By Wm. Bruce Clevenger, OSU Extension Educator, Assistant Professor
Agriculture is Ohio’s largest industry. Because much of the state is characterized by fertile, flat soils and adequate rainfall, crop production occurs on 45 percent of Ohio’s land area. About 55 percent of Ohio’s agricultural soils need drainage improvement to minimize soil erosion, excess soil-water conditions in the plant root zone, and unfavorable field conditions for farm equipment in the spring and fall. Improved drainage has been found to reduce water runoff, peak outflow rates, and sediment losses while increasing crop production yields. This increase in productivity increases the value of the land and land rents, but comes at a cost. It frequently will cost $600-$800 per acre to install systematic subsurface drainage tile and this expense must be written off over time as depreciation.
Depreciation is a term used in accounting to spread the cost of an asset over the span of the assets expected life. Depreciation reduces the value of the asset over time due to its use, wear and tear, or uselessness. Depreciation is a farm business expense deducted on a taxpayer’s Federal tax return.
Economic vs. Tax Depreciation
Economic depreciation relates to the asset’s declining ability to produce revenue as the asset wears out and ages. Farm managers need to plan for asset repairs and eventual replacement. Tax depreciation is the allowable business expense for IRS purposes. It may or may not be close to the economic depreciation. Farm drainage tile that has a zero or salvage value for tax depreciation may be efficient and productive on the farm if having been properly installed and well maintained.
To be eligible for depreciation, property must meet all the following requirements
• It must be property you own.
• It must be used in your business or income-producing activity.
• It must have a determinable useful life.
• It must have a useful life that extends substantially beyond the year you place it in service.
How is the Depreciation Figured?
To figure your depreciation, you determine (a) the depreciation system, (b) property class, (c) recovery period, (d) depreciation method, (e) basis amount, (f) placed-in-service date, and (g) convention.
Depreciation System, Property Class, Recovery Period, Depreciation Method
Farm drainage tile is depreciated under the (a) Modified Accelerated Cost Recovery System (MACRS) and (b) is classified as tangible property with a (c) recovery period of 15 years when using the General Depreciation System (GDS). MACRS provides three (d) depreciation methods under GDS and one method under the Alternative Depreciation System (ADS). However, the recovery period for drainage facilities (tile) are determined as follows:
• GDS – 15 years
• ADS – 20 years
For drainage tile, this means the choice of (d) depreciation methods are:
• GDS using 150% Declining Balance
• GDS using Straight Line (15 years)
• ADS using Straight Line (20 years)
If you are using the declining balance method, you switch to the straight line method in the year it provides an equal or greater deduction than the declining balance.
Farm drainage tile qualifies as IRS Section 179 property expensing. Section 179 allows for the recovery of all or part of the cost of certain qualifying property up to a limit, by deducting the expense in the year the asset was placed in service. A farm owner/operator or a crop-share landowner who is materially participating both meet the minimum criteria for using Section 179 on expensing of farm drainage tile. Cash-rent landowners do not qualify for Section 179 because they are not materially participating but they can use regular depreciation and “bonus” depreciation when offered by the IRS. Depreciation, Section 179 property expensing and “bonus” depreciation are subject to recapture (Section 1245 Property) upon the sale of the asset prior to the expiration of the recovery period.
A (e) basis amount is the beginning or adjusted value used to calculate the annual dollar amount deducted as a depreciation expense for each asset item. Any IRS Section 179 expense deduction and/or bonus depreciation is subtracted from the basis and the remaining balance is then depreciated.
When multiple assets are purchased or inherited in one transaction, the new owner must allocate the purchase price or estate value among the assets to establish the basis in each of the assets. If the buyer and seller agree on an allocation based on the value of each asset and the buyer and seller have adverse interests, the IRS will generally accept the allocation. IRC 1060 may require taxpayers to report the allocation on Form 8594 if the assets constitute a trade or business or if there is “goodwill or going concern” value attached to other assets. Regardless, the basis is allocated among the tangible assets in accordance with fair market values.
New drainage systems:
Fair market values for basis are easily determined if the landowner is adding a new farm drainage system. The basis becomes the cost of the material and the labor for installation minus any allowable Section 179 expense deduction and/or “bonus” depreciation.
Previously installed drainage system:
Fair market values for basis of previously installed drainage systems must consider several factors. The first is to ascertain how much tile is installed on the land in question. Tile maps, acquired from the previous landowner or the drainage contractor, are the best source of information. These maps should contain the location and size for laterals, mains, and control drainage structures. Another good source of information are depreciation schedules maintained since installation about the cost and amount of tile installed. Furthermore, aerial photographs taken following a heavy rain early in the year when vegetation is sparse or non-existent often reveal the location of mains and laterals. Aerial photographs may be available from local soil and water conservation district offices or free on-line computer software (ie Google Earth©). Once the amount and size is determined, replacement cost is often used as the starting point to determine fair market value of the drainage tile system. The replacement cost is typically discounted to reflect the age, size and material of the tile as well as the condition of the tile field. The fair market value calculated may not coincide with the remaining basis of the previous owner’s depreciation schedule. In the absence of evidence, the IRS suggests two options. One, check the property tax statements for the ratio between the land and the improvements. If the statement shows that land is 40% of total property value, then you know that 40% is not depreciable. Or two, the tile should approximate five percent of the cost of the unimproved land. This percentage method is rough and does not reflect the age, condition, size or type of the farm drainage tile.
In rare cases, comparable sales located in the area where comparable land can be found with and without tile lines, the taxpayer may be able to show the value of the farm drainage tile by showing the difference in the market value of land that does not have tile.
Placed-In-Service Date, Convention
You begin to depreciate your property when you (f) place it in service for use in your trade or business or for the production of income. You stop depreciating property either when you have fully recovered your cost or other basis or when you retire it from service, whichever happens first. Under MACRS, (g) averaging conventions establish when the recovery period begins and ends. The convention you use determines the number of months for which you can claim depreciation in the year you place property in service and in the year you dispose of the property. Use one of the following conventions:
• Mid-Month Convention
• Mid-Quarter Convention
• Half-Year Convention
Mid-Month Convention: Use this convention for nonresidential real property, residential rental property.
Mid Quarter Convention: Use this convention if the mid-month convention does not apply and the total depreciable bases of MACRS property you placed in service during the last 3 months of the tax year are more than 40% of the total depreciable bases of all MACRS property you placed in service during the entire year. Under this convention, you treat all property placed in service or disposed of during any quarter of the tax year as placed in service or disposed of at the midpoint of the quarter . This means that 1½ months of depreciation is allowed for the quarter the property is placed in service or disposed of.
Half-Year Convention: Use this convention if neither the mid-quarter convention nor the mid-month convention applies. Under this convention, you treat all property placed in service or disposed of during a tax years as placed in service or disposed of a the midpoint of the year. This means that a one-half year of depreciation is allowed for the year the property is placed in service or disposed of.
Over the past decade, Congress has repeatedly allowed faster depreciation of capital assets to stimulate business investment by providing a Special Depreciation Allowance or “bonus” depreciation allowance in the year the asset is purchased. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 extended the depreciation bonus for 2011 and 2012 to encourage new equipment purchasing. The additional first-year depreciation rules allowed farmers to deduct on their 2011 income tax returns 100% of the cost of qualifying assets purchased in 2011 and 50% of the cost of qualifying assets in 2012.
Farm Drainage Tile Depreciation Example
Assume that a crop-share rental landlord who is materially participating installs farm drainage tile costing $50,000 on his property in July, 2012. Assuming he meets the other requirements of Section 179 Expense Deduction and uses the GDS 150% Declining Balance method, his depreciation record could look like this for the first 5 years:
Original Basis $50,000
Section 179 $12,000
50% Bonus (2012) $19,000 ($50,000-$12,000 x .50)
Remaining Basis $19,000
2012 depreciation $950 ($19,000 x 5.0%*)
2013 depreciation $1,805 ($19,000 x 9.5%*)
2014 depreciation $1,625 ($19,000 x 8.55%*)
2015 depreciation $1,463 ($19,000 x 7.7%*)
2016 depreciation $1,317 ($19,000 x 6.93%*)
* Percentage tables are available in IRS Publication 946, How to Depreciate Property.
Total depreciation for 2011 for this farm drainage tile could be $31,950 ($12,000+$19,000+$950).
Common Questions & Answers
1. Do tile expenditures qualify for Section 179 Expense Deduction?
Answer: Maybe. The person paying for the tile has to be in a trade or business, be materially participating according to earned income rules, and meet Section 179 requirements. Therefore, a crop-share landowner may qualify; a cash-rent landowner would not.
2. Do I separate the cost of material from installation costs?
Answer: No, the total cost of installing the farm drainage system is considered the depreciable basis. Labor costs for installing the tile is a part of the total
3. Do I have recapture of depreciation as ordinary income if I sell the farm before the end of the depreciation (Recovery) period?
Answer: Yes, farm drainage tile falls in Section 1245 property so expensing, special depreciation, and regular depreciation must be recaptured to the extent it exceeds straight line depreciation upon sale of the property. The calculated recapture amount must be reported as income for the year the asset was sold.
4. Does the installation of farm drainage tile come under the Soil and Water Conservation Expense limits of 25% of gross income from farming?
Answer: No, assets that are depreciable are not eligible for deduction as Soil and Water Conservation Expense.
5. If the farm drainage tile installed has dual purposes (drainage and subsurface irrigation), are the depreciation rules changed?
Answer: No, it appears that the underground pipes and wells would qualify as Section 1245 property used as an integral part of production and therefore be 15-year MACRS property eligible for Section 179. Pumps and portable sprinklers are tangible personal property, qualify as Section 1245 property eligible for Section 179, and have a 7-year class life.
Landowners install farm drainage tile because it helps remove excess soil water, improve soil productivity, reduce erosion plus has a positive cost-benefit ratio ranging from 1.2 to 2.5 across various tillage and crop rotation systems. When properly installed and maintained in combination with improved surface drainage, it reduces year-to-year variability plus increase yields. However, the cost of installing, major improvements, or original basis must be written off as depreciation in an IRS approved method.
• Fleming, Robert D., “Farm Income Tax Management: Depreciation of Field Drainage Tile,” Ohio State University Extension, 2002.
• Harl, Neil E., “Depreciating farm drainage tile”, Agricultural Law Digest, Agriculture Law Press Publications, Kelso, Washington, January 2012.
• Internal Revenue Service, “Farmers Tax Guide,” Publication 225, Department of the Treasury, 2011.
• Internal Revenue Service, “How To Depreciate Property,” Publication 946, Department of the Treasury, 2011.
• McEowen, Roger, “Farmland Acquisition-Allocation of Value to Depreciable Items,” Iowa State University, Center for Agricultural Law and Taxation, Ames, Iowa. February 2011.