The value to society, from the benefits of various conservation program improvements, may be much greater than the benefits received by the taxpayer. Therefore, federal and state governments have encouraged farmers and other landowners to apply conservation practices and improvements through cost share incentives. Would it be expected that these cost share monies be provided tax free? Such is not the case. In fact, the general rule is for government payments to be included as income and subject both to income and self-employment tax. However, cost share payments are generally offset by the deduction of associated expenses. This article will discuss appropriate deductions to be taken and even the possibility of exclusion from tax, under certain conditions, for conservation cost share payments.
First, expenditures related to soil and water conservation practices may be deductible as ordinary and necessary business expense if they were incurred in the course of a trade or business and were not an asset with more than one year of useful life. Examples of seed used for a cover crop or for a grass waterway, the fertilizer as well, would be deducted on Schedule F as seed and fertilizer expenses. A concrete manure storage structure or field drainage tile are examples of items that may be depreciated or considered for I.R.C. Section 179 Expensing. These expenses are otherwise deductible and are not eligible for the soil and water conservation deduction under I.R.C. Section 175 (line 14 on Schedule F).
Second, farmers and share rent landlords may deduct soil and water conservation expenditures for non-depreciable capital improvements that would ordinarily be added to the basis of the land. These expenses must be consistent with a NRCS conservation plan. Under the I.R.C. Section 175 provision examples of these deductions include: the movement of earth for such things as leveling, grading, contouring or restoration of soil fertility; construction, control or protection of drainage ditches, earthen dams, waterways, outlets or ponds; the eradication of brush or planting of windbreaks. The taxpayer’s deduction limit per year is 25% of the gross income from farming. There is no limit as to how many years that excess expense may be carried forward.
Third, part or all of the cost sharing payments that a farmer, share rent landlord or cash rent landlord receives may be eligible for an election to exclude form income under I.R.C. Section 126. A somewhat complicated provision, it may be useful to either a cash rent landlord not eligible for section175 treatment of expenses since they receive no share of the crop production, or to a farmer in a situation that the government payment exceeds the allowable depreciation for a capital asset in the year it was placed in service. I.R.C Section 126 excludes part or all of certain cost sharing payments made under approved state and federal programs, to an extent that they were made primarily for the purpose of conserving soil and water, protecting the environment, or improving wildlife habitat. Furthermore, it may not substantially increase the annual income derived by the taxpayer from the affected property. The amount of gross income that a taxpayer realizes upon the receipt of a section 126 cost share payment is the value of the section 126 improvement reduced by the sum of the excludable portion and the taxpayer’s share of the cost of the improvement. Taxpayers may be surprised at how little, if any, cost share money is included in income under this formula.
The fair market value of an improvement is not defined under I.R.C. Section 126 or in the regulation, rather there is an example in a treasury regulation. The example is an improvement that cost $700,000 but had a fair market value (what a willing buyer would pay a willing seller for the improvement) of only $21,000. In other words, this expense did not add much market value to the property, however remember who receives the environmental benefit. In effect, it is all those taxpayers living down stream. This fair market value is further reduced by fraction defined in the regulation to arrive at the “Section 126 Value.” This value is further reduced by the excludable portion which is the market value of the right to receive annual income equal to the greater of 10% of the average annual income derived from the affected acres for the last three tax years or $2.50 per acre times the affected acres. To determine the market value, the present value is calculated by dividing the annual income by a discount factor (interest rate) such as an Applicable Federal Rate or the Federal Land Bank interest rate used for special use valuation. An example would be as follows:
Value of the Section 126 Improvement $90,000
Tax payers cost – 25,000
Excludable portion * – 150,000
Amount of Cost Share included
as income $ 0
* The excludable portion example is:
10% of $300 (3 year average income) = $30 income per acre X 300 affected acres divided by 6% discount factor equals the excludable portion $150,000.
To report the Secton 126 exclusion, attach a statement to the income tax return including the following: The dollar amount of the cost funded by the government payment, the value of the improvement, and the amount to be excluded. Report the total cost share payment on Schedule F line 6a and the taxable amount on 6b.
More information is found in the IRS Publication 225, The Farmers Tax Guide. It should be obvious that the assistance of a competent tax accountant or practitioner may be essential to accurately determine the income tax implications from cost share payments. Many tax practitioners have received training on this subject at the Ohio Income Tax Schools sponsored by OSU Extension and the Land Grant University Tax Education Foundation, INC. However complicated tax regulations are, it still should not discourage farmers or landlords from participating in conservation programs to save soil and water or to protect the environment.