific definition of the term, and the relation of the substance or material to the land’s surface and the method and effect of its removal. The Court also noted that deeds are like contracts and should be interpreted in accordance with their plain and ordinary meaning to give effect to the parties’ mutual intent at the time of execution. 

The Court noted that the term “minerals” is defined in various areas of Montana statutory law (including tax provisions) and none include “fossils,” and that the only statutory provision mentioning fossils and minerals in the same statute referred to them separately.  The Court also noted that the U.S. Department of Interior (for purposes of federal law) had made an administrative decision in 1915 that dinosaur fossils are not “minerals.”  As such, the terms were mutually exclusive as used in the mineral deed between the parties, and the plaintiffs maintained ownership of any interests that the two sons had not specifically reserved in the mineral deed.  The deed simply did not contemplate including “fossils” under the mineral reservation clause.  Instead, the Court concluded that “minerals” under Montana law are a resource that is mined as a raw material for further processing, refinement and eventual economic exploitation.  Fossils are not mined, they are excavated, and they are not rare and valuable due to their mineral properties.  Therefore, unless specifically mentioned in the mineral deed, language identifying “minerals” would not “ordinarily and naturally” include fossils.

Based on the Montana Supreme Court’s answer to the certified question, the U.S. Court of Appeals for the Ninth Circuit affirmed the federal district court’s order granting summary judgment to the plaintiffs and declaring them the sole owners of the dinosaur fossils.  Murray v. BEJ Minerals, LLC, No. 16-35506, 2020 U.S. App. LEXIS 19064 (9th Cir. Jun. 17, 2020).

Conclusion

While it’s not possible to anticipate what might be found on or under a tract of land, drafters of mineral deeds must carefully consider the potential impact of drafting language.  This issue can be of primary importance, as the Montana case illustrates.  Also, while it didn’t apply to the Montana case, the Montana Governor signed H.B. 229 into law on April 16, 2019.  That legislation specifies that dinosaur fossils are not minerals and that fossils belong to the holder of the surface estate.  

If only that Mastodon unearthed in the 1950s had been a Tyrannosaurus rex….

June 20, 2020 in Real Property | Permalink | Comments (0)

Wednesday, May 27, 2020

Ag Law and Tax Developments

Overview

During the last couple of months while various state governors have issued edicts randomly declaring some businesses essential and other non-essential, the ag industry has continued unabated.  The same is true for the courts – the ag-related cases and tax developments keep on coming in addition to all of the virus-related developments.

As I periodically do, I provide updates of ag law and tax issues of importance to agricultural producers and others in the ag industry, as well as rural landowners in general.

That the topic of today’s post – a few recent developments in ag law and taxation.

FSA Not Entitled To Set-Off Subsidy Payments 

In Re Roberts, No. 18-11927-t12, 2020 Bankr. LEXIS 1338 (Bankr. D. N.M. May 19, 2020)

Bankruptcy issues are big in agriculture at the present time.  Several recent blog articles have touched on some of those issues, including bankruptcy tax issues.  This case dealt with the ability of a creditor to offset a debt owed to it by the debtor with payments it owed to the debtor.  The debtors (husband and wife) borrowed $300,000 from the Farm Service Agency (FSA) in late 2010. The debtors enrolled in the Price Loss Coverage program and the Market Facilitation Program administered by the FSA. The debtors filed Chapter 11 bankruptcy in mid-2018 and converted it to a Chapter 12 bankruptcy in late 2019. The debtors defaulted on the FSA loan after converting their case to Chapter 12.

The debtors were entitled to receive approximately $40,000 of total MFP and PLC payments post-petition. The FSA sought a set-off of the pre-petition debt with the post-petition subsidy payments. The court refused to the set-off under 11 U.S.C. §553 noting that the offsetting obligations did not both arise prepetition and were not mutual as required by 11 U.S.C. §553(a). There was no question, the court opined, that the FSA’s obligation to pay subsidy payments arose post-petition and that the debtors’ obligation to FSA arose pre-petition. Thus, set-off was not permissible.

HSA Inflation-Adjusted Amounts for 2021

Rev. Proc. 2020-32, 2020-24 I.R.B.

Persons that are covered under a high deductible health plan (HDHP) that are not covered under any other plan that is not an HDHP, are eligible to make contributions to a health savings account (HSA) subject to certain limits. For calendar year 2021, an HDHP is a health plan with an annual deductible of at least $1,400 for individual coverage or $2,800 for family coverage, and maximum out-of-pocket expenses of $7,000 for individual coverage or $14,000 for family coverage. For 2021, the maximum annual contribution to an HSA is $3,600 for self-only coverage and $7,200 for family coverage. 

Charitable Deduction Allowed for Donated Conservation Easement 

Champions Retreat Golf Founders, LLC v. Comr., No. 18-14817, 2020 U.S. App. LEXIS 15237 (11th Cir. May 13, 2020), rev’g., T.C. Memo. 2018-146

 The vast majority of the permanent conservation easement cases are losers for the taxpayer.  This one was such a taxpayer loser at the Tax Court level, but not at the appellate level.  Under the facts of the case, the petitioner claimed a $10.4 million charitable deduction related to the donation of a permanent conservation easement on a golf course. The IRS denied the deduction on the basis that the easement was not exclusively for conservation purposes because it didn’t protect a relatively natural habitat of fish, wildlife, or plants, or a similar ecosystem as required by I.R.C. §170(h)(4)(A)(ii). The IRS also asserted that the donation did not preserve open space for the scenic enjoyment of the general public or in accordance with a governmental conservation policy for the public’s benefit under I.R.C. §170(h)(4)(A)(iii). The Tax Court agreed with the IRS and denied the deduction. The Tax Court determined that the “natural habitat” requirement was not met – there was only one rare, endangered or threatened species with a habitat of only 7.5 percent of the easement area. In addition, the Tax Court noted that part of the golf course was designed to drain into this habitat area which would introduce chemicals into it. Thus, the easement’s preservation of open space was not for public enjoyment nor in accordance with a governmental policy of conservation.

On further review, the appellate court reversed. The appellate court found that the deduction was proper if the donation was made for the protection of a relatively natural habitat of fish, wildlife, or plants, or similar ecosystem or was made for the preservation of open space for the scenic enjoyment of the general public. The appellate court noted that without the golf course, the easement would satisfy the requirements and an easement deduction is not denied simply because a golf course is included. The appellate court remanded the case for a determination of the proper amount of the deduction. 

Residence Built on Farm Was “Farm Residence” For Zoning Purposes

Hochstein v. Cedar County. Board. of Adjustment, 305 Neb. 321, 940 N.W.2d 251 (2020)

Many cases involve the issue of what is “agricultural” for purposes of state or county zoning and related property tax issues.  In this case, Nebraska law provided for the creation of an “ag intensive district.” In such designated areas, any “non-farm” residence cannot be constructed closer than one mile from a livestock facility. The plaintiff operated a 4,500-head livestock feedlot (livestock feeding operation (LFO)) and an adjoining landowner operates a farm on their adjacent property. The adjoining landowner applied to the defendant for a zoning permit to construct a new house on their property that was slightly over one-half mile from the plaintiff’s LFO. The defendant (the county board of adjustment) approved the permit and the plaintiff challenged the issuance of the permit on the basis that the adjoining landowner was constructing a “non-farm” residence. The defendant affirmed the permit’s issuance on the basis that the residence was to be constructed on a farm. The plaintiff appealed and the trial court affirmed. On further review, the appellate court affirmed. On still further review by the state Supreme Court, the appellate court’s opinion was affirmed. The Supreme Court noted that the applicable regulations did not define the terms “non-farm residence” or “farm residence.” As such, the defendant had discretion to reasonably interpret the term “farm residence” as including a residence constructed on a farm.

Ag Cooperative Fails To Secure Warehouse Lien; Loses on Conversion Claim. 

MidwestOne Bank v. Heartland Co-Op, 941 N.W.2d 876 (Iowa 2020)

I dealt with the issue in this case in my blog article of March 27.  You may read it here:  https://lawprofessors.typepad.com/agriculturallaw/2020/03/conflicting-interests-in-stored-grain.html  In the article, I detail many of the matters that arose in this case. 

The facts of the case revealed that a grain farmer routinely delivered and sold grain to the defendant, an operator of a grain warehouse and handling facility. The contract between the parties contemplated the sale, drying and storage of the grain. The farmer also borrowed money from the plaintiff to finance the farming operation and granted the plaintiff a security interest in the farmer’s grain and sale proceeds. The plaintiff filed a financing statement with the Secretary of State’s office on Feb. 29, 2012 which described the secured collateral as “all farm products” and the “proceeds of any of the property [or] goods.” The financing statement was amended in late 2016 and continued. The underlying security agreement required the farmer to inform the plaintiff as to the location of the collateral and barred the farmer from removing it from its location without the plaintiff’s consent unless done so in the ordinary course of business. It also barred the farmer from subjecting the collateral to any lien without the plaintiff’s prior written consent. However, the security agreement also required the farmer to maintain the collateral in good condition at all time and did not require the plaintiff’s prior written consent to do so.

The plaintiff complied with the 1985 farm products rule and the farmer gave the plaintiff a schedule of buyers of the grain which identified the defendant. From 2014 through 2017, the farmer sold grain to the defendant, and the defendant remitted the net proceeds of sale via joint check to the farmer and the plaintiff after deducting the defendant’s costs for drying and storage – a longstanding industry practice. The plaintiff, an ag lender in an ag state, claimed that it had no knowledge of such deductions until 2017 whereupon the plaintiff sued for conversion. The defendant did not properly perfect a warehouse lien and the lien claim was rejected by the trial court, but asserted priority on a theory of unjust enrichment. The trial court rejected the unjust enrichment claim.

The state Supreme Court agreed, refusing to apply unjust enrichment principles in the context of Article 9 of the Uniform Commercial Code (UCC). The court did so without any mention of UCC §1-103 (b) which states that, "Unless displaced by the particular provisions of the Uniform Commercial Code, the principles of law and equity” including the law merchant [undefined] and the law relative to capacity to contract; duress; coercion; mistake; principal and agency relationships; estoppel, fraud and misrepresentation; bankruptcy, and other validating or invalidating cause [undefined] supplement its provisions.” This section has been characterized as the "most important single provision in the Code." 1 J. White & R. Summers, Uniform Commercial Code § 5. “As such, the UCC was enacted to displace prior legal principles, not prior equitable principles.” However, the Supreme Court completely ignored this “most important single provision in the Code.” The Court also ignored longstanding industry practice and believed an established ag lender in an ag state that it didn’t know the warehouse was deducting its drying and storage costs before issuing the joint check. 

Conclusion

The developments keep rolling in.  More will be covered in future articles.

May 27, 2020 in Bankruptcy, Income Tax, Real Property, Secured Transactions | Permalink | Comments (0)

Monday, May 25, 2020

Conservation Easements – The Perpetuity Requirement and Extinguishment

Overview

A taxpayer that donates a “qualified real property interest” to a “qualified organization” can receive a charitable contribution deduction upon satisfying numerous technical requirements.  A primary requirement is that the easement donation be exclusively for conservation purposes.  That requirement, however, can only be satisfied if the conservation purposes are protected in perpetuity.  I.R.C. §§170(h)(2)(C); (h)(5)(A).  Essentially, that means that legally enforceable restrictions must be in place that will bar the use of the portion of the property that the taxpayer retains from being used in a manner that is inconsistent with the conservation purposes of the donated easement.

But, can anything here on earth really last forever?  What if the easement is extinguished by court action?  There’s a rule for that contingency and it requires careful drafting of the easement deed.  Numerous court opinions have dealt with the issue, including a couple in recent weeks.

Dealing with potential extinguishment of a perpetual conservation easement donation – it’s the topic of today’s post.

The Issue of Extinguishment – Treasury Regulation

While the law generally disfavors perpetual control of interests in land, for a taxpayer to claim a tax deduction for a donated conservation easement, the easement must be granted in perpetuity.  But if the conditions surrounding the property subject to a perpetual conservation easement make impossible or impractical the continued use of the property for conservation purposes, a Treasury Regulation details the requirements to be satisfied to protect the perpetual nature of the easement if a judicial proceeding extinguishes the easement restrictions.  Treas. Reg. §1.170A-14(g)(6)(i)-(ii). 

The regulation requires that, at the time of the donation, the donor must agree that the donation gives rise to a property right that is immediately vested in the donee.  Treas. Reg. §1.170A-14(g)(6)(ii).  The value of the gift must be the fair market value of the easement restriction that is at least equal to the proportionate value that the easement restriction, at the time of the donation, bears to the entire property value at that time. See Treas. Reg. §1.170A-14(h)(3)(iii) relating to the allocation of basis.  The proportionate value of the donee’s property rights must remain constant such that if the conservation restriction is extinguished and the property is sold, exchanged or involuntarily converted, the done is entitled to a portion of the proceeds that is at least equal to that proportionate value of the restriction.  The only exception is if state law overrides the terms of the conservation restriction and specifies that the donor is entitled to the full proceeds from the conversion restriction.  Treas. Reg. §1.170A-14(g)(6)(ii). 

Extinguishment – Cases

The formula language necessary to comply with the regulation must be precisely drafted.  The IRS has aggressively audited perpetual easement restrictive agreements for compliance.  Consider the following:

  • In Carroll, et al. v. Comr., 146 T.C. 196 (2016), the petitioner contributed a conservation easement on a tract of land to two qualified organizations. The easement provided that if the conservation purpose was extinguished because of changed circumstances surrounding the donated property, the donees were entitled to a proportionate share of extinguishment proceeds not to be less than the amount allowed as a deduction to the donor for federal income tax purposes over the fair market value of the property at the time of the contribution. The plaintiff claimed a charitable contribution for the year of the contribution and carried forward the remaining balance to tax years 2006-2008.

Because the easement at issue provided that the value of the contribution for purposes of the donees’ right to extinguishment proceeds was tied to the amount of the petitioner’s allowable deductions rather than the fair market value of the easement, the court determined that the easement violated the Regulation and was not protected in perpetuity under I.R.C. §170(h)(5)(A). The court also imposed an accuracy-related penalty. 

  • In Palmolive Building Investors, LLC v. Comr., 149 T.C. No. 18 (2017), the petitioner acquired a building in 2001 for $58.5 million. In 2004, the petitioner transferred a façade easement on the building via deed to a qualified charity (a preservation council) to preserve the exterior building perimeter. The easement deed placed restrictions on the petitioner and its successors with respect to the façade easement and the building – the petitioner and any subsequent owner couldn’t demolish or alter the protected elements without the charity’s permission. The building was subject to two mortgages, but before executing the easement deed, the petitioner obtained mortgage subordination agreements from its mortgagee banks. However, the easement deed provided that in the event the façade easement was extinguished through a judicial proceeding, the mortgagee banks will have claims before that of the donee charity to any proceeds received from the condemnation proceedings until the mortgage is satisfied.

By the time of the easement donation, the value of the building had increased to $257 million, of which $33.4 million was attributable to the easement. The petitioner claimed a $33.4 million charitable contribution deduction for the tax year of the easement contribution. The IRS disallowed the deduction, claiming that the easement deed failed to satisfy the perpetuity requirements of I.R.C. §170 and Treas. Reg. §1.170A-14(g)(6)(ii) because it provided the mortgagees with prior claims to the extinguishment proceeds in preference to the donee. Specifically, the lender had agreed to subordinate the debt to the charity's claims, but the easement deed said that the lender would have priority access to any insurance proceeds on the property if the donor had insurance on the property. The easement deed also said that the lender would have priority to any condemnation proceeds.

The petitioner claimed that the First Circuit's decision in Kaufman v. Comr., 687 F.3d 21 (1st Cir. 2012) applied. In that case, the First Circuit rejected the view that a subordination must remove any preferential treatment of the lender in all situations, creating an exception for unusual situations that could possibly occur at some point in the future. The First Circuit determined that the Tax Court's reading of what is necessary to grant a perpetual easement would eliminate easement donations because an easement represented only a partial interest in property. In addition, the First Circuit reasoned that a broad reading was improper because, for example, a tax lien could arise if the donor failed to pay property tax when they became due which could result in the loss of the property without the charity receiving a pro rata portion of the property value.

In the present case, the Tax Court rejected the view of the First Circuit, noting that its decision would be appealable to the Seventh Circuit and, thus, the Tax Court was not bound by the First Circuit's decision. The Tax Court reasoned that because the lender had superior rights in certain situations, the mortgages did not meet the subordination requirement of Treas. Reg. §1.170A-14(g). Thus, the donated easement did not meet the perpetuity requirement of I.R.C. §170(h)(5). The Tax court also pointed out that other Circuits had agreed with the Tax Court's interpretation of the subordination rule since Kaufman was decided. The Tax Court also noted a difference concerning what must be done to subordinate an existing liability at the time of the donation (such as a mortgage) as opposed to a possible future liability that was not yet in existence. The Tax Court also noted that the Treasury Regulations specifically mentioned mortgages in the list of requirements necessary to satisfy the perpetuity requirement, but made no mention of a need to have taxing agencies to agree to give up rights to a priority interest that might arise in the future for delinquent taxes when the taxes were not delinquent.

The IRS assessed a gross valuation misstatement penalty in 2008 and additional accuracy-related and negligence penalties in 2014. The petitioner contested the penalties, but the Tax Court, in a later proceeding, determined that there is no requirement that IRS determine the penalties at the same time or by the same IRS agent. The only requirement, the Tax Court held, was that each penalty, at the time of initial determination, was approved in writing by a supervisor before being communicated to the petitioner. That requirement was satisfied. That later proceeding on the penalty issue is at 152 T.C. No. 4 (2019).

  • In Salt Point Timber, LLC, et al. v. Comr., T.C. Memo. 2017-245, the petitioner was a timber company that granted a perpetual conservation easement on a 1,032-acre property for which the petitioner claimed a $2.13 million deduction on its 2009 return. The easement preserved the view of natural, environmentally significant habitat on the Cooper River by barring development. The petitioner received $400,000 for the donated easement, and the done satisfied the definition of a “qualified organization” under I.R.C. §170(h)(1)(B). The appraised value of the easement was $2,530,000. The IRS disallowed the deduction on the basis that the easement grant allowed the original easement to be replaced by an easement held by a disqualified entity. In addition, the IRS claimed that the grant allowed the property to be released from the original easement without the extinguishment regulation being satisfied. The petitioner claimed that there was a negligible possibility that the easement could be held by a non-qualified party. The court agreed with the IRS, noting that the grant did not define the term “comparable conservation easement” or what type of organization could hold it, just that an “eligible donee” could hold it. The court noted that an assignment of the easement is different from a replacement of the easement. As such, the grant did not restrict that the holder of the easement had to be a “qualified organization.” The court also determined that the chance that the easement could be replaced was other than negligible as Treas. Reg. §1.170A-14(g)(3) required. 
  • In PBBM-Rose Hill, Ltd., v. Comr., 900 F.3d 193 (5th Cir. 2018), the petitioner owned a tract of land subject to a use restriction requiring it to only be used for recreational facilities open space for 30 years. At the time of the petitioner’s ownership, the property was a golf course with a clubhouse. The petitioner wanted to sell the property, but before doing so wanted to remove the use restriction. A local buyer expressed interest, but also wanted to block any removal of the use restriction. The sale went through after the buyer agree to allow the removal of the use restriction. However, before the sale closed, the petitioner conveyed a conservation easement of the property to a land trust. The terms of the easement stated that the property was to remain open for public use for outdoor recreation and that fees for such use could be charged. Upon extinguishment of the easement, the land trust would be entitled to a portion of the sale proceeds equal to the greater of the fair market value of the easement at the time of the donation or a share of the proceeds after expenses of sale and an amount attributable to improvements constructed on the property. The IRS denied the charitable deduction.

The Tax Court agreed with the IRS position based on its findings that the easement did not protect the conservation purpose under I.R.C. §170(h)(4)(A) and didn’t satisfy the perpetuity requirement of I.R.C. §170(h)(5)(A) because the easement deed’s extinguishment provision did not comply with Treas. Reg. §1.170A-14(g)(6). As such, the easement donation was not “exclusively for conservation purposes as required by I.R.C. §170(h)(1)(C). The Tax Court held that the easement value was $100,000 rather than the $15.2 million that the petitioner claimed. The Tax Court also upheld the gross valuation misstatement penalty that the IRS had imposed. On appeal, the appellate court affirmed that the petitioner was not entitled to any charitable deduction and upheld the penalty. The appellate court held that when determining whether the public access requirement for a recreation easement is fulfilled, the focus is to be on the terms of the deed and not the actual use of the land post-donation. The appellate court determined that the terms of the easement satisfied the public-access requirement of Treas. Reg. §1.170A-14(d)(5)(iv)(C). However, the appellate court concluded that the contribution was not exclusively for conservation purposes because the requirements of Treas. Reg. §1.170A-14(g)(6)(ii) were not satisfied.  The deed, the appellate court noted, allowed the value of improvements to be subtracted from the proceeds before the donee took its share, and that Priv. Ltr. Rul. 200836014 no longer represented the current position of the IRS and could not be used to alter the plain meaning of the regulation which mandates that the donee receive at least the proportionate value of the “proceeds.” The appellate court also agreed with the Tax Court that the gross valuation misstatement penalty applied to the difference between the amount the petitioner deducted on its return ($15 million) and the $100,000 deduction allowed by the Tax Court. 

  • In Coal Property Holdings, LLC v. Comr., 153 T.C. No. 7 (2019), the petitioner donated to a qualified charity an open space conservation easement over property which was previously subjected to surface coal mining and which was also subject to oil and gas leases and certain improvements. The IRS denied a charitable deduction because the easement wasn’t protected in perpetuity, and the Tax Court agreed. The conservation purpose of allowing the land subject to the easement to continue to recover from and provide scientific insight into the long-term effects of mining didn’t entitle the charity to a proportionate part of the proceeds if the subject property were sold upon a judicial extinguishment of the easement. As such, the easement wasn’t perpetual in nature as required by I.R.C. §170(h)(5)(A) and I.R.C. §1.170A-14(g)(6). While the petitioner claimed that the deed language contained a “regulation override” mandating that the deed be interpreted to satisfy the perpetuity requirements of the Code and Regulations, the Tax Court rejected that argument because it was a condition subsequent constituting a savings clause that the court would not enforce. 

On this issue, the IRS also argues that when an easement deed’s proceeds allocation formula deducts (from the proceeds allocable to the done) an amount attributable to “improvements” made by the owner after the donation, no charitable deduction is allowed.  The IRS position is that the deduction violates the extinguishment regulation (Treas. Reg. 1.170A-14(g)(6)(ii)), making the charitable deduction unavailable.  See, e.g., Priv. Ltr. Rul. 200836014 (Sept. 5, 2008).

  • In Railroad Holdings, LLC, et al. v. Comr., T.C. Memo. 2020-22, the petitioner donated a permanent conservation easement to a qualified entity and claimed a $16 million charitable deduction. The deed granting the easement contained a clause specifying the result if the easement were extinguished as the result of a court order. The IRS pointed out that in the event of a forced judicial sale, Treas. Reg. §1.170A-14(g)(6)(ii) requires the charity to receive an equal proportionate value of the sale proceeds that extinguishes the interest to the value of the easement as compared to the value of the property at the date of the donation. The language of the deed at issue held the charity’s payment constant, equal to the value as of the date of the contribution. It did not tie the charity’s payment to a percentage of the value of the property at the time of the forced sale equal to the percentage of value the easement was to the property at the time of the donation. The IRS denied the entire $16 million donation and the Tax Court agreed.

The Tax Court noted that the deed language did not create a proportion or fraction representing the donee’s share of the property right and a corresponding fraction of the proceeds to which the donee was entitled in perpetuity. Rather, the Tax Court noted, the language gave the charity a “proportionate value…at the time of the gift” which guaranteed only that a fixed dollar amount would go to the charity. The Tax Court also held as irrelevant a declaration of intent executed by an officer of the charity that the deed language reflected the charity’s intent to be in full compliance with the Code. What mattered was the donor’s intent, not the charity’s intent. Even so, the deed language failed to conform to the Code. The Tax Court also determined that the deed language was not ambiguous. Thus, the easement was not protected in perpetuity and the full deduction was disallowed. 

Challenge to the Validity of the Regulation

In Oakbrook Land Holdings, LLC v. Comr., 154 T.C. No. 10 (2020), the petitioner challenged the validity of the extinguishment regulation.  In 2008, the petitioner donated a permanent conservation easement to a qualified organization and claimed a charitable deduction.  The easement deed specified that upon extinguishment of the conservation restriction the donee would receive a share of the proceeds equal to the fair market value of the easement as of the date of the contribution.  That value, the deed specified, was to be reduced by the value of any improvements that the donor made after granting the easement.  The IRS denied the charitable deduction because (inter alia) violated the extinguishment regulation of Treas. Reg. §1.170A-14(g)(6). 

The Tax Court, agreeing with the IRS, upheld the validity of the regulation.  The full Tax Court   held that the extinguishment regulation (Treas. Reg. §1.170A-14(g)(6)) had been properly promulgated and did not violate the Administrative Procedure Act.  The full Tax Court also determined that the construction of I.R.C.§170(h)(5), as set forth in the extinguishment regulation, was valid under the agency deference standard set forth in Chevron, U.S.A. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984). 

In a related memorandum opinion, the Tax Court held that the easement deed did not create a perpetual easement because the donee’s share of the extinguishment proceeds was based on fixed historical value, reduced by the value of improvements that the donor made.  Oakbrook Land Holdings, LLC v. Comr., T.C. Memo. 2020-54.  It was not, as it should have been, based on a proportionate share of extinguishment proceeds that are at least equal to the total proceeds (unadjusted by the value of the petitioner’s improvements), multiplied by a fraction defined by the ratio of the fair market value of the easement to the fair market value of the unencumbered property determined as of the date of the execution of the deed.  However, the Tax Court did not uphold penalties that the IRS imposed, finding that the petitioner’s position was reasonable.

Conclusion

The extinguishment regulation is, perhaps, the most common audit issue for IRS when examining permanent conservation easement donations.  The clause specifying how proceeds are to be split when a donated conservation easement is extinguished is routinely included in easement deeds.  The cases point out that the clause must be drafted precisely to fit the confines of the regulation.  A regulation that now has survived an attack on its validity.  Many perpetual easement donations will potentially be affected. 

May 25, 2020 in Environmental Law, Income Tax, Real Property | Permalink | Comments (0)

Thursday, May 21, 2020

Obtaining Deferral for Non-Deferred Aspects of an I.R.C. §1031 Exchange

Overview

The TCJA eliminated tax-deferred like-kind exchanges of personal property for exchanges completed after 2017.  However, exchanges of real estate can still qualify for tax-deferred treatment if the exchange involves real estate that is “like-kind.”  But, what if the exchange involves non-like-kind cash “boot” or otherwise fails the requirements of the Code?  Is there a way to still achieve tax deferral?

“Fixing” a tax-deferred exchange that has failed – it’s the topic of today’s post.

Code Requirements

The tax deferral of an IRC §1031 exchange is only achieved if the requirements of IRC §1031 are satisfied.  If the requirements are not satisfied, the exchange is taxable as a sale or exchange under the general rules of IRC §1001

There are four basic requirements to achieving tax-deferred treatment under IRC §1031:

  • There is an exchange of property rather than a sale; IRC §1031(a)(1).
  • The property exchanged and the property received must be like-kind real estate;
  • The property exchanged and the property received must both be held for the productive use in a trade or business or for investment; and
  • The exchange of properties must be simultaneous, or the replacement property must be identified within 45 days of the exchange and the identified property must be received within 180 days of the identification or the due date of the return (including extensions), if shorter. IRC §§1031(a)(3)(A)-(B)((ii).

Interaction of IRC §1031 and IRC §453

If an exchange satisfies the requirements of IRC §1031, but property is received that is not like-kind (such as money or other non-like kind property, the recipient of the property recognizes gain to the extent of the sum of the money and the fair market value of the non-like-kind property received. I.R.C. §1031(b).  That means that tax deferral is not achieved with respect to the non-like-kind property (or “boot”) received in the exchange.  But a taxpayer may elect to recognize the gain on the boot under the installment method of I.R.C. §453.  Similarly, a taxpayer that fails to satisfy the requirements of IRC §1031 may be able to defer gain on the transaction under IRC §453 by properly structuring the sale.

Treasury Regulation Example

Treasury Regulation §1.1031(k)-(1)(j)(2)(vi), Example 4, indicates that a buyer’s installment note issued to a seller qualifies for installment treatment under IRC §453.   In the Example, the buyer offers to buy the seller’s real property, but doesn’t want to have the transaction structured as a like-kind exchange.  As a result, the seller enters into an exchange agreement with a qualified intermediary to facilitate the exchange.  Under the agreement, the seller transfers the real property to the qualified intermediary who then transfers the property to the buyer.  The buyer pays $80,000 cash and issues a 10-year installment note for $20,000.  The Example specifies that the seller has a bona fide intent to enter into a deferred exchange, and the exchange agreement specifies that the seller cannot receive, pledge, borrow or otherwise obtain the benefits of the money or other property that the qualified intermediary held until the earlier of the date the replacement property is delivered to the seller or the end of the exchange period.  The Example also points out that the buyer’s obligation bears adequate stated interest and is not payable on demand or readily tradable.  The qualified intermediary acquires replacement property having a fair market value of $80,000 and delivers it, along with the $20,000 installment obligation, to the seller. 

While the $20,000 of the seller’s gain does not qualify for deferral under IRC §1031(a), the seller’s receipt of the buyer’s obligation is treated as the receipt of an obligation of the person acquiring the property for purposes of installment reporting of gain under IRC §453.  Thus, the Example concludes that the seller may report the $20,000 gain on the installment method on receiving payments from the buyer on the obligation

Safe Harbor 

A safe harbor exists that provides protection against an IRS assertion that a taxpayer is in actual or constructive receipt of money or other property held in a qualified escrow account, qualified trust, or by a qualified intermediary. Treas. Regs. §§1.1031(k)-1(g)(3)-(4); T.D. 8535 (Jan. 1994). With respect to a qualified intermediary, the determination of whether a taxpayer has received payment for purposes of IRC §453 is made as if the qualified intermediary is not the taxpayer’s agent. Treas. Regs. §§1.1031(k)-1(j)(2)(ii); (g)(4).   Thus, when a taxpayer transfers property under such an arrangement and receives like-kind property in return, the transaction is an exchange rather than a sale, and the qualified intermediary is not deemed to be the taxpayer’s agent. See Priv. Ltr. Rul. 200327039 (Mar. 27, 2003). Similarly, when a buyer places money in an escrow account or with the qualified intermediary, the seller is not in constructive receipt of the funds if the seller’s right to receive the funds is subject to substantial restriction. See, e.g., Stiles v. Commissioner, 69 T.C. 558 (1978).  The Treasury Regulations state that any agency relationship between the seller and the qualified intermediary is disregarded for purposes of IRC §453 and Treas. Reg. §15a.453-1(b)(3)(i) in determining whether the seller has constructively received payment.  Treas. Reg. §1.1031(k)-1(j)(2)(vi), Example 2.

Exchange Transaction Example

Assume that Molly Cule owns a tract of farmland that she uses in her farming business and would like to exchange it for other farmland in an I.R.C. §1031 transaction.  Bill Bored and Molly enter into a purchase contract, calling for Bill to buy Molly’s farmland.  The purchase contract clearly states that Bill must accommodate Molly’s desire to complete an IRC §1031 exchange and states that Molly desires to enter into an IRC §1031 exchange.  Molly and a qualified intermediary then enter into an exchange agreement specifying that the qualified intermediary agrees to acquire Molly’s farmland and transfer it to Bill.  The agreement also states that the qualified intermediary will acquire like-kind farmland and transfer it to Molly.  Molly assigns her rights in and to the farmland she gave up to the qualified intermediary.  She also assigns her rights to the qualified intermediary in all contracts she enters into with the owner who holds title to the replacement farmland. 

The exchange agreement requires Molly to identify replacement farmland within 45 days of the initial exchange and to notify the qualified intermediary of the identified parcel within that 45-day period.  The exchange agreement allows Molly 180 days from the date of the first exchange to receive the identified property. 

The exchange agreement specifies that the qualified intermediary will sell Molly’s farmland and hold the sales proceeds until the qualified intermediary buys replacement farmland.  When the replacement farmland is purchased, it will then be transferred to Molly. 

Structured sale aspect.  The exchange agreement says that if the transaction qualifies under I.R.C. §1031, but Molly receives “boot,” the qualified intermediary and Molly must engage in a structured sale for the boot.  This is to bar Molly from having any right to receive cash from the exchange.  Similarly, the exchange agreement contains additional language stating that if the transaction fails to qualify for I.R.C. §1031 treatment for any reason, the qualified intermediary and Molly must engage in a structured sale.  The structured sale involves the qualified intermediary making specified periodic payments to Molly pursuant to an installment sale agreement (based on the consideration the qualified intermediary holds) coupled with a note for a set number of years.  Thus, the exchange agreement is drafted to specify that if an installment sale results, Molly will report each payment received into income in the year she receives it. 

The assignment agreement.  If the installment sale language is triggered, the exchange agreement specifies that the qualified intermediary will assign its obligations to make the periodic payments under the installment note to an assignment company pursuant to a separate assignment agreement between the qualified intermediary and the assignment company.  Molly is not a party to this agreement.  The assignment agreement requires the qualified intermediary to transfer a lump sum to the assignment company.  The lump sum amount equals the discounted present value of the stream of payments that the qualified intermediary must make under the installment note and exchange agreement.  In return, the assignment company assumes the qualified intermediary’s obligation to pay Molly.  Thus, the assignment company becomes an obligor under the installment note. 

As discussed above, Example 4 of Treas. Reg. §1.1031(k)-1(j)(vi), involves an installment note that the buyer issues to the seller of the property.  That note qualifies for installment treatment under I.R.C. §453.  In the example involving Molly, it is the qualified intermediary that issues the note.  While the regulation states that the qualified intermediary is not the agent of the Molly for purposes of IRC §453, that is only the case until the earlier of the identification (or replacement) period, or the time that Molly has the unrestricted right to receive, pledge, borrow or otherwise benefit from the money or other property that the qualified intermediary holds. Treas. Reg. §1.1031(k)-1(j)(2)(ii).   But, the risk of Molly being in constructive receipt of the buyer’s funds is eliminated if the exchange agreement is drafted carefully to fit within the safe harbor. 

Alternative Approach

As an alternative to the approach of the example involving Molly, what if a different taxpayer, Millie, engaged in a similar transaction and used installment reporting but received all of the cash up front via a loan.  Will an arrangement structured in this manner achieve tax deferral?

Facts of the example.  Millie sells an asset to Howard’s Exchange Service (HSE) and HSE resells the asset to Andy.  Millie receives a loan from Usurious Bank, an independent lender shortly after selling the asset to HSE for an amount equating the selling price to HSE.  The repayment of the loan is funded by installment payments over a period of time that HSE makes to Usurious Bank.  Three escrow accounts are established with an escrow company affiliated with Usurious Bank.  The escrow company, on a monthly basis, takes funds from HSE and moves it into Escrow Account No. 1 as an interest payment on the loan; then to Escrow Account No. 2 (which is designated as Millie’s account); and then to Escrow Account No. 3 to pay interest on the loan.  The transactions are conducted as automatic debit/credit transactions that occur on a monthly basis over the length of the installment period.  

Analysis.  IRC §453 requires that the initial debt obligation be that of the buyer of the property for the seller to receive installment treatment on the proceeds of sale.  If the obligor is someone other than the buyer, the debt is treated as payment on the sale.  Treas. Reg. §15a.453-1(b)(3)(i).  Thus, for installment sale treatment to result, HSE must be both the buyer of the asset and the obligor on the installment note rather than only being the obligor.  This means that the transaction must be structured such that the obligation is due to Millie from Andy, followed by a substitution of the obligor via an independent transaction in which Andy assigns the obligation. In Rev. Rul. 82-122, 1982-1 C.B. 80, amplifying Rev. Rul. 75-457, 1974-1 C.B. 115, the substitution of a new obligor on the note and an increase in the interest rate, together with an increase in the amount paid monthly to reflect the higher interest rate, was not considered to be a satisfaction or disposition of an installment obligation within the meaning of I.R.C. §453B(a).

As for the escrow accounts, generally an installment note of the buyer cannot be used as security or pledged to support any other debt that benefits the seller.  If that happens, the net proceeds of the debt are treated as a payment received on the installment sale.  See IRC §453A(d)(1); Treas. Reg. §15A.453-1(b)(3)(i); Rev. Rul. 79-91, 1979-1, C.B. 179; Rev. Rul. 77-294, 1977-2, C.B. 173; Rev. Rul. 73-451, 1973-2, C.B. 158.  However, there is an exception to this “pledge rule” that triggers gain recognition if the seller uses an installment obligation to secure a loan.  Property that is used or produced in the trade or business of farming is not subject to the rule. I.R.C. §453A(b)(3)(b).   Thus, a taxpayer who sells farmland (or other farm property) in an installment sale may use that installment receivable as security, or in a pledged manner, to borrow funds from a third party.  The third party should collateralize the payments and file a UCC-1 to formally pledge and secure the installment payments

Conclusion

Tax-deferred exchanges post-2017 are limited to real estate exchanges.  Normally, only the like-kind portion of the exchange qualifies for deferral.  However, if an exchange involving farm property is structured properly, tax deferral can be achieved for the entire transaction.  Careful drafting of the contracts involved is critical.

May 21, 2020 in Income Tax, Real Property | Permalink | Comments (0)

Tuesday, April 21, 2020

Abandoned Railways and Issues for Adjacent Landowners

Overview

For farmers and ranchers (and other rural landowners) owning agricultural land adjacent to railroads, the abandonment of an active rail line presents a number of real property issues.  What is the legal effect of the abandonment?  Does state or federal law apply?  What about fencing?  These (and others) are all important questions when a railroad abandons a line.

Abandoned rail lines and legal issues – that’s the topic of today’s post.

Legal Effect of Abandonment

During the nineteenth century, many railroad companies acquired easements from adjoining landowners to operate rail lines.  In some instances, railroads acquired a fee simple interest in rights-of-way and in those situations, can sell or otherwise dispose of the property.  In most situations, however, a railroad was granted an easement for railroad purposes, usually acquired from adjacent property owners.  The general rule is that a right-of-way for a railroad is classified as a limited fee with a right of reverter if received from Congress on or before 1871, but is classified as an exclusive use easement if the right of way is received after 1871.

If the railroad held an easement, the abandonment of the line automatically terminates the railroad's easement interest, and the interest generally reverts to the owners of the adjacent land owning the fee simple interest from which the easement was granted. See, e.g., Penn. Central Corp. v. United States Railroad Vest Corp., 955 F.2d 1158 (7th Cir. 1992).

After abandonment, state law controls the property interests involved.  Once abandonment occurs, federal law does not control the property law questions involved. The only exception is if the United States retained a right of reverter in the abandoned railway.  Under the Abandoned Railroad Right of Way Act (43 U.S.C. § 912), land given by the United States for use as a railroad right-of-way in which the United States retained a right of reverter had to be turned into a public highway within one year of the railroad company’s abandonment or be given to adjacent landowners.  Later, the Congress enacted the National Trails System Improvement Act of 1988 under which those lands not converted to public highways within one year of abandonment would revert back to the United States, not adjacent private landowners.

What About Recreational Trails? 

In 1976, the Congress passed the Railroad Revitalization and Regulatory Reform Act (Act) in an effort to promote the conversion of abandoned lines to trails.  Under the Act, the Secretary of Transportation is authorized to prepare a report on alternate uses for abandoned right-of-ways.  The Secretary of the Interior can offer financial, educational and technical assistance to local, state and federal agencies.  In addition, the Interstate Commerce Commission (ICC) was authorized to delay disposition of railroad property for up to 180 days after an order of abandonment, unless the property was first offered for sale on reasonable terms for public purposes including recreational use.  The National Trails System Act amendments of 1983 authorized the ICC to preserve for possible future railroad use, rights-of-way not currently in service and to allow interim use of land by a qualified organization as recreational trails.  Effective January 1, 1996, the Congress replaced the ICC with the Surface Transportation Board (STB) and gave the STB authority to address rail abandonment and trail conversion issues.  The organizations operating the corridors as trails assume all legal and financial responsibility for the corridors.  This is known as railbanking.

Under the 1983 amendments, a railroad must follow a certain procedure if it desires to abandon a line.  A potential trail operator must agree to manage the trail, take legal responsibility for the trail and pay any taxes on the trail.  The STB engages in a three-stage process for railroad abandonment.  First, a railroad must file an application with the STB and notify certain persons of its planned abandonment.  The application must state whether the right-of-way is suitable for recreational use.  In addition, the application must notify government agencies and must be posted in train stations and newspapers giving the public a right to comment.  Second, the STB then determines whether “present or future public convenience and necessity” permit the railroad to abandon.  A trail organization then must submit a map and agreement to assume financial responsibility and the STB will then determine whether the railroad intends to negotiate a trail agreement.  Third, if such a determination is made, the STB will issue a “certificate of interim trail use” or a certificate of abandonment.  The parties have 180 days to reach this agreement.  If no agreement is reached, the line is abandoned.  Abandonment of a railroad right-of-way cannot occur without the prior authorization of the STB.  See, e.g., Phillips Company v. Southern Pacific Rail Corp., 902 F. Supp. 1310 (D. Colo. 1995).  But, once abandonment occurs, the STB no longer has any jurisdiction over the issue.  See, e.g., Preseault v. Interstate Commerce Commission, 494 U.S. 1 (1990).

Before passage of the 1983 amendments, it was clear that when a railroad ceased line operation and abandoned the railway, the easement interest of the railroad in the line reverted to the adjacent landowners of the fee simple.  See, e.g., Consolidated Rail Corp. Inc. v. Lewellen, 682 N.E.2d 779 (Ind. 1997)However, as noted, the 1983 amendments established a more detailed process for railroad abandonment and gave trail organizations the ability to operate an abandoned line.  While most railroads hold a right-of-way to operate their lines by easement specifying that the easement reverts to the landowner upon abandonment, after passage of the 1983 amendments, a significant question is when, if ever, abandonment occurs. One court has held that the public use condition on abandonment does not prevent the abandonment from being consummated, at which time STB jurisdiction ends, federal law no longer pre-empts state law, and state property law may cause the extinguishment of the railroad's rights and interests.  See, e.g., Fritsch v. Interstate Commerce Commission, 59 F.3d 248 (D.C. Cir. 1995), cert. denied sub. nom. CSX Transportation v. Fritsch, 516 U.S. 1171 (1996).

A more fundamental issue is whether a preclusion of reversion to the owner of the adjacent fee simple is an unconstitutional taking of private property. I will analyze the constitutional takings issue is a subsequent post.  Suffice it to say, however, in 1990 the U.S. Supreme Court upheld the 1983 amendments as constitutional.  Preseault v. Interstate Commerce Commission, 494 U.S. 1 (1990). But see Swisher v. United States, 176 F. Supp.2d 1100 (D. Kan. 2001).  

Recent Case

A recent federal case involved adjacent landowners’ taking claim when a railroad abandoned its line and sought to transfer the abandoned line to a city for the use as a recreational trail.  The landowners claimed that full ownership of the line should have been in their hands but the city disagreed, and the court was left to sort it out. 

In Anderson v. United States, Court of Federal Claims, No. 17-668L, 2020 U.S. Claims LEXIS 526 (Fed. Claims Apr. 10, 2020), the plaintiffs were a group of 24 landowners who own real property adjacent to a rail line near Waco, Texas. The line was acquired in 1902 by Texas Central Railroad Company, the predecessor to the current owner Union Pacific Railroad Co.  Texas Central acquired its right-of-way through various methods, including a declaration of trust, court-ordered condemnation, and four deeds. In 2015, Union Pacific indicated its intention to abandon the 2.45-mile line, and stated their intention to salvage the limited amount of track material and transfer the right-of-way to the City of Waco as a utility corridor and for possible trail use.  In 2017, the plaintiffs filed a complaint alleging a Fifth Amendment taking on the basis that the railroad only had an easement in the rail line and that the abandonment of the line and reverted to them upon abandonment.  The plaintiffs requested just compensation for their property in the form of fair market value of the taken property.

The Court examined the underlying deeds granting the line to Texas Central and noted that they didn’t contain any right-of-way language but rather conveyed a fee simple subject to a condition subsequent that benefited the original grantors solely.  As a conveyance of a fee simple, there was no property right that reverted to the adjacent owners, and their taking claim failed.  State property law determined the outcome.

Conclusion

Abandoned rail lines create numerous legal issues for adjacent landowners, including a mix of federal and state law.  In addition, fencing issues get involved and those may be handled not under the general fence laws of the particular state, but in accordance with fencing provisions specific to the conversion of abandoned rail lines to trails.  In any event, for those that believe they have been negatively impacted by a rail line abandonment, seeking good legal counsel is a must to protect whatever landowner rights remain. 

April 21, 2020 in Real Property | Permalink | Comments (0)

Wednesday, February 12, 2020

Deed Effectiveness – Signing and Delivery

Overview

Transferring real estate is often an essential aspect of farm and ranch estate and business planning.  But, what does it take to effectively transfer title to real estate?  Centuries ago in England, a ceremony was held on the land to be transferred and the seller would physically hand some of the soil to the buyer to commemorate the transfer of title to the buyer.  That ceremony is not done today, but other requirements must be satisfied to signify that title has been transferred. Clearly a real estate deed must be signed, and the grantor must have the present intent to deliver the deed. But, based on the facts of a particular situation, those requirements may not be as straightforward as they might seem.

Transferring title to real estate – the signing and delivery requirements.  These are the topics of today’s post.

The Signing Requirement

A real estate deed must be signed to be effective to convey title.  That seems like a simple requirement to satisfy.  However, facts can complicate the matter and raise a question of just exactly who must sign the deed.  This was on display in a recent case.  In In re Estate of Tatum, 580 S.W.3d 489 (Tex. Ct. App. 2019), a married couple had ten children. In 1982 they executed a warranty deed for their 134-acre farm, reserving a life estate in each of them and leaving a remainder interest to each of the children equally. One of the children died in 1999, with his interest passing to his surviving spouse. Later in 1999, the mother requested that the attorney draft a deed conveying the deceased son’s remainder interest back to the parents. This deed listed all ten children (including the surviving spouse of the pre-deceased child) as grantors, and it claimed to convey the farm in fee simple back to the parents. The deed made no reference to the undivided future interests of the children. There was no request that each child (and the surviving spouse of the pre-deceased child) sign the deed, but they understood that the deed would not be effective unless all of them signed it. Two of the children never signed the deed.

The father died in 2000. In 2001 and 2002 four of the children executed affidavits rescinding their signatures. In 2003 the mother and the children had a meeting requesting that the children transfer their interest to one of the children. Five of the children transferred their interest to this child resulting in that child holding a 6/10ths interest in the farm. An agreement could not be reached with the four remaining children. The mother then filed the 1999 deed in March of 2004.

The mother died in 2016 with a will that was based on the assumption that she owned 80 percent of the farm, because of the 1999 deed that eight of children signed. The estate executor sought a probate court determination that the 1999 deed transferred 80 percent of the remainder interest to the parents and that the affidavits were ineffective rescissions. Some of the children counterclaimed seeking validity and enforceability of the 1999 deed and 2001 and 2002 affidavits rescinding their signatures. Other children argued that the deed was never fully executed and delivered so it never became effective to convey any interest in the property.

The probate court granted the executor’s motion for summary judgment and determined that the 1999 deed was "valid, effective, and enforceable against the eight grantors who signed" and was unambiguous. On appeal, the appellate court reversed and remanded.

The only issue on appeal was whether the probate court erred in granting the executor’s motion for summary judgment. The defendant children claimed that there was a genuine issue of material fact as to whether the 1999 deed was enforceable because not all of the children had signed it.  The appellate court determined that the evidence revealed an oral understanding among the children that the deed required all of their signatures. This created, the appellate court reasoned, a condition precedent that wasn’t inconsistent with the deed.  The deed was silent concerning whether all of the children needed to sign or if it would convey an individual interest. Further the deed described the property as a fee simple absolute, and did not describe the individual interest of the children. Since each of the children owned a one tenth interest, the only way for a full fee simple absolute to be transferred was for all of the children to sign the deed. The appellate court determined that the children had proffered sufficient evidence of the oral condition precedent to raise a genuine issue of material fact.

The Delivery Requirement

Not only must a deed be signed, it must be delivered to be effective to pass title.  However, intention to deliver is the controlling element in determining whether a purported delivery is effective to transfer the real estate.  For example, in Masek v. Estate of Masek, No. A-10-279, 2010 Neb. App. LEXIS 196 (Neb. Ct. App. Dec. 28, 2010), title to farmland was held not to have transferred due to the lack of the transferor’s present intent to deliver the deed.  The deed had been executed in 1977, but was not recorded and later discovered in the transferor’s desk upon his death in 2007.  Other facts showed that the transferor exercised ownership and control of the farm until he died.

While no particular form of delivery or ceremony is necessary, any event that clearly manifests the grantor's intent to deliver is effective to convey title.  Thus, it is not necessary for a physical transfer of the deed to take place if the grantor has the present intent to part with legal control of the property.  In other words, if delivery is not accepted, that has no bearing on the transferor’s present intent to deliver the deed.  Conversely, a physical transfer of the deed is not effective to convey title if the delivery is not completed with the requisite intent.

Because of the requirement of a present intent to deliver, any conveyance where the grantor intends to withhold from the grantee complete ownership until the performance of some condition or the happening of some event is a conditional delivery and is ineffective to convey the associated real estate.  For example, a deed delivered to a third party with instructions to record it upon the grantor's death is ineffective to transfer title.  A deed cannot be used to transfer property at death as can a will unless the statutory requirements for an effective will are satisfied.  The formalities for deeds and wills are different.  As a result, a deed that fails to transfer title because the grantor did not have the present intent to deliver is seldom treated as a valid will even if the grantor's intent would be furthered.

For instance, in Giefer v. Swenton, 23 Kan. App. 2d 172, 928 P.2d 906 (1996), the decedent owned a small farm.  His wife had already died, leaving him with their seven adult children – one son and six daughters.  In the fall of 1990, the decedent executed a deed to the farm which conveyed a 1/7 interest in it to each of his children as tenants in common.  His will was executed the same day.  He didn’t physically transfer the deed to the children, instead holding it until early 1993.  At that time, he told one of the daughters to record it.  About five months later, he executed a second will leaving the farm to all of the children, but it also contained a provision giving the son the absolute right to buy the farm from his sisters for $400 per acre.  About three weeks after executing the second will, the decedent died.  All of the daughters except one sold their interest in the farm to their brother.  This issue in the case was whether the decedent died owning the family farm or deeded it away before his death.  In other words, the issue was whether the deed had been properly delivered. 

The court determined that the deed had been effectively delivered when it was recorded.  That’s the rule in Kansas – recordation constitutes delivery.  Manual delivery to the grantee is not necessary.  Here, the deed was recorded at the decedent’s express direction.  The court also noted that the deed contained no reservations or qualifications, and that it was clear that the decedent knew what he wanted to do about deeding the farm – he did not want to own the farm at the time of his death.  That outcome had an impact on the son.

 

Conclusion

While it may seem simple to transfer real estate, there can be unique sets of facts that can complicate the signing and delivery requirements.  In many situations, a well-trained real estate attorney can provide sound advice to help avoid problems that might arise.

February 12, 2020 in Real Property | Permalink | Comments (0)

Friday, January 17, 2020

Principles of Agricultural Law

Overview

Principles2020springedition400x533The fields of agricultural law and agricultural taxation are dynamic.  Law and tax impacts the daily life of a farmer, rancher, agribusiness and rural landowner practically on a daily basis.  Whether that is good or bad is not really the question.  The point is that it’s the reality.  Lack of familiarity with the basic fundamental and applicable rules and principles can turn out to be very costly.  As a result of these numerous intersections, and the fact that the rules applicable to those engaged in farming are often different from non-farmers, I started out just over 25 years ago to develop a textbook that addressed the major issues that a farmer or rancher and their legal and tax counsel should be aware of.  After three years, the book was complete – Principles of Agricultural Law - and it’s been updated twice annually since that time. 

The 46th edition is now complete, and it’s the topic of today’s post – Principles of Agricultural Law.

Subject Areas

The text is designed to be useful to farmers and ranchers; agribusiness professionals; ag lenders; educational professionals; laywers, CPAs and other tax preparers; undergraduate and law students; and those that simply want to learn more about legal and tax issues.  The text covers a wide range of topics.  Here’s just a sample of what is covered:

Ag contracts.  Farmers and ranchers engage in many contractual situations, including ag leases, to purchase contracts.  The potential perils of verbal contracts are numerous as one recent bankruptcy case points out.  See, e.g., In re Kurtz, 604 B.R. 549 (Bankr. D. Neb. 2019).  What if a commodity is sold under forward contract and a weather event destroys the crop before it is harvested?  When does the law require a contract to be in writing?  For purchases of goods, do any warranties apply?  What remedies are available upon breach? If a lawsuit needs to be brought to enforce a contract, how soon must it be filed?

Ag financing.  Farmers and ranchers are often quite dependent on borrowing money for keeping their operations running.  What are the rules surrounding ag finance?  This is a big issue for lenders also?  For instance, in one recent Kansas case, the lender failed to get the debtor’s name exactly correct on the filed financing statement.  The result was that the lender’s interest in the collateral (a combine and header) securing the loan was discharged in bankruptcy.   In re Preston, No. 18-41253, 2019 Bankr. LEXIS 3864 (Bankr. D. Kan. Dec. 20, 2019). 

Ag bankruptcy.  A unique set of rules can apply to farmers that file bankruptcy.  Chapter 12 bankruptcy allows farmers to de-prioritize taxes.  That can be a huge benefit.  Knowing how best to utilize those rules is very beneficial.

Income tax.  Tax and tax planning permeate daily life.  Deferral contracts; depreciation; installment sales; like-kind exchanges; credits; losses; income averaging; reporting government payments; etc.  The list could go on and on.  Having a basic understanding of the rules and the opportunities available can add a lot to the bottom line of the farming or ranching operation. 

Real property.  Of course, land is typically the biggest asset in terms of value for a farming and ranching operation.  But, land ownership brings with it many potential legal issues.  Where is the property line?  How is a dispute over a boundary resolved?  Who is responsible for building and maintaining a fence?  What if there is an easement over part of the farm?  Does an abandoned rail line create an issue?  What if land is bought or sold under an installment contract? 

Estate planning.  While the federal estate tax is not a concern for most people and the vast majority of farming and ranching operations, when it does apply it’s a major issue that requires planning.  What are the rules governing property passage at death?  Should property be gifted during life?  What happens to property passage at death if there is no will?  How can family conflicts be minimized post-death?  Does the manner in which property is owned matter?  What are the applicable tax rules?  These are all important questions.

Business planning.  One of the biggest issues for many farm and ranch families is how to properly structure the business so that it can be passed on to subsequent generations and remain viable economically.  What’s the best entity choice?  What are the options?  Of course, tax planning is part and parcel of the business organization question. 

Cooperatives.  Many ag producers are patrons of cooperatives.  That relationship creates unique legal and tax issues.  Of course, the tax law enacted near the end of 2017 modified an existing deduction for patrons of ag cooperatives.  Those rules are very complex.  What are the responsibilities of cooperative board members? 

Civil liabilities.  The legal issues are enormous in this category.  Nuisance law; liability to trespassers and others on the property; rules governing conduct in a multitude of situations; liability for the spread of noxious weeds; liability for an employee’s on-the-job injuries; livestock trespass; and on and on the issues go.  It’s useful to know how the courts handle these various situations.

Criminal liabilities.  This topic is not one that is often thought of, but the implications can be monstrous.  Often, for a farmer or rancher or rural landowner, the possibility of criminal allegations can arise upon (sometimes) inadvertent violation of environmental laws.  Even protecting livestock from predators can give rise to unexpected criminal liability.  Mail fraud can also arise with respect to the participation in federal farm programs.  The areas of life potentially impacted with criminal penalties are worth knowing, as well as knowing how to avoid tripping into them.

Water law.  Of course, water is essential to agricultural production.  Water issues vary across the country, but they tend to focus around being able to have rights to water in the time of shortage and moving the diversion point of water.  Also, water quality issues are important.  In essence, knowing whether a tract of land has a water right associated with it, how to acquire a water right, and the relative strength of that water rights are critical to understand.

Environmental law.  It seems that agricultural and the environment are constantly in the news.  The Clean Water Act, Endangered Species Act and other federal (and state) laws and regulations can have a big impact on a farming or ranching operation.  Just think of the issues with the USDA’s Swampbuster rules that have arisen over the past 30-plus years.  It’s good to know where the lines are drawn and how to stay out of (expensive) trouble.

Regulatory law.  Agriculture is a very heavily regulated industry.  Animals and plants, commodities and food products are all subject to a great deal of regulation at both the federal and state level.  Antitrust laws are also important to agriculture because of the highly concentrated markets that farmers buy inputs from and sell commodities into.  Where are the lines drawn?  How can an ag operation best position itself to negotiate the myriad of rules?   

Conclusion

The academic semesters at K-State and Washburn Law are about to begin for me.  It is always encouraging to me to see students getting interested in the subject matter and starting to understand the relevance of the class discussions to reality.  The Principles text is one that can be very helpful to not only those engaged in agriculture, but also for those advising agricultural producers.  It’s also a great reference tool for Extension educators. 

If you are interested in obtaining a copy, you can visit the link here:  http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/principlesofagriculturallaw/index.html

January 17, 2020 in Bankruptcy, Business Planning, Civil Liabilities, Contracts, Cooperatives, Criminal Liabilities, Environmental Law, Estate Planning, Income Tax, Insurance, Real Property, Regulatory Law, Secured Transactions, Water Law | Permalink | Comments (0)

Friday, December 13, 2019

Is a Tenancy-in-Common Interest Eligible for Like-Kind Exchange Treatment?

Overview

The Tax Cuts and Jobs Act (TCJA) changed the like-kind exchange rules of I.R.C. §1031 such that only real estate can be exchanged in a tax-deferred manner.  Personal property trades no longer qualify for tax-deferred treatment if entered into after 2017.  But what if the real estate is not owned 100 percent outright by the taxpayer?  What if the taxpayer owns a fractional interest in real estate either for convenience or as part of a business entity?  In that situation, can the fractional interest be traded for other real estate with any gain on the transaction deferred under I.R.C. §1031?  Or, instead, is it possible that owning property in that manner could constitute a partnership with the result that the taxpayer’s “partnership” interest wouldn’t qualify for like-kind exchange treatment?

Fractional interests in real estate and qualification for gain deferral under I.R.C. §1031 – it’s the topic of today’s blog post. 

Like-Kind Exchange Basics

A like-kind exchange of real estate is a popular method to dispose of appreciated real estate without incurring tax currently.  I.R.C. §1031.  A tract of real estate can be traded for other real estate that the taxpayer will hold for business or investment purposes.  The rules are liberal enough that the exchange of the properties need not be simultaneous – the taxpayer has up to 45 days to identify the replacement property after the transfer of the relinquished property and must receive the replacement property within the earlier of 180 days after the transfer or by the extended due date of the return for the year of the transfer. 

Eligibility of Undivided Fractional Interests

In prior posts, I have looked at the issue of what constitutes “real estate” for purposes of the like-kind exchange rules of I.R.C. §1031.  In those posts, implied in the analysis was outright, full ownership of the taxpayer’s interest in the real estate that the taxpayer sought to exchange on a deferred basis.  But, what if the interest in real estate is a fractional interest such as a tenancy in common?  A tenancy-in-common is an arrangement where two or more people share ownership rights in real estate or a tract of land that can be commercial, residential or farmland/ranchland.  When two or more people own property as tenants-in-common, all areas of the property are owned equally by the group – they each own a physically undivided interest in the entire property.  In addition, the co-tenants may have a different share of ownership interests.  Also, each tenant-in-common is entitled to share with the other tenant the possession of the whole parcel and has the associated rights to a proportionate share of rents or profits from the property, to transfer the interest, and to demand a partition of the property.   When a tenant in common dies, the decedent’s interests in the property becomes part of the decedent’s estate and passes in accordance with the decedent’s will or trust, or state law if the decedent did not have a will or trust. 

A significant question is whether a tenancy-in-common ownership arrangement constitutes a partnership for tax purposes.  The question is important because the like-kind exchange rules don’t apply to exchanges of partnership interests – a partnership interest is not like-kind to a fee simple interest in real estate.  I.R.C. §1031(a)(2)(D).  Presumably, the exclusion of partnership interests also applies to multi-member LLC interests where the LLC is taxed as a partnership.   Under Treas. Reg. §1.761-1(a) and Treas. Reg. §301.7701-1 through 301.7701-3, a partnership for federal tax purposes does not include mere co-ownership of property where the owners’ activities are limited to keeping the property maintained, repaired, rented or leased.  However, the regulations point out that a partnership for federal tax purposes is broader in scope than the common law meaning of “partnership” and may include groups not classified by state law as partnerships.  

In 1997, the IRS issued a private letter ruling noting that, in some situations, a tenancy in common arrangement resulting in multiple owners holding an undivided fractional interest in real estate could result in a partnership such that the exchange of the owners’ interests would not qualify for like-kind exchange treatment.  Priv. Ltr. Rul. 974017 (Jul. 10, 1997).  The issuance of the ruling created a stir and the IRS, in 2000, indicate that it would further study the issue.  Rev. Proc. 2000-46, 2000-2 C.B. 438.  Later, in 2002, the IRS issued Rev. Proc. 2002-22, 2002-1 C.B. 733 setting forth 15 conditions (factors) indicating that an undivided co-ownership in rental real estate would not result in the creation of a federal tax partnership.  In essence, the factors point to the tenant-in-common owners not going beyond mere co-ownership of property to the point of engaging in business together.  The factors (e.g., “guidelines”) aren’t intended to be substantive rules and are not intended to be used for audit purposes. 

The factors (guidelines; conditions) set forth in Rev. Proc. 2002-22 are as follows:

  • Each co-owner must hold title as a tenant-in-common under local law;
  • The number of co-owners must be limited to no more than 35 persons;
  • The co-owners must not file a partnership or corporate tax return; conduct business under a common name; or execute an agreement identifying any or all of the co-owners as partners, shareholders or members of a business entity;
  • The co-owners may enter into a limited co-ownership agreement that may run with the land. These agreements may provide that a co-owner must offer its interest for sale to another co-owner at fair market value before exercising any right to partition;
  • The co-owners must unanimously approve the hiring of any manager; the sale or other disposition of the property; any leases of the property; or the creation or modification of a blanket lien;
  • Each co-owner must have the right to transfer, partition and encumber the co-owner’s undivided interest without the agreement of any person;
  • Upon the sale of the property, the net proceeds (after payment of liabilities) must be distributed to the co-owners;
  • Each co-owner must proportionally share in all revenues and costs generated by the property and all costs associated with the property pro-rata;
  • Each co-owner must share in all debt secured by blanket liens on the property;
  • A co-owner may issue an option to purchase its TIC interest, as long as the exercise price reflects the fair market value;
  • The activities of the co-owners must be limited to those customarily performed in connection with the maintenance and repair of rental real property;
  • The co-owners may enter into management or brokerage agreements, which must be renewable no less frequently than annually;
  • All leases must be bona fide leases for federal tax purposes. Rent must reflect the fair market value of the property;
  • The lender may not be a related person.; and
  • The amount of any payments to a “sponsor” must reflect the fair market value of the acquired co-ownership interest and may not depend on the income or profits derived from the property.

Private Letter Rulings

As noted above, one of the factors of Rev. Proc. 2002-22 is that a co-owner’s activities must be limited to those customarily performed in connection with the maintenance and repair of rental property and that the income from performing such activities is not unrelated business taxable income.   All of the activities of the co-owners and their affiliates concerning the property are taken into account, including the sponsor’s efforts to sell the tenancy-in-common interests in the property.  But, the activities of a co-owner or related person with respect to the property is ignored if the co-owner owns a tenancy-in-common interest for less than six months.  In Priv. Ltr. Rul. 200327003 (Mar. 7, 2003), however, the IRS determined that an undivided fractional interest in real estate qualified for like-kind exchange treatment and was not an interest in a business entity.  This ruling helped alleviate concerns about the imputation of activities of a sponsor.

In Priv. Ltr. Rul. 200513010 (Dec. 6, 2004), the IRS provided a good roadmap for real estate investors (and others) to follow when structuring fractional ownership arrangements.  The ruling was favorable to the taxpayer and detailed how to structure partition rights; co-owner purchase options; manager substation rights; and how a management company can properly operate without the arrangement being deemed to be a partnership. 

PMTA 2010-005 (Mar. 15, 2010) involved a situation where tenants-in-common had taken action to deal with a master tenant’s bankruptcy.  They appointed interim agents and there were temporary non-pro-rata contributions from some of the tenants-in-common.  The IRS concluded that the owners would not be treated as partners in a partnership for federal tax purposes. 

In 2016, the IRS issued additional guidance on a tenancy-in-common arrangement.  Priv. Ltr. Rul. 201622008 (Feb. 23, 2016).  The facts involved in the private ruling involved a co-ownership agreement between a landlord and a tenant and a management agreement that would become effective after the parties entered into a lease for the property at issue, and a call/put option for the lessee to buy a portion of the property.  The landlord owned a commercial office building via a single member limited liability company (LLC).  The tenant was to enter into a triple net lease with the LLC set at fair market value with the rental amount not tied to the income or profits derived from the property.  The transaction was incredibly complex, but the IRS determined that if the landlord/LLC  were to exercise the option and sell a tenancy-in-common interest to the tenant, the relations would not be considered to be a partnership, with the result that each a co-owner could sell his undivided interest in the property in a I.R.C. §1031 exchange because the conditions of Rev. Proc. 2002-22 had been satisfied. 

Accounting and Management

To avoid having a tenancy-in-common ownership arrangement be characterized as a partnership with the interests not eligible for like-kind exchange treatment, proper recordkeeping, accounting and management of the arrangement is essential.  Care should be taken not to account for the arrangement or manage it in the manner of a business entity.  Certainly, a partnership or corporate income tax return should not be filed, even though doing so might simplify reporting expenses and revenues of the arrangement.  

Election

A co-tenancy that is established for investment purposes (and not for trade or business purposes can elect to be excluded form partnership treatment.  I.R.C. §761(a)(1).  But, qualifying for the election can be difficult.  See Treas. Reg. 1.761-2.  The co-tenants must have chosen to be treated as a partnership pursuant to state partnership law and they must have limited involvement in the operation of the property (which might be the case with bare land ownership).  There also must be limited to no restrictions on the rights of co-owners to individually sell their interests, and there should not be any provision in the partnership agreement requiring a vote of a majority to transfer the asset.  In addition, each owner must be allocated a constant pro rata share of income and loss based on their share of ownership.  If these requirements can be satisfied, the election can be made by attaching a statement to the partnership return that is filed by the filing deadline for the partnership return for the year in which the partnership wants the election to be in place.  Whether a partnership agreement can be amended to satisfy the requirement so that an election can be made is an open question. 

Conclusion

Many tenancy-in-common arrangements exist in agriculture and elsewhere.  Avoiding partnership status so that a like-kind exchange can be achieved can be important in certain situations.  Knowing the IRS boundaries is beneficial. 

December 13, 2019 in Income Tax, Real Property | Permalink | Comments (0)

Thursday, December 5, 2019

“Slip Slidin’ Away” – The Right of Lateral and Subjacent Support

Overview

I have published articles on this blog on prior occasions concerning easements.  In those posts, I have noted that an easement can either be affirmative (entitling the holder to do certain things upon the land subject to the easement) or negative (entitling the holder to require the owner of the land subject to the easement to either do or not do certain things with respect to the burdened land).  Negative easements are synonymous with covenantal land restrictions and are similar to certain “natural rights” that are incidents of land ownership.

One of those natural rights that is an incident of land ownership (or may come along with an easement) is the right of lateral and subjacent support.  It’s such an important right, that some states have statutes concerning it.  See, e.g., Ohio Rev. Code Ann. §§723.49-50; Idaho Code §55-310. For example, California law states that, “each coterminous owner [owners having the same or coincident boundaries] is entitled to the lateral and subjacent support which his land receives from the adjoining land…”  Cal. Civ. Code §832

The right of lateral and subjacent support is not a right that many persons are familiar with, but it is an important right to all landowners.

Lateral and subjacent support rights – it’s the topic of today’s post.

The Basics of Lateral and Subjacent Support

Lateral support.  An owner of a tract of land has the right to have the surface of the tract be supported by the land lying beneath it.  “Lateral support” exists when the adjoining lands are side-by-side. It is the right of the land to be naturally upheld by its neighboring land(s) and supported against subsidence, i.e. slippage, cave-in or landslide.  Lateral support is a common law right – it’s a right incident to the land itself.  In addition, as noted above, some states have statutory provisions governing lateral support rights.

The right of lateral support raises questions when a landowner engages in construction and/or excavation activities.  In practice, a landowner’s right of lateral support of adjoining property is subject to the right of the adjoining owner to excavate and improve his property.  But, the neighbor’s excavation/improvement activity must be conducted in a reasonable manner.  This is conceptually similar to nuisance law – a landowner can do whatever they want on their property so long as they don’t unreasonably interfere with a neighbor’s right to do what they want on their property (that’s an oversimplification, buy you get the point).  If lateral support rights are alleged to have been violated, it’s a negligence-type tort. 

So how are these mutual rights balanced?  First, it’s a good idea (and required by statute in some states) to notify potentially affected neighbors (those beyond simply the owners of coterminous lands) of the excavation project in a manner that gives them sufficient time to protect their existing structures if those structures could be impacted.  State law might require the excavating party to protect neighboring land and buildings from damage. 

Subjacent support.  A subjacent support right is the right of surface land to be supported by the land beneath it against subsidence. Subsidence is the sinking or lowering of the earth's strata caused by the removal of a substance (e.g., soil, coal, water, or some other mineral or natural resource).  Subsidence usually appears as a sinkhole, trough, or fissure.  In essence, a surface landowner has a common law right to have the surface remain in its natural state without subsidence caused by an adjacent owner as well as subsidence that the subsurface owner might create. See, e.g.,  XI Properties, Inc. v. RaceTrac Petroleum, Inc., 151 S.W.3d 443 (Tenn. 2004).  Over the past two centuries, federal and state courts have developed legal principles to deal with subsidence and a surface owner's right of subjacent support, particularly as surface and subsurface estates have been severed (such as with oil and gas development).  The basic principle is that a property owner is owed lateral and subjacent support, from an adjoining landowner; has a right to be free from unreasonable nuisances; and other similar rights that the law may require.  See, e.g., Cecola v. Ruley, 12 S.W.3d 848 (Tex. Ct. App. 2000). 

Reasonable Use

The right of lateral and subjacent support is subject to an adjacent owner’s reasonable use of their property.  For example, in Finley v. Teeter Stone, Inc, 251 Md. 428 (Md. 1968), the conducting of quarrying operations was held to be a legitimate and reasonable use of land, and there was no suggestion that quarrying was unreasonable or inappropriate under the circumstances. Consequently, the adjacent landowners were not entitled to recover damages to their farmland from sinkholes on their land created by the quarrying activity because the landowners failed to claim or prove that there was any negligence in excavating or that the quarry operation was an unreasonable use.

As for severed estates, while both a surface owner and a subsurface owner (they could be the same or different parties depending on whether the surface estate has been severed from the subsurface estate) have the right (in accordance with either state common or statutory law) to access and divert/remove water (or minerals) beneath the surface of the property that is connected with legitimate use of the land, that right cannot be exercised in an unreasonable manner that causes injury to the similar right of an adjacent owner. The rule is that in situations where the ownership of the surface of the land has been severed from the ownership of the minerals under it, the owner of the surface has an absolute right to the necessary support of the land.  However, it is possible for that right to be altered by contract or conveyance (if the deed language waiving the right is clear and unequivocal). See, e.g., Jensen v. Sheker, 231 Iowa 240 (1941); Breeding v. Koch Carbon, Inc., 726 F. Supp. 645 (W.D. Va. 1989). 

Damages – Rights and Remedies

For claims asserting damages from lateral and subjacent support, the cause of action arises upon the subsidence of the land, not its excavation. In other words, a lawsuit may be brought only once the subsidence occurs, and for each separate occurrence.  The suit can be filed by the owner of the damaged property and any disaffected tenant against the party (or parties) responsible for the damage.  It also may be possible to head-off potential subsidence filing an action that seeks an injunction if it can be shown that the suspect activity would likely create irreparable damage.   

If a landowner is negatively impacted by subsidence of the surface of their property, the landowner is entitled to proven damages from the party that caused the subsidence.  See, e.g., Platts v. Sacramento Northern Railway, 205 Cal. App. 3d 1025 (Cal. Ct. App. 1988).   It doesn’t matter whether the subsidence was the result of negligent conduct (e.g., failing to conduct mining or excavation activities, for example, in a lawfully reasonable and proper manner).  Once damages are established, the responsible party is liable – at least according to the California Court of Appeals.  Id. 

While the right of lateral and subjacent support is not dependent upon the activities that a landowner conducts on the surface of their property, the owner of the surface has a responsibility to refrain from conduct that would contribute to subsidence.  Id.  For example, the owner of the surface has a duty to support buildings and other structures which were in existence at the time of the creation of the interest in the subjacent stratum.  A person who withdraws the necessary lateral and subjacent support of land in another’s possession or the support that substitutes the naturally necessary support will be liable for a subsidence of the land to the other that was dependent upon the support withdrawn.  See, e.g., Western Indiana Coal Company v. Brown, 36 Ind. App. 44 (Ind. Ct. App. 1905).   For example, in the early 1900s case of Collins v. Gleason Coal Co., 140 Iowa 114 (Iowa 1908), the plaintiff was the owner of the surface of the land and the defendant was the owner of the coal beneath the same land.  The plaintiff farmed the surface, and also had a house, outbuildings and trees on the property.  The defendant’s coal mining operations damaged the plaintiff’s property.  The court held that each party was entitled to use their respective property interests (the plaintiff’s surface estate and the defendant’s subsurface estate) in a manner that did not interfere or deprive the rights, benefits, profits and enjoyment of the other party’s property interest.  The surface owner was entitled, the court determined, to have an enforceable support right that was the basis for recovering damages.

Conclusion

The right of lateral and subjacent support, while not well known by landowners, is a well-recognized property right.  It’s just another one of those issues that can arise from time-to-time for a farmer, rancher, rural landowner, and any other owner of real estate.  “You know the nearer the destination, the more you’re slip slidin’ away.”

December 5, 2019 in Real Property | Permalink | Comments (0)

Thursday, November 21, 2019

Co-Tenancy or Joint Tenancy – Does it Really Matter?

Overview

For many farmers and ranchers, the land is the most significant asset that is owned, at least in terms of value.  Land value often predominates in a farmer or rancher’s estate.  How the land is titled is important.  Holding title in the proper form facilitates estate planning in accordance with expressed goals and can ease the tax burden upon death or upon subsequent transfer of the property by the heir or heirs.  Conversely, failing to title property appropriately can undermine estate planning expectations, create family disharmony and result in a higher tax burden.

The distinction between co-tenancy and joint tenancy and why it matters – it’s the topic of today’s post.

Tenancy-In-Common

A tenant in common holds an undivided interest in property that does not terminate upon the tenant predeceasing surviving co-tenants.  Upon the death of a tenant in common, that person’s interest passes under that person’s will (or in accordance with state law if there is no will (or trust)) to heirs of the deceased cotenant.  For federal estate and state inheritance/estate tax purposes, only the portion of the property owned by the deceased tenant in common is subject to tax. 

Joint Tenancy

The distinguishing characteristic of joint tenancy is the right of survivorship, with the surviving joint tenant or tenants taking all upon the death of a fellow joint tenant regardless of the terms of the deceased joint tenant’s will.  In other words, when a joint tenant dies, the deceased joint tenant’s share in the property passes to the surviving joint tenant (or surviving joint tenants).  It does not pass to the heir of the deceased joint tenant (tenants).  Upon the death of the last of the joint tenants to die, the joint tenancy is extinguished.    

In addition, upon a conveyance of real property, transfer to two or more persons generally creates a tenancy in common unless it is clear in the deed or other conveyancing document that a joint tenancy is intended.  A joint tenancy is created by specific language in the conveyancing instrument.  That specific language, often referred to as “magic words of conveyance,” clearly denotes the survivorship feature of a joint tenancy.  In addition, unless the conveyancing instrument is clear in its intent to create a joint tenancy, the legal presumption is against joint tenancy and that a tenancy-in-common was created.  For example, assume that O conveys Blackacre to “A and B, husband and wife.”  The result of that language is that A and B own Blackacre as tenants in common.  To own Blackacre as joint tenants O needed to convey Blackacre as required by state law to create a joint tenancy.  The language for creating a joint tenancy is typically to “A and B as joint tenants with rights of survivorship” or to “A and B as joint tenants with right of survivorship and not as tenants in common.”

Except for husband-wife joint tenancies, the survivorship feature may generate an unacceptable property disposition pattern upon death.  However, on the death of the first of the joint tenants to die, probate may be simplified or eliminated with title obtained by the surviving joint tenant perfected by showing non-liability for taxes and by proving the death of the decedent by affidavit or death certificate.  This is possible in most (but not all) states.

When it cannot be determined that two (or more) joint tenants have died other than at the same time an interesting problem may arise.  Most states have enacted a simultaneous death statute to handle just such a situation.  Such statutes typically provide that the jointly held property is to be divided into as many equal shares as there were joint tenants and that the share allocable to each joint tenant is to be distributed as if such joint tenant had survived all of the other joint tenants.

A major estate planning limitation of the joint tenancy form of property ownership is that the survivorship right of joint tenancy precludes the use of the life estate-remainder arrangement for the non-marital portion of the estate to reduce the death tax burden upon the survivor’s death.  The entire property, therefore, will pass to the survivor and may be taxed again in the survivor’s estate.  In addition, another problem with joint tenancy is that each joint tenant has a right to sever the joint tenancy relationship unilaterally (except for tenancies by the entirety).  As a result, a joint tenant furnishing consideration for acquisition of the property in effect grants to the other tenant a revocable interest that could be partitioned and severed at any time.  Consequently, each co-owner has the power to amend or destroy the other’s estate plan.

Joint tenancy is not a cure-all for tax planning but, depending upon the circumstances, it may be a convenient means of owning and passing property.  For total estates of each of the husband and wife under $22.8 million (for 2019), there is no federal estate tax liability.  Therefore, joint ownership may serve a useful purpose as a will substitute in the first estate for estates that are not potentially subject to federal estate tax.  However, since it is not known which joint tenant will die first, the estate of the surviving joint tenant will be subject to probate as an intestate estate (where death occurs without a will), unless the survivor prepares a will or otherwise disposes of the property.  For combined spousal estates exceeding $22.8 million (for 2019) in value, joint tenancy ownership may expose a portion of the total estate of the surviving joint tenant to additional taxes, causing an otherwise unnecessary reduction of the estate assets passing to the heirs or other beneficiaries.

Recent Case

A recent case from Texas illustrates the difference between tenancy-in-common and joint tenancy.  It also illustrates how misunderstandings about how property is titled can create family problems.  In, Wagenschein v. Ehlinger, 581 S.W.3d 851 (Tex. Ct. App. 2019), a married couple had seven children.  The parents also owned a tract of land.  Upon the last of the parents to die, each child held an undivided one-seventh interest as tenants in common in the tract.  In 1989, the heirs sold the land and but executed a deed reserving a royalty interest.  The deed reservation read as follows:  “THERE IS HEREBY RESERVED AND EXCEPTED from this conveyance for Grantors and the survivor of Grantors, a reservation until the survivor's death, of an undivided one-half (1/2) of the royalty interest in all the oil, gas and other minerals that are in and under the property and that may be produced from it. Grantors and Grantors' successors will not participate in the making of any oil, gas and mineral lease covering the property, but will be entitled to one-half (1/2) of any bonus paid for any such lease and one-half (1/2) of any royalty, rental or shut-in gas well royalty paid under any such lease. The reservation contained in this paragraph will continue until the death of the last survivor of the seven (7) individuals referred to as Grantors in this deed.” 

An oil and gas company drilled a producing well in 2010 and began paying royalties to the heirs. As each heir died, the credited their royalty interest to the surviving heirs of each deceased heir.  That had the effect of increasing the respective royalty payments of the surviving heirs.  There were no problems until 2015.  In 2015, a child of a deceased heir sued claiming that the deed crediting the royalty reservation to “Grantors and Grantors’ successors created a “tenancy in common” and not a “joint tenancy”.  If the deed created a tenancy in common, the children of the deceased heirs, rather than the surviving heirs, would inherit their parents’ royalty interests.  The trial court disagreed, noting that while the deed used “successor”, it only did so once and clearly and unambiguously reserved the royalty interest to the heirs and the “survivor[s]” of the heirs, rather than their “successors”, “heirs” or “beneficiaries.”  As such, the trial court concluded that the deed unambiguously created a joint tenancy with the right of survivorship, rather than an a tenancy in common that the children of the deceased heirs could inherit.   Thus, as each heir died, their interest in the tract passed to the surviving siblings, not their children.  On appeal, the appellate court affirmed. 

Conclusion

Properly titling property is important for various reasons – not the least of which is to fulfill expectations on property passage.  In the Texas case, confusion over how property was titled resulted in a family lawsuit.  Regardless of how the case would have been decided, some in the family would not be pleased.   

November 21, 2019 in Estate Planning, Real Property | Permalink | Comments (0)

Tuesday, October 15, 2019

Cost Depletion of Minerals

Overview

A taxpayer that is engaged in a trade or business can recover the cost of a business asset through depreciation.  In other words, an asset is not depreciable unless it is used in the taxpayer’s trade or business or used for the production of income.  In essence, the depreciation deduction is to account for the wear-and-tear of the asset as it is used in the business or to produce income for the taxpayer.   But, the asset must have a determinable useful life of more than one year.  Land, for example, is not depreciable because it does not have a determinable useful life.

But, there are other business and/or income-producing assets that are not eligible for depreciation.  For example, natural resources such as sand and gravel deposits, as well as deposits for oil and gas are not depreciated.  But don’t these assets wear out?  They do and can be eligible for a depletion allowance.  The deductible allowance for depletion is computed differently than is the deduction for depreciation.  One method of computing it is called “cost depletion.”   

The cost depletion method of computing deductions associated with oil, gas and other minerals – it’s the topic of today’s post.

Cost Depletion

Depletion is the descriptive term for the using of a natural resource by mining, drilling, quarrying or the like.  A depletion allowance allows the owner of the resource to recover the cost of the reduction of reserves of the resource as production and sales occur. To be a resource “owner” entitled to a claim depletion, the taxpayer must have an “economic interest” in the natural resource as an owner, and the legal right to the income from the extraction of the minerals.  In addition, a depletion deduction is only allowed when there is production and sale activity from the minerals which provides income to the taxpayer for the tax year. 

As noted, a taxpayer is entitled to recover the taxpayer’s cost basis in natural resources over the life of the resources.  The cost depletion method of computing that cost recovery is tied to the quantity of the resource sold each year.  There are unique rules that can apply when determining cost depletion on production payments, advance royalties, bonuses.  In addition, sometimes the computational rules are different depending upon the particular natural resource involved.  These unique aspects are beyond the scope of today’s post.

Via cost depletion, the taxpayer recovers the taxpayer’s capital investment (i.e., tax basis) in the minerals while the minerals produce income.  Thus, with respect to oil and gas, for example, the cost basis of the property must be allocated between the land and the associated capital assets that were acquired with the land purchase – fences; tile lines; buildings; equipment; and the mineral deposit.  The use of the cost depletion method is dependent upon having made these allocations.

Under the cost depletion approach, the taxpayer annually deducts a portion of the taxpayer’s capital investment, less prior deductions, that equal the fraction of the estimated remaining recoverable reserves that have been produced and sold during that particular year.  Over the life of the deposit, the total cumulative amount recovered under the cost depletion method cannot exceed the taxpayer’s capital investment.    

The IRS does not provide a form for computing the cost depletion deduction.  However, a formula is utilized to make the computation.  Under the formula, the deposit’s adjusted basis is divided by the units of the mineral deposit that remain as of the end of the tax year (i.e., total recoverable units).  The result of that is known as the “depletion unit” or a rate per unit.  That amount is then multiplied by the units of mineral that were sold within the tax year based on the taxpayer’s accounting method.  The taxpayer bears the burden of establishing basis, remaining units and the units sold during the year.  Treas. Reg.§1.612-1(b)(1)(i).  

With respect to oil and gas, cost depletion is computed with respect to each oil and gas property by reference to the total number of recoverable units that the property is estimated to contain, and the number of units sold from the property during the tax year.  Treas. Reg. §1.611-2(a).  An account is to be maintained for each property and annually adjusted for units sold and for depletion claimed.  Treas. Reg. §1.611-2(a).  The total recoverable units is the sum of the number of units that remain at year end plus the number of units of minerals sold during the tax year.  The landowner must determine the recoverable units of minerals via industry custom, and can utilize (by election) an IRS safe harbor.  See Rev. Proc. 2004-19, 2004-10 IRB 563.     

Consider the following example:

Jed buys a tract of land that contains a mineral deposit of sand and gravel.  Jed paid $500,000 for the tract, and his accountant allocated $125,000 to the land and $375,000 to the minerals.  Jed hired other experts to measure the amount of the marketable minerals via a geological survey and they determined that the deposit contained $100,000 tons of marketable minerals.  During the year, 5,000 tons of minerals were mined and sold.  Jed’s cost depletion deduction would be computed as follows:  $375,000/$100,000 x 5,000 = $18,750.                

In the second year (Year 2), another 5,000 tons of the sand and gravel are mined and sold. In Year 2, the property's basis has been reduced to $356,250 by the depletion allowed in the first year. Also, the units remaining as of the tax year have been reduced to 95,000 by the units sold in the first year.  The cost depletion deduction in Year 2 would be $18,747.37 ($356,200/95,000 x 5,000).   

The Importance of Basis

Clearly, properly computing income tax basis is critical to determining the proper depletion deduction.  The basis number only applies to the mineral property.  Thus, it doesn’t include non-mineral real estate or non-mineral assets that aren’t used for producing minerals.  It also doesn’t include the residual value of land and improvements when operations end.  Treas. Reg.§1.612-1(b)(1)(ii).   But, it does include capitalized drilling and development costs recoverable through depletion.  Treas. Reg.§1.612-1(b)(1).

Adjustments to basis will occur over time and include (as applied to oil and gas) oil and gas drilling and development costs that were capitalized. But, not included in any basis adjustment are any mineral exploration and development expenses that are treated as deferred expenses and any basis of depreciable property that is leased together with depletable mineral property.  Treas. Reg. §1.612-1(b)(1).

Deductions for cost depletion stop once the sum of the depletion deductions equals the cost or other basis of the property plus allowable capital additions.  Treas. Reg. §1.611-2(b)(2).  

Recordkeeping is essential.  The basis of the depletable property is to be recorded in a separate account, along with any capital additions and adjustments.  Treas. Reg. §1.611-2(b)(1).  If that’s not done, the cost depletion deduction may be lost for the tax year and/or upon later disposition of the property.  See, e.g., Winifrede Land Company, 12 T.C.M. (CCH) 289 (1953). 

Conclusion

Last year, I devoted a post to the issue of depletion of minerals.  https://lawprofessors.typepad.com/agriculturallaw/2018/07/the-depletion-deduction-for-oil-and-gas-operations.html.  Today’s post took a bit of a closer look at one aspect of depletion – cost depletion.  The depletion deduction can be complicated, but when big dollars are involved, getting it right matters.

October 15, 2019 in Real Property | Permalink | Comments (0)

Wednesday, October 9, 2019

Ag Law in the Courts

Overview 

Agricultural law issues in the courts are many.  On a daily basis, cases involving farmers, ranchers, rural landowners and agribusinesses are decided.  Periodically, on this blog I examine a few of the recent court decisions that are of particular importance and interest.  Today’s post is one such post.

Proving water drainage damage; migrating gas and the rule of capture; and suing for Clean Water Act (CWA)  – these are the topics of today’s post.

The Case of the Wayward Water

In Kellen v. Pottebaum, 928 N.W.2d 874 (Iowa Ct. App. 2019), the defendant installed a drain pipe that discharged water from the defendant’s land to the plaintiffs’ land. The plaintiff sued alleging that the pipe caused an unnatural flow of water which damaged the plaintiff’s farmland and sought damages and removal of the pipe. The defendant counterclaimed arguing that the plaintiff’s prior acts and/or inaction regarding the flow of the water caused damage to the defendant’s property. The trial court determined that neither party had established their claims and dismissed each claim with prejudice.

The appellate court affirmed.  As for the sufficiency of the evidence, the appellate court noted that the defendant owned the dominant estate and the plaintiff owned the servient estate. As such, if the plaintiff could prove that the installation of the pipe considerably increased the volume of water flowing onto the plaintiff’s land or substantially changed the drainage and actual damage resulted, the plaintiff would be entitled to relief. However, most of the evidence presented to the court was the observations of lay witnesses rather than measured water flow. Accordingly, the appellate court agreed with the trial court that the plaintiff did not prove by a preponderance of the evidence that installation of the pipe caused the increased water flow. The appellate court noted that a “reasonable fact finder” could attribute the additional water on the plaintiffs’ property to the increased rain fall during the years at issue. The appellate court also determined that the plaintiffs did not prove by preponderance of the evidence that installation of the pipe substantially changed the drainage. The water did not flow in a different direction on the plaintiff’s property. Rather, the defendant altered the flow of water across his property in a natural direction towards the plaintiff’s drainage, which is permissible under state (IA) law. Thus, the plaintiff did not prove harm by a preponderance of the evidence. The appellate court also concluded that the trial court did not abuse its discretion excluding some of the plaintiff’s evidence. 

Ownership of Migrated Gas

In Northern Natural Gas Co. v. ONEOK Field Servs. Co., LLC, No. 118,239, 2019 Kan. LEXIS 324 (Kan. Sup. Ct. Sept. 6, 2019), the plaintiff operated an underground gas storage facility, which was certified by the proper state and federal commissions. The defendants were producers with wells located two to six miles from the edge of the plaintiff’s certified storage area. Stored gas migrated to the defendants’ wells and the defendants captured and sold the gas as their own. The plaintiff sued for lost gas sales and the defendants moved for summary judgment on the grounds that the Kansas common law rule of capture allowed the gas extraction. The trial court granted the defendants’ motion. Two years later, the plaintiff received certification to expand the storage area into the areas with the defendants’ wells. Another dispute arose as to whether the defendants could capture the gas after the plaintiff’s storage area was expanded. The trial court held that the defendants could under the common law rule of capture.

On review, the Kansas Supreme Court reversed and remanded on the basis that the rule of capture did not apply. That rule, the Court noted, allows someone that is acting within their legal rights to capture oil and gas that has migrated from the owner’s property to use the migrated oil and gas for their own purposes. The rule reflects the application of new technology such as injection wells and applies to non-native gas injected into common pools for storage. However, the Court reasoned, the rule does not apply when a party (such as the plaintiff) is authorized to store gas and the storage is identifiable. The Court determined that state statutory law did not override this recognized exception to the application of the rule of capture. The Court remanded the case for a computation of damages for the lost gas. 

Jurisdiction Over CWA §404 Permit Violations – Who Can Sue?

A recent case involving a California farmer has raised some eyebrows.  In the case, the trial court allowed the U.S. Department of Justice (DOJ) to sue the farmer for an alleged CWA dredge and bill permit violation without a specific recommendation from the Environmental Protection Agency (EPA).  The farmer was alleged to have discharged “pollutants” into a “waters of the United States” (WOTUS) as a result of tractor tillage activities on his farmland containing or near to wetlands contiguous to a creek that flowed into a WOTUS.  Staff of the U.S. Army Corps of Engineers (COE) saw the tilled ground and investigated.  The COE staff then conferred with the EPA and then referred the matter to the U.S. Department of Justice (DOJ).  The DOJ sued (during the Obama Administration) for enforcement of a CWA §404 permit “by the authority of the Attorney General, and at the request of the Secretary of the Army acting through the United States Corps of Engineers.”  The DOJ alleged that the equipment "constituted a 'point source'" pollutant under the CWA and "resulted in the placement of dredged spoil, biological materials, rock, sand, cellar dirt or other earthen material constituting “pollutants” (within the meaning of 33 U.S.C. § 1362(6) into waters of the United States. The DOJ alleged that the defendant impacted water plants, changed the river bottom and/or replaced Waters of the United States with dry land, and "resulted in the 'discharge of any pollutant' within the meaning of 33 U.S.C. § 1311(a)." 

The defendant moved for summary judgment on the basis that the CWA authorizes only the EPA Administrator to file a CWA §404 enforcement action and that the court, therefore, lacked jurisdiction.  The court disagreed with the defendant on the basis that 28 U.S.C. §1345 conferred jurisdiction.  That statute states, “Except as otherwise provided by Act of Congress, the district courts shall have original jurisdiction of all civil actions, suits or proceedings commenced by the United States or by any agency or officer thereof expressly authorized to sue by Act of Congress.  The court rejected the defendant’s claim that 33 U.S.C. §1319(b) and 33 U.S.C. §1344(s)(3) authorized only the EPA to sue for violations of the CWA, thereby limiting the jurisdiction conferred by 28 U.S.C. §1345.  Those provisions provide that the EPA Secretary is the party vested with the authority to sue for alleged CWA violations.  The court determined that there is a “strong presumption” against implied repeal of federal statutes, especially those granting jurisdiction to federal courts.  In addition, the court determined that the defendant failed to show that the general grant of jurisdiction was irreconcilable with either of the statutes the defendant cited.  Accordingly, the court determined that the defendant could be sued by the U.S. Department of Justice upon the mere recommendation of the COE and without a specific recommendation from the EPA alleging a CWA violation, and in a situation where the CWA did not determine any CWA jurisdiction and only the COE did.  This finding was despite a 1979 Attorney General opinion No. 197 determining that the EPA and not the COE has the ultimate authority to construe what is a navigable WOTUS.

Ultimately, the parties negotiated a settlement. The settlement included $1,750,000 civil penalty. The land which the farmer’s acts occurred will be converted to a conservation reserve and a permanent easement will run with the land to bar any future disturbance.  The settlement also specified that the farmer would spend $3,550,000 "to purchase vernal pool establishment, re-establishment, or rehabilitation credits from one or more COE-approved mitigation banks that serve the [applicable] area . . . .".  The settlement also included other enforcement stipulations, including fines and the civil penalty for noncompliance.  No comments on the settlement were received during the public comment period, after which the settlement was submitted to the court for approval.  The court approved the settlement ad consent decree on the basis that it was fair, reasonable, properly negotiated and consistent with governing law.  The court also determined that the settlement satisfied the goals of the CWA in that it permanently protected the Conservation Reserve (which contained between 75 and 139 acres of WOTUS); fixed damage caused by unauthorized discharges; applied a long-term pre-clearance injunction; required off-site compensatory mitigation and recouped a significant civil penalty.  The case is United States v. Lapant, No. 2:16-CV-01498-KJM-DB, 2019 U.S. Dist. LEXIS 75309 (E.D. Cal. May 3, 2019)United States v. Lapant, No. 2:16-CV-01498-KJM-DB, 2019 U.S. Dist. LEXIS 93590 (E.D. Cal. Jun. 3, 2019).

Conclusion

The three cases summarized today further illustrate the various legal battles that involve farmers, ranchers and rural landowners.  They also illustrate the need to legal counsel that is well-versed in agricultural issues.  That’s what we are all about in the Rural Law Program at Washburn Law School – providing high-level training in agricultural legal and tax issues and then getting new graduates placed in rural areas to represent farmers and ranchers. 

October 9, 2019 in Environmental Law, Real Property, Water Law | Permalink | Comments (0)

Wednesday, August 28, 2019

How Does the Rule Against Perpetuities Apply in the Oil and Gas Context?

Overview

One of the most difficult concepts for law students, and practicing lawyers for that matter, is the Rule Against Perpetuities (RAP).  The rule bars a person from using a deed or a will (or other legal instrument) to control the ownership of property well beyond their death – known as “control by the dead hand.”  It’s an ancient rule of property law that is intended to enhance the marketability of property by limiting the ability to tie-up the ownership of property for too long of a time period.  Wedel v. American Elec. Power Service Corp., 681 N.E.2d 1122 (Ind. Ct. App. 1997).  The RAP is, essentially, grounded in public policy.  See, e.g., Symphony Space, Inc. v. Pergola Properties, Inc., 88 N.Y.2d 466, 669 N.E.2d 799 (N.Y. 1996).

The RAP often comes into play in estate planning situations with respect to wills and trusts, particularly in large estates where the desire is to keep land in the family for many generations into the future.   But, it can also be involved when real estate is transferred and oil production is present or might be in the future.  But the Rule has been applied to oil, gas, and mineral leases, too. If some future interest in a mineral deed is granted, the RAP requires the interest to vest (the point in time when a person becomes legally entitled to what has been promised) within 21 years of the lifetimes of those living at the time of the grant. If it is possible for the vesting to happen beyond that 21 years, then the Rule voids the contingent future interest.

Indeed, in 2018, the Texas Supreme Court modified the application of the rule in the context of oil and gas, and recently the Kansas Supreme Court refused to apply the RAP to a defeasible term mineral interest (an interest that is capable of being terminated/voided) – a very common form of mineral ownership.

The implications of not applying the RAP to oil and gas interests - that’s the topic of today’s post.

The RAP

The RAP originated In the late 17th century in England.  In the Duke of Norfolk’s Case, 3 Ch. Cas. 1, 22 Eng. Rep. 931 (Ch. 1682), Henry, the 22nd Earl of Arundel, created an estate plan that sought to pass a portion of his property to his oldest son (who was mentally disabled) and then to his second son.  Other property would pass to his second son, and then to his fourth son.  Henry’s estate plan also contained provisions for shifting property many generations later if certain conditions should occur.  When Henry’s second son succeeded to his older brother’s property, he didn’t want the property to pass to his younger brother.  The younger brother sued to enforce his interest as created by Henry’s estate plan.  The House of Lords held that the shifting condition that the estate plan created could not have an indefinite existence.  The Court was of the view that tying up the ability to transfer property for too long of a time period beyond the lives of the persons that were alive at the time of the initial transfer was impermissible.  Just how long was too long was not determined until 1833 in Cadell v. Palmer, 1 Cl. & Fin. 372, 6 Eng. Rep. 936 (H.L. 1832, 1833) where the court set the time limit at lives in being plus 21 years. 

A similar property law concept to the RAP is the rule barring unreasonably restraints on alienation.  Both concepts are based on the common law’s general distaste of restrictions on the ability to transfer property.  See, e,g, Cole v. Peters, 3 S.W.3d 846 (Mo. Ct. App. 1999).  But, the concepts are not identical – it is possible for an unreasonable restraint on alienation to occur without triggering the RAP.      

2018 Texas Case

In Conoco Phillips Co. v. Koopmann, 547 S.W.3d 858 (Tex. Sup. Ct. 2018), the Texas Supreme Court held that the RAP did not void a 15-year non-participating royalty interest that was reserved in a deed. Accordingly, the Court changed the application of the RAP such that, at least in Texas, it will not void an oil, gas and mineral deed if, regardless of the grant or reservation (it no longer makes a difference whether the interest is created by grant or reservation), the holder of the future remainder interest is at all times ascertainable and the preceding estate was/is certain to terminate.  Thus, according to the Texas Supreme Court the RAP will not apply if the future contingent interest is transferable and/or inheritable; the holder of the future interest is known or knowable at all time; and the previous estate is certain to end at some point. 

Recent Kansas Case

As noted above, a recent Kansas Supreme Court decision, Jason Oil Company v. Littler, No. 118,387, 2019 Kan. LEXIS 204 (Kan. Sup. Ct. Aug. 16, 2019), involved the application of the RAP to a defeasible term mineral interest.  The Court refused to apply the rule. 

A defeasible term mineral interest is a durational estate that involves a mineral, royalty or nonexecutive mineral interest for a fixed term of years and for an indefinite period of time thereafter, usually so long as oil or gas is produced.  That’s what was it issue in Jason Oil. 

In late 1967, a grantor executed two deeds conveying tracts of real estate in the same section of the county.  The east half of the section was conveyed to one grantee and the a quarter of the section was conveyed to another grantee.  Both deeds stated, “"EXCEPT AND SUBJECT TO:  Grantor saves and excepts all oil, gas and other minerals in and under or that may be produced from said land for a period of 20 years or as long thereafter as oil and/or gas and/or other minerals may be produced therefrom and thereunder."  The grantor died a few years later and the local probate court distributed set percentages of the residue of the grantor’s estate, including the reserved mineral interest, to the grantor’s descendants. 

The 20-year term expired on December 30, 1987.  From that time until May 31, 2017, there was no drilling activity on either tract and no gas or mineral production.  In 2016, the plaintiff sued to quiet title to both tracts.  The plaintiff claimed that it held valid and subsisting oil and gas leases.  One set of the grantor’s heirs claimed that they owned an interest in the minerals via the grantor’s will – the grantor owned a fee simple determinable in the mineral rights and that, as a result, they were devised an interest in the minerals.  However, another set of the grantor’s heirs claimed that those mineral interests were subject to an invalidated by the RAP because they were “springing executory interests.” 

Note: A springing executory interest is an interest in an estate in land created by the conditions of a grant wherein the grantor cuts short the grantor's own interest in the property in favor of the grantee, contingent upon the occurrence of a specific condition.   It’s an executory (future) interest that follows an interest that the grantor held upon the happening of a stated event. 

If the RAP applied to invalidate their interests, those heirs claimed that their interests should be reformed under the Uniform Statutory RAP contained in Kan. Stat. Ann.  §59-3405(b) to conform to the parties’ intent and avoid violating the RAP.  The other set of heirs continued to maintain that the RAP invalidated the other heirs’ interest and that the Uniform Statutory RAP was void for violating the Kansas Constitution.  As a result, they claimed that they owned the minerals by virtue of the residuary clause of the grantor’s will. 

The trial court held that a defeasible term mineral interest is a future estate reserved to the grantor and a reversion.  As a reversion remaining to the grantor, the court concluded, it wasn’t subject to the RAP.  In addition, the trial court determined that the grantor’s reserved right had not alienated the surface and mineral estates of the tracts. 

The Supreme Court agreed with the trial court that the decedent reserved a defeasible term interest.  However, the Supreme Court opined that the trial court “…veered off course” by finding (1) the future estate kept by the decedent in the mineral estate was a reversion and (2) the reservation of the defeasible mineral interest was a reversion and not subject to the RAP.  However, the Supreme Court declined to apply the RAP concluding that the application of the RAP would be counterproductive to the purpose behind the RAP and create “chaos.”  The Supreme Court held that when a grantor (the decedent in this case) creates a defeasible term (plus production) mineral interest by exception that leaves a future interest in an ascertainable person, the future interest in the minerals is not subject to the RAP.  In sum, the Supreme Court held that the RAP did not apply because the interest vested during a lifetime, however it reverted back to the surface estate because of the lack of production.  

Conclusion

Defeasible term mineral interests are prevalent with oil and gas properties.  If the RAP were to apply to these interests, the RAP would invalidate the grantee’s interest.  That would often be contrary to the parties’ intent.  In fact, had the Kansas court applied the RAP, the future right to the on-half mineral interest upon termination would be void and the landowner (and heirs) would own it forever.  Clearly, the parties in Jason Oil did not intend that result.  Thus, the Court’s refusal to apply the RAP advanced the underlying public policy of protecting the transferability of interests in land. 

The Kansas Supreme Court’s opinion is significant.  When application of the RAP would fail to promote transferability of interests in land, it should not be applied.  In addition, when a a particular form of property interest (such as a defeasible term mineral interest) has a long history of usage within a particular industry, it is not a good idea to have the RAP apply.  In that situation, it would have the serious potential of disrupting titles and impairing commerce in property rights.    These points are true even though the Kansas Supreme Court said it was creating a “narrow exception” to the RAP for defeasible term mineral interests.  That means the public policy implications of the Court’s decision could apply in future cases.

August 28, 2019 in Real Property | Permalink | Comments (0)

Thursday, July 11, 2019

More On Real Estate Exchanges

Overview

My post last fall on what constitutes real estate for purposes of a like-kind exchange under I.R.C. §1031 generated a great deal of interest among readers, lots of good questions and lengthy discussion. https://lawprofessors.typepad.com/agriculturallaw/2018/10/what-is-like-kind-real-estate.html  In light of that, it’s worth expanding the topic a bit to address some rather interesting scenarios that can arise in the context of like-kind exchanges.

That’s the topic of today’s post – a deeper dive on like-kind exchanges.

The Basics

I.R.C. §1031 provides for tax deferred treatment of real property that is exchanged for real property of “like-kind.”  Personal property trades were eligible for tax-deferred treatment before 2018, but now the provision only applies to real estate trades.  Thus, real estate that is used in the taxpayer’s trade or business or held for investment can be “traded” for any other real estate that the taxpayer will hold for use in the taxpayer’s trade or business or for investment.  It’s a broad standard.  For example, eligible real estate can be rental properties; farmland; office buildings; retail real estate properties; storage units; bare land held for investment; golf courses; conservation easements; partial interests in property; water rights (in some states (as pointed out in the prior post); and even vacation homes (if certain requirements are satisfied). In addition, the rules don’t require real property trades to be by type.  Any type of real estate can be traded with any other type.  Treas. Reg. §1.1031(a)-1(b).  What matters is the reason the taxpayer held the relinquished property and the replacement property.  

What About Property That Doesn’t Produce Income?

A permissible reason for trading real estate is to hold the replacement property on the hopes that it will appreciate in value.  Thus, real estate that is held for appreciation purposes without producing income can be traded for other real estate.  The replacement real estate can also be held for value-appreciation purposes.  Basically, this is a favorable tax rules for those that speculate on a tract of real estate appreciating in value.  It also means, for example, that a farmer can defer tax on a trade of farmland that the farmer uses in the farming operation for farmland that is not farmed but used for hunting or fishing purposes, etc.  The farmer is deemed to hold the replacement property for investment purposes.  But, whenever real estate is traded for real estate that will be held for investment purposes, depending on the real estate market, the replacement property should be held long enough to sufficiently illustrate the investment purpose of holding the replacement property.  There is no bright line to determined how long is long enough.

But, there is a distinction to note with respect to property held for investment purposes.  I.R.C. §1031 treatment does not apply to real estate that is held for resale or as inventory.  This is a rule that is of particular importance to land developers and building contractors.  That’s because the real estate that such parties hold constitute inventory.  The same result occurs for a taxpayer that acquires an apartment complex with the intent at the time of the acquisition of selling the complex to current occupants as condominiums.  The IRS views such deals as a “resale” transaction. 

The line between property that is held for investment purposes and property that is held for resale can be rather fine.  For example, what about a taxpayer that buys homes, renovates them and then as soon as the home has been renovated (i.e., updated) list the homes for sale at a profit?  You may have seen the television shows featuring parties that do this.  Rather than being sold, can these homes qualify for I.R.C. §1031 treatment?  It’s not likely.  In these situations, the IRS has a legitimate claim that the homes were acquired and “held” for the intent and purpose of selling them (resale) and not for investment purposes.  To qualify for I.R.C. §1031 treatment at some point in the future, the homes would need to be rented out for a period of time (the longer the better) or be clearly held for appreciation. 

Mixed-Use Real Estate

Quite often, the question arises as to how to handle a like-kind exchange of farmland when a personal residence is involved.  Indeed, I had this question come up at a tax seminar in Missouri earlier this week.  It’s a great question.  Many exchanges of farmland involve more than just bare farmland.  Buildings, structures, and the farm residence may also be involved in the transaction.  As for the personal residence, I.R.C. §121 allows the exclusion of gain of up to $500,000 on a joint return ($250,000 on a single return) if the taxpayer owned the home and used it as the taxpayer’s principal residence for at least two of the immediately previous five years.  If the residence gain can qualify for the I.R.C. §121 exclusion, the residence portion of the real estate should be parceled out from the other real estate that will qualify for a like-kind exchange?  Keeping in mind that an exclusion from income is better from a tax standpoint than is income tax deferral, as much real estate as possible should be included with the residence.  But, how much? The maximum benefit is obtained if enough real estate along with the residence can be combined to “max-out” the $500,000 exclusion. Certainly, land that is adjacent to the residence that is functionally used along with and as part of the residence counts as the “residence” for purposes of the I.R.C. §121 exclusion.  The caselaw is all over the board on this issue.  It’s a very fact-specific issue with the question being how much land can reasonably be claimed to be used along with the residence. For additional guidance on the matter see Rev. Proc. 2005-14, 2005-1 C.B. 528.

From a transactional and practice standpoint, the documents supporting the exchange (known as the “exchange agreement”) should detail only the real estate that qualifies for tax deferral under I.R.C. §1031.  To this end, it may be helpful to include in the documentation a map of the property that distinguishes the property that will be treated as the personal residence for purposes of I.R.C. §121 from the I.R.C. §1031 property with the exchange agreement only listing the I.R.C. §1031 property.  A closing statement can then be utilized for the I.R.C. §121 property, and then a separate statement can be used for the I.R.C. §1031 property.  Indeed, separate closing statements can be used in any transaction involving mixed-use properties – not just when a principal residence is involved. This is of particular importance post-2017 because personal property involved in a trade of real-property no longer qualifies for I.R.C. §1031 treatment.

Also, the IRS position is that property that is used for both business and personal purposes cannot be treated as two separate properties for purposes of the holding requirement – that the property be held for the productive use in a trade or business or for investment.  See, e.g., C.C.A. 201605017 (Jan. 29, 2016).    

Do Vacation Homes Qualify?

The upfront answer is, “no” – a vacation home doesn’t qualify for I.R.C. §1031 treatment.  It’s not qualifying property unless it is held for the right reason – as trade or business property or for investment purposes.  So, while a vacation home wouldn’t normally meet the test, it may be possible to convert the home to a qualified use to eventually allow it to qualify as part of an I.R.C. §1031 exchange.  That can be accomplished by the taxpayer renting the vacation home out and either limiting or eliminating personal use.  For example, in a case involving the exchange of two vacation houses, Moore, et ux. v. Comr., T.C. Memo. 2007-134, the Tax Court determined that the vacation homes at issue failed to qualify for I.R.C. §1031 treatment because the taxpayer failed to prove that they were held for primarily for investment.  Instead, the evidence revealed that the taxpayer basically used the home as a second residence and for personal vacation retreats for family.  The Tax Court also pointed out that the taxpayer did not rent or attempt to rent the properties; didn’t offer the replacement property for sale until forced to do so by liquidity needs; spent a great deal of time fixing up the property; kept a boat at the lake for personal use; didn’t claim any deductions for depreciation or maintenance expenses; claimed home mortgage interest deductions; and failed to maintain the relinquished property during the last two years of ownership (i.e., failed to protect the taxpayer’s investment in the property). 

But, Moore doesn’t stand for the proposition that a vacation home cannot qualify as part of an I.R.C. §1031 transaction.  Under an I.R.S. safe harbor (that was issued after Moore was decided), if the relinquished and/or the replacement property is owned for two years either immediately before or after the exchange; the taxpayer rents out the property at fair market value for 14 days or more during the tax year; and the taxpayer’s personal use of the property does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period during which the property is rented at fair market rental, the safe harbor applies.  See, Rev. Proc. 2008-16, 2008-1 C.B. 547.  In addition, the safe harbor is just that – a safe harbor.  A transaction involving a vacation home can still qualify under I.R.C. §1031 without being in the safe harbor, but it could be subject to IRS challenge. 

Conclusion

Like-kind exchanges are tricky.  While the rules presently in place only allow deferred tax treatment on real estate trades, the appropriate reason for holding the properties exchanged must be satisfied.  In addition, mixed use properties can present special problems.  Again, it’s best to seek out competent counsel.  And, one thing I didn’t address, is that often a “qualified intermediary” (Q.I.) must be involved in the exchange to make sure that deferred tax treatment is preserved.  One such Q.I. is a firm in Iowa operated by a colleague of mine (and his wife) that were in law school with me.  They do a fine job.  Let me know if you need assistance on trades and I can point you in the right direction. 

July 11, 2019 in Income Tax, Real Property | Permalink | Comments (0)