I have reviewed your memo regarding our client Howdy Brewster describing his business activities and the recent events which have occurred that could have an impact on his 2011 tax returns. His business is a farm and dairy operation on 850 acres of land. The land has been in the family for close to 125 years. There are three existing houses on his property.
Mr. Brewster recently signed a contract with Aztec Oil and Gas Pipeline to allow the company to lease a portion of his land in order to run a pipeline; Aztec will need access to maintain the pipeline over its useful life. Mr. Brewster received $9200 from Aztec. Aztec requested to know the boundaries of Brewster’s land; so Brewster paid a lawyer $7500 so that he and his neighbor would be in agreement on the issue.
In order to have access to water in times of drought he made a dam over a slow flowing stream on his property. The dam formed a small, approximately one acre reservoir which is for use by the livestock when needed. Construction of the dam cost $30,000. A payment of $35,000 was made to those living downstream (for inconvenience caused).
He and his family moved out of the inherited home and sold the house with a 22.5 acres parcel of land. Mr. Brewster’s basis in the inherited home is $75,000 and the basis on the land is $400 pr acre.
These issues are considered below to determine an appropriate tax regime.
The purpose of the lease by Aztec Gas and Oil Company is to run a pipeline through land belonging to Mr. Brewster. 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 has product moving through the pipeline. Based on this we can only assume the payment to Mr. Brewster from Aztec is a one-time lease payment including the future. The amount of money paid for the lease is 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. The surface area plus some buffer area (the easement) is no longer available for farming crops because farm equipment might dig too deeply into the ground and pierce the pipeline.
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 on the lease money. Mr. Brewster would also like a determination made on who is responsible for a payment of $7500 in attorney fees to establish the legal boundaries to his property to determine issues about the easement.
Mr. Brewster’s purpose in building the dam in 2011 downstream from the house he inherited from his parents was to provide his livestock with a reliable source water in case of dry weather. He paid $30,000 to construct the dam. The land now flooded with water has created about a one acre reservoir. Another issue is that he paid $35,000 to residents living downstream from the dam for the inconvenience he caused by building the dam. A determination needs to made about whether the amount paid to his neighbors for inconvenience is deductable or taxable.
Mr. Brewster sold the home he inherited from his parents. This home had been the 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.
Analysis of the Issues
Is Income Received by Mr. Brewster Subject to Capital Gains Tax?
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.
Easement and right-of-way were treated equally in the case, CONDEMNATION OF EASEMENT AND RIGHT OF WAY ACROSS LANDS OF Rosemarie K. CHRISTIANSON by UGI Utilities, Inc., For Public Purposes. Appeal of UGI Utilities, Inc. Argued Dec. 3, 2002. -- January 08, 2003 ] This court case established that an easement or right-of-way payment for a pipeline on private land could be paid to the owner of the land in the form of a onetime payment for rental of the area in which the pipeline as placed. 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) The issue of tax treatment with regard to capital gains is raised in the case of Work v. U.S. ex rel. Mosier [261 U.S. 352, 357 , 358 S., 43 S.Ct. 389].
Deduction of Attorney’s Fee
Mr. Brewster’s question of his payment to the attorney for boundary issues is answered in IRS (2011) which explains that attorney fees can be included in as additional expenses associated with the property at issue. For example if the land is the easement for the pipeline or the portion of the land sold with the inherited house; than Brewster can deduct the amount incurred Individuals may deduct attorney fees in the year the expenses were incurred. The IRS rule on attorney’s fees deduction is # 263 concerning capital expenditures. An appropriate allocation of attorney fees is illustrated in the cases of 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, IRS, 2012, § 1201).
Tax Treatment of Dam and Compensation for People Leaving Downstream
The dam was not built to make a profit so it is not a capital expenditure. By using the reservoir to hold water he is attempting to ensure there will be enough water for his livestock during periods of drought. The dam is a cost that produces a benefit to Brewster’s farm operation and is capitalized. The dam will be there for many years which meets the necessary criteria for IRC Prop. Reg. § 162, 1.263(a)-2(d)(4)(i) which requires the dam to be a benefit and last ‘substantially’ longer after the end of the tax year (IRC, 2012).
In compliance with IRC § 162, 212, 263 (f) the dam was made for Mr. Brewster’s in order to conserve water. The IRS is changing their historical rules on water uses due to the beginning of water shortages in the USA. Because Brewster’s motive is water conservation he needs to follow the specific IRS rules on constructing a reservoir for that purpose. . Also IRC §1237 provides the tax treatment of ‘necessary improvements which shall not be deemed as substantial improvement for purposes if the lot or parcel is held by the taxpayer for a period of 10 years or longer and if such an improvement is the building or installation of water of a water conservation system therefore constituting a substantial improvement.’
In accordance with I.R.C. §162(a) payments to his neighbors 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 case Guill v. Commissioner [112 T.C. 325, 328 (1999)] considers the tax deduction of miscellaneous expenses. The payments for inconvenience to his neighbors downstream constitute miscellaneous expenses. The expenses Mr. Brewster paid to those people directly relate to farming and livestock operation. The court recognized the legitimacy of deducting the miscellaneous expenses deductable. Similar cases address this issue, such as : Kornhauser v. United States [276 U.S. 145, 153 (1928)]; O’Malley v. Commissioner [91 T.C. 352, 361 (1988), aff’d. 972 F.2d 150 (7th Cir.].
Tax Treatment of the Home Residence Sold with the Parcel
Gates v. Commissioner 135 T.C. 1 (2010) David A. Gates and Christine A. Gates, Petitioners, v. Commissioner of Internal Revenue, Respondent Docket No. 19350-05, United States Tax Court, Filed July 1, 2010. 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  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)
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.
O’Barr v. Commissioner, 44 T.C. 501 (1965) mainly addressed the issue of a principal residence a piece of land being sold separately. But the statement was clearly made as an argument to the taxpayer (O’Barr) that the court would not accept that a house could be sold without land and therefore a qualification for deferral for paying the taxes was based on 121(a). They above mentioned court cases are based on amount of time taxpayers were dwelling in the house not the amount of the attached land.
If according to 112 (n) Brewster sold the inherited house and within one year moved into the new house downstream “gain if any from such sale shall be recognized only to the extent that the taxpayers’ selling price of the old residence (the inherited home) exceeds the taxpayer’s cost of the new home.”
Bogley v. Commissioner, 263 F 2d 746 (4th cir. 1959), revg. 30 T.C. 453 (1958) 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 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 qualifying as part of the principal residence. In accordance or parcel shall not “be deemed to be held primarily for sale to customers in the ordinary course of trade or business” nor as a part of tract of real property was not held by Mr. Brewster primary for sale under the same circumstances. 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, 263 F 2d 746 (4th cir. 1959), revg. 30 T.C. 453 (1958) 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.
Conclusions and Recommendations
In order to properly account payment and expenses for the tax purposes related events that occurred in 2011 Mr. Brewster should consider the following information:
1. The $9200 payment received from Aztec Oil and Gas Pipeline to Mr. Brewster. If the payment is less than the basis of the property; it just reduces the basis. But if the payment is equal or more than the basis, after reducing the basis to zero; the remaining is treated as a capital gain. The basis for Mr. Brewster’s land is $400/acre but we have no acreage values in order to predict the outcome.
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. Texas has precedents where similar lawsuits were affirmed in behalf of plaintiffs.
3. $30,000 was cost of dam construction. The dam is a cost that produces a benefit to Brewster’s farm operation and is capitalized. The dam is a cost that produces a benefit to Brewster’s farm operation and is capitalized. The dam will be there for many years and it meets the necessary criteria for IRC Prop. Reg. § 162, 1.263(a)-2(d)(4)(i).
4. Payments for inconvenience to his neighbors downstream should be reported as miscellaneous expenses. (Total paid for inconvenience was $35,000)
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. We consider that under the known information and the cases reviewed, Mr Brewster can sell the 22.5 acres of land with the dwelling and not incur any extra taxation. Exclude gain under section 121. (unless it is treated as personal residence and no business purposes)
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)
Internal Revenue Service. (2009). Publication f 535 Business Expenses.
Intern Reverse 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
Work v. U.S. ex rel. Mosier [261 U.S. 352, 357 , 358 S., 43 S.Ct. 389]
IN RE: CONDEMNATION OF EASEMENT AND RIGHT OF WAY ACROSS LANDS OF Rosemarie K. CHRISTIANSON by UGI Utilities, Inc., For Public Purposes. Appeal of UGI Utilities, Inc. Argued Dec. 3, 2002. -- January 08, 2003]