I have reviewed your memo regarding our client Howdy Brewster which describes his business activities and the recent events which may impact his 2011 Federal Tax Return. Here is a review of the factual information about Brewster which pertains to the income tax questions. His business is an eight hundred fifty acre farm and dairy operation. About 150 Holstein milk cows are part of the dairy operation. Approximately 150 Black Angus steers are raised to sell. Brewster has one part-time employee. He employs his two teen-age sons for the daily farm work. The land has been in the family for close to 125 years. There are three existing houses on the property. Brewster, his wife and their sons live in one of the houses until it was sold to Brewster’s nephews along with the surrounding 22 acres of land. Brewster and his family moved to one of the other houses on the property.
Mr. Brewster recently signed a contract with Aztec Oil and Gas Pipeline to allow the company to lease a portion of his land to run a pipeline; Aztec will need access to maintain the pipeline over the pipeline’s useful life. Mr. Brewster received $9200 from Aztec. Brewster paid a lawyer $7500 in order to determine the boundaries of his property. He was motivated to do this because Aztec requested the limits of his property boundaries.
In order to have access to water in times of drought Brewster built a dam over a slow flowing stream on his property. The dam formed a small, approximately one acre reservoir. The purpose of the reservoir is so the livestock will have water during droughts. Construction of the dam cost $30,000. A payment of $35,000 was made to the residents living downstream from the dam. The purpose of the payments which totaled $35,000 were for the inconvenience of not having as much water because most of it will be held in the reservoir on the Brewster property.
Brewster and his family sold the house which they had been using a principal residence and the adjoining 22.5 acre parcel of land to a nephew. The house which was sold with the 22.5 acre adjoining parcel of land had been inherited by Mr. Brewster. The basis in the inherited home is $75,000 and the basis on the land is $400 per acre.
These issues are considered below in order to determine the best tax treatment for Mr. Brewster. Consideration has been given to the desire of Brewster to be ‘fairly aggressive’ without taking too much risk. The following strategies should be defensible based on previous court findings identified with each issue.
Tax Issues
The amount of money paid is directly proportional to the amount of land above the underground pipeline. The pipeline has been placed and recovered with soil. The surface area directly above the pipeline plus some buffer area makes up the total area of the easement. A determination needs to be made on the payment of $9200 from Aztec to Mr. Brewster for the land holding the pipeline on whether or not tax must be paid. Is the $9200 taxable income or is it a nontaxable recovery of capital?
Mr. Brewster would like a determination on how to treat the payment of a $7500 in attorney fees to establish the legal boundaries to his property to determine issues about the easement. Is the $7500 paid as the attorney fee deductible or is does it need to be capitalized?
Mr. Brewster’s purpose in building the dam in 2011 downstream was to provide his livestock with a reliable source water in case of dry weather. He paid $30,000 to construct the dam. Is the money spent for dam construction (the expenditure) deductible or is does it need to be capitalized?
Brewster paid $35,000 to the residents living downstream from the dam for the inconvenience he caused by building the dam. Was the amount paid to the downstream residents for inconvenience a capitalized expense or is it deductable?
Mr. Brewster sold one of the homes on the land he inherited from his parents. This home had been the principal residence for Mr. Brewster and his family until it was sold and they moved into another house on the property. The inherited house was sold with a 22.5 acre portion of land. A determination needs to be made on the tax situation of the sale of the house and land: (a) Should the gain from the house sale be treated as taxable or as deductible? (b) Should the entire 22.5 acres be included as part of the sale of the principal residence?
Analysis of the Issues
Is Income Received by Mr. Brewster Subject to Capital Gains Tax?
Aztec requires access to the pipeline for as long as it is in use. No mention was made of a ‘temporary lease’ or ‘removal of pipeline’ when the oil company no longer needs to use the pipeline. Based on this, an assumption might be made that the payment to Mr. Brewster from Aztec is a one-time lease payment including the future. The amount of money paid for the directly proportional to the amount of land above the underground pipeline. A trench was built for the pipeline. The pipeline has been placed and recovered with soil. Mr. Brewster received $9,200 under the terms of the contract signed with Aztec Oil and Gas Pipeline. Mr. Brewster received a one-time payment from the Oil Company. The land was not sold nor leased for any other business use except to hold the pipeline on his property The basis of the land is assessed to be $400 per acre. In the case of Lawrence E. Gilbertz and Verna Ann Gilbertz, Plaintiffs-Appellees v. United States of America, Defendant-Appellant [87-1 USTC 9116] (CA-10), U.S. Court of Appeals, 10th Circuit, 84-1323, 1/7/87, 808 F2d 1374., Reversing, affirming and remanding the District Court, 84-1 ustc 9138 , 574 FSupp 177 the court held that payment received for easement must be considered as basis in other words “miscellaneous payments represent a recovery of basis in the ranch.” In the case of Tom Linebery and Evelyn Linebery, Petitioners v. Commissioner of Internal Revenue, Respondent, U.S. Tax Court, CCH Dec. 33,159, T.C. No. 33,159, 64 T.C. No. 108, 64 T.C. No. 9, (Apr. 28, 1975) the court held that the payments for the pipelines (owned by Shell and carrying water) must be considered as ordinary income.
[Tax Research Consultant, FARM: 3, 158, Farm Income: Easements and Rights-of-Way. Revenues received for granting easements (or rights-of-way) on a farm (or ranch), (for flooding land), for laying pipelines] A farmer allows pipeline to be laid on their farm and continues to grow crops on the surface over the top of the laid pipeline. ‘If the payment received is less than the basis for the area affected; the basis becomes equal to zero and the rest of payment is a gain. If the farmer owned the property for more than one year; gain is treated as a Section gain.’ (CCH)
The IRS states that if the payment is less than the basis (the assessed purchase price) no tax is due. If the payment is greater than the basis, capital gain tax needs to be paid on the total amount above the basis. If the pipeline will at some later date be removed than rent payment should be treated as rent payment for any other land or building. (IRS, 2009, 353; IRS, 2009, 225)
Attorney’s Fee
Aztec requested clarification of Brewster’s property boundaries which was necessary to perfect title. Brewster paid attorney fees amounting to $7200. Brewster’s payment to the attorney to establish his property’s boundaries is not a nondeductible capital expenditure. The IRS Section 263 (2011) concerns capital expenditures on attorney’s fees’ deduction. Expenditure incurred to defend or perfect title to property must be capitalized and is not deductible. In the case Charles H. Butler and Judith K. Butler v. Commissioner, U.S. Tax Court, CCH Dec. 52,241(M), T.C. Memo. 52241(M), 74 T.C.M. 552, T.C. Memo. 1997-408, (Sept. 15, 1997, the Butler’s were not allowed to deduct the attorney fees the paid because the money paid was to perfect title. Any expense paid due to the defense of perfect title is a considered capital and non-deductible. In the case of United States v. Gilmore United States Tax Cases (1913-1999), [63-1 USTC 9285], United States, Petitioner v. Don Gilmore et al., (Feb. 18, 1963), U.S. Supreme Court, (Feb. 18, 1963) 372 U.S. 39, 49 (1963), “the Supreme Court held that the deductibility of legal expenses is determined by the ‘origin’ and character of the claim with respect to which an expense was incurred, rather than its potential consequences upon the fortunes of the taxpayers.” In the case Deinlein v. Johnson 29 A.3d 714 (2011) 201 Md. App. 373 No. 788, September Term, 2010. Court of Special Appeals of Maryland. The petitioners wanted to receive reimbursement of attorney’s fees they had paid in order to perfect title on a piece of property they wanted to split into two parcels. They wanted to split the property for tax purposes. The case was decided that the petitioners could not be reimbursed because the expense paid was nondeductible and considered a capital expense.
Tax Treatment of Dam
Improvements to the land such as a dam could be treated either as tax deductions or as capital expenditures depending on Mr. Brewster’s intentions. A fundamental distinction between two types of tax treatment is whether the amount of $30,000 expended belongs to a capital expenditure or a deductible expense. In accordance with IRC Section 162,212 expenses attributed to profit making farm activities are deducted from income. In compliance with IRC Section 263 (C) the dam was made by Mr. Brewster in order to conserve water. By using the reservoir to hold water he would be ensure to have water during periods of drought. IRS Section 175 explains possibilities of deductions for water conservation and limits to 25% of Gross Annual Income.
The land now flooded with water has created about a one acre reservoir The dam was not built to make a profit so it is not a capital expenditure. By using the reservoir to hold water Brewster is attempting to ensure there will be enough water for the livestock Brewster owns during periods of drought. The dam is a cost that produces a benefit to Brewster’s farm operation and is capitalized. Brewster stated his intention was to conserve water so the livestock would have drinking water during a drought therefore the $30,000 cost of the dam can be deducted bade on IRC Section 175.
IRS Sect. 175 addresses water conservation. Sect. 175(a) states that a farmer can treat expenditures used by the purpose of water conservation (in respect to land used in farming) “as expenses which are not chargeable to capital account. Sect 175(c)(2) “Land used in farming” applies because the land was used as farm before the construction of the dam and the reservoir created by the dam is for use by the livestock. This particular expenditure can be allowed as a deduction. Sect. 175(b). The amount deducted cannot be greater than 25% of the Gross Income for any one year. If the amount is calculated to be greater than 25% for any given year the amount over 25% Gross Income can only be deducted over subsequent years (and each of these years no more than the amount over 25% Gross Income can be deducted).
Current Internal Revenue Code,SEC. 175. (CCH, 2012, Federal. Tax)
Compensation for Residents Living Downstream
In accordance with I.R.C. §162(a) payments to the residents living downstream (who were inconvenienced due to the building of the dam and making of the reservoir) can be allowed as ordinary and necessary expenses of a trade or business. The payments for inconvenience to the residents downstream are part of ordinary and usual business. The expenses Mr. Brewster paid to those people directly related to improvements he had made on his farming and livestock operation. In the case Sam C. and Patricia L. Evans v. Commissioner, U.S. Tax Court, CCH Dec. 32,808(Memo 1974-267, (Oct. 15, 1974) the couple had made extensive repairs to a dam which would cause it to last a long time. They were told to consider it a capital improvement and therefore an expense. The water conservation rules have nothing to say about compensation to the downstream residents if they are inconvenienced by loss of some of their water supply. Because in usual circumstances (not conservation purposes) a dam is an expense common sense suggests that any compensation paid due to the building of Brewster’s dam would also be a capital expense. The court held that in Evans v. Commissioner the treatment “costs incurred in the acquisition or disposition of a capital asset are to be treated as capital expenditures” according to the findings in Woodward v. Commissioner [ 70-1 ustc 9348], 397 U. S. 572, 575 (1970).
Tax Treatment of the Home Residence Sold with the Parcel
In the case David A. Gates and Christine A. Gates v. Commissioner., U.S. Tax Court, CCH Dec. 58,259, 135 T.C. No. 1, (Jul. 1, 2010) principal residence was defined as the house where the taxpayer had resided for at least five years before the date of sale. Definitions for ‘property’ and ‘principal residence’ were carefully scrutinized for the above case. A conclusion was made after considering dictionary definitions, legislative history and Congress’ intent that ‘property’ refers to as something owned such as a piece of real estate and ‘principal residence’ to refers to the primary home or the primary dwelling. To quote the conclusion “Although a principal residence may include land surrounding the dwelling, the legislative history supports a conclusion that Congress intended the section [2] exclusion to apply only if the dwelling the taxpayer sells was actually used as his principal residence for the period required by section 121(a).” ([135 T.C. 10] para. 2) To qualify as a principal residence must be owned and used for two to five years preceding its selling. The house Mr. Brewster inherited, then used as his principal residence, then sold meets the two necessary requirements. He lived in the house for over the minimum time. Therefore the sale of Brewster’s inherited home is not subject to sales tax law. The former principal residence of Mr. Brewster was sold to his nephew. Brewster agreed to credit his nephew for local property taxes from January 2011 to May 2011. Starting January, 1, 2012 his nephew took responsibility for the property taxes. Tax Treatment of the
Portion of Land Sold with the Home Residence
Mr. Brewster sold his inherited home for $225,000 along with an adjoining 22.5 acres of land. Bogley v. Commissioner, 263 F 2d 746 (4th cir. 1959) is an example of a case where the taxpayer sold the house with only 3 acres of the total 13 acres on which the house sat. After less than 12 months the 10 acre parcel of land was sold. In this case the Id. The Court of Appeals for the Fourth Circuit “concluded that the character of the 10 acres never changed and held that the sale of the 10 acres qualified as a sale of the taxpayers’ principal residence.” Id. At 748. The land and the house had been in Brewster’s family for about 125 years. Brewster had lived in the house with his family long enough the that the house and the land were considered one parcel of property. “The portion of the land adjacent to the home totals 22.5 acres according to the above case (Bogley v. Commissioner) the parcel could be sold while as part of the principal residence. In addition, being a part of a transaction “in which the entire interest in property is transferred to any person or persons” the sale of the parcel can be considered as exception under the provision There is an explanation of the tax treatment of the home selling with the adjacent parcel of land in the case of Bogley v. Bogley v. Commissioner. Unlike the case Hughes v. Commissioner, 54 T.C. 1049, 1055 (1970 )affd. Per curiam 450 F.2d 980 (4th Circ. 1971) where the original house and the land were sold in unrelated transactions; whereas the two transactions for sale of house and land were related transactions in Bogley v. Commissioner therefore allowing the 1034 exclusion In Hughes v. Commissioner the court referred to Bogley v. Commissioner, pointing out that (a) the 13 acres sold at a different time than the old residence were intact with the residence, the property did not necessarily have to be used as a residence by the seller on the sale date, and (c) the second (10 acre) parcel of land sold was considered as part of the seller’s former residence. The difference between Bogley and Hughes is that Hughes is dealing with a vacant plot of land shows no signs of improvement. (court referred to 112(n)(1) (now sec. 1034(a)) In court decision Section 1034 is interpreted as applicable to this type of case, the outcome depends on the particulars of the case brought to trial. In the case of O'Barr v. Commissioner [ Dec. 27,463], 44 T.C. 501 (1965) sold a tract of land on which their principal residence was setting but the tract of land was not sold with the principal residence. The land sold must include the former principal residence or the court explained “the taxpayer must dispose of their old dwelling.” Brewster was no longer living in his former principal residence as he had moved his family to another house on his property. In the case Hale v. Commissioner [ Dec. 39,339(M)], T.C. Memo. 1982-527 the court held that “The sale of a taxpayer's residence requires the sale of a structure which is used as a principal place of abode, and we have held that the sale of land without the structure does not constitute a sale of a residence within the meaning of section 1034.” Once again the difference in the Brewer situation is that the house on the property sold to his nephew had been the principal residence for many years. The property was sold to the nephew first with a 13 acre portion of the land and then with the adjoining portion which had been considered the principal residence for many years.
Conclusions and Recommendations
In order to properly account for payment and expenses for tax purposes Mr. Brewster should consider the following information:
1. The $9200 payment received from Aztec Oil and Gas Pipeline to Mr. Brewster.
The payment has to be compared to the basis because if the payment is less than the basis of the property then the only thing that happens is that the basis is reduced. But if after reducing the basis to zero, the payment is equal or more than the basis then the remaining is treated as a capital gain.
2. Attorney fees associated with establishing the boundaries of his land can be deducted. Deduct the amount paid from his expenses for the year the fees were paid.
3. Cost of dam construction.
Improvements to the land such as a dam could be treated either as tax deductions or as capital expenditures depending on Mr. Brewster’s intentions. Brewster stated his intention was to conserve water so the livestock would have drinking water during a drought therefore the $30,000 cost of the dam can be deducted bade on IRC Section 175.
4. The total of $35,000 Brewster paid to the residents downstream from the dam should be reported for inconvenience should be stated as a capital expense. The payment was due to the dam which is an improvement on the land which will last for longer than one year.
5. Selling his family’s principal residence the home he grew up in and inherited from his parents incurs no taxation based on his meeting the time limits for residency in the house. Exclude gain under section 121. (Sold for $225,000 including house and the 22.5 acres of land)
6. Mr. Brewster can sell the 22.5 acres of land with the dwelling and not incur any extra taxation IRS Section 121.
References
Primary
Bogley v. Commissioner, 263 F 2d 746 (4th cir. 1959), revg. 30 T.C. 453 (1958)
Church v. Commissioner [80 T.C. 1104, 1110 (1983)] and Alexander v. Commissioner [T.C. Memo. 1995-51, aff'd 72 F.3d 938 (1st Cir. 1995)] (IRS, 2011)
Deinlein v. Johnson 29 A.3d 714 (2011) 201 Md. App. 373 Frederick R. Deinlein v. Andrew R. Johnson, et al. No. 788, September Term, 2010. Court of Special Appeals of Maryland, September 30, 2011. Case No. CAE-99-10119.
Sam C. and Patricia L. Evans v. Commissioner, U.S. Tax Court, CCH Dec. 32,808(M), T.C. Memo. 32,808(M), 33 T.C.M. 1192, T.C. Memo. 1974-267, (Oct. 15, 1974)
David A. Gates and Christine A. Gates v. Commissioner., U.S. Tax Court, CCH Dec. 58,259, 135 T.C. No. 1, (Jul. 1, 2010)
Hale v. Commissioner [ Dec. 39,339(M)], T.C. Memo. 1982-527
Tom Linebery and Evelyn Linebery, Petitioners v. Commissioner of Internal Revenue, Respondent, U.S. Tax Court, CCH Dec. 33,159, T.C. No. 33,159, 64 T.C. No. 108, 64 T.C. No. 9, (Apr. 28, 1975)
O'Barr v. Commissioner [ Dec. 27,463], 44 T.C. 501 (1965),
United States Tax Cases (1913-1999), [87-1 USTC 9116], Lawrence E. Gilbertz and Verna Ann Gilbertz, Plaintiffs-Appellees v. United States of America, Defendant-Appellant , (Jan. 07, 1987), U.S. Court of Appeals, Tenth Circuit, (Jan. 7, 1987) Lawrence E. Gilbertz and Verna Ann Gilbertz, Plaintiffs-Appellees v. United States of America, Defendant-Appellant [87-1 USTC 9116] (CA-10), U.S. Court of Appeals, 10th Circuit, 84-1323, 1/7/87, 808 F2d 1374., Reversing, affirming and remanding the District Court, 84-1 ustc 9138 , 574 FSupp 177
United States Tax Cases (1913-1999), [63-1 USTC 9285], United States, Petitioner v. Don Gilmore et al., (Feb. 18, 1963), U.S. Supreme Court, (Feb. 18, 1963)
It is well settled that “costs incurred in the acquisition or disposition of a capital asset are to be treated as capital expenditures.”
Woodward v. Commissioner [ 70-1 ustc 9348], 397 U. S. 572, 575 (1970)
Secondary
(CCH) Federal Tax Court Databas. Accessed 24 April 2012 fro http://intelliconnect.cch.com.ezproxy.stthom.edu:2048/scion/secure/index.jsp#page[59]
Internal Revenue Service. (2009). Publication f 535 Business Expenses.
Internal Revenue Service. (2009). Publication 225 Farmers Tax Guide.
Internal Revenue Code. USA Congress. (2012). Legal Information Institute. Retrieved from http://www.law.cornell.edu/uscode/text/26
Internal Revenue Service (IRS). (2011). Lawsuits, Awards, and Settlements Audit Techniques Guide. Retrieved from http://www.irs.gov/businesses/small/article/0,,id=248471,00.html
Legal Information Institute (2012). Old Colony R. CO. v. Commissioner of Internal Revenue. No. 349. Retrieved from http://www.law.cornell.edu/supremecourt/text/284/552
