Vinyards and Orchards 2010

Cost Recovery - Depreciation and Depletion

Because farming is a capital intensive industry, a farmer is allowed cost recovery or depreciation on machinery, equipment, and buildings. Depreciation is also allowed on purchased livestock acquired for breeding, draft, and sporting purposes, unless the farmer uses the accrual method of accounting and the livestock is included in inventory. A significant expense on a farm return is depreciation.

The same depreciation rules apply to farming as to any other business. In addition to MACRS, farmers and other taxpayers have three options for depreciating property acquired after 1986 (IRC § 168).

1. Use straight-line method over the regular MACRS recovery period.
2. Use straight-line method over the regular Asset Depreciation System (ADS) midpoint (also know as class life or ADS class life). This method is usually referred to as alternative MACRS.
3. Use 150% declining balance method over the longer ADR midpoint life. This method is available for property other than real property, and is usually referred to as 150% MACRS.

NOTE: Vineyards and orchards are limited to straight-line depreciation.

Farm property placed in service after 1988 is limited to the 150% declining balance on property used in a farming business with less than a MACRS recovery period of 15 years, rather than the 200% available for non-farm property. This change was enacted with TAMRA 88.

There are limits in the depreciation deduction a farmer may claim on listed property placed in service after July 18, 1994. If not used more that 50% in a qualified business, the deduction is denied.  If the property was placed in service before 1987, the property must be depreciated using the straight-line method over a longer life. Dollar limitations change yearly (IRC § 280F).

Alternative Minimum Tax (AMT) Adjustment
If the farmer is correctly using the 150% declining balance rate for farm assets placed in service after 1988,  there will be an Alternative Minimum Tax (AMT) adjustment. The 150% declining balance method for farm property under normal MACRS rules is calculated using the MACRS recovery period, but under AMT rules, the depreciable life is defined as the alternative MACRS life. Usually, this is a longer time span, and an adjustment will be required in computing AMT.

IRC § 179 Deduction
IRC § 179 is an election that must be made in the tax year that the property is placed in service. The maximum Section 179 deduction for taxable years beginning after 2002 and before 2008 is limited to $100,000 with an adjustment for inflation for any taxable year beginning in a calendar year after 2003 and before 2008. The ceiling is reduced by the excess cost of qualified property placed in service during the year over $400,000, which is subject to the above mentioned adjustment for inflation. Qualified property is tangible, depreciable IRC § 1245 property that is purchased for use in the active conduct of a farm business.

The following properties do not qualify for IRC § 179 deduction:

1. Property acquired by gift or inheritance
2. Property acquired by estates or trusts
3. For property traded in, only the cash paid is deductible as an IRC § 179 expense
4. The property acquired from a spouse, ancestor, lineal descendant, or a controlled entity
5. Trees and vines.  See “e” below, per Rev. Rul. 67-51, 1967-1 C.B. 68. 

IRC § 179 Recapture
Gains from sales of IRC § 179 assets are treated as IRC § 1245 gains. The amounts expensed are recaptured as ordinary income in the year the asset is sold. The IRC § 179 expense deduction is combined with depreciation allowed to determine the amount of gain reported as ordinary income on Form 4797. This also includes sales on the installment method.

If property placed in service after 1986 is converted to personal use, or if the business usage drops to 50% or less, the IRC § 179 recapture is applicable no matter how long the property was held for business use. The amount recaptured is the excess of the IRC § 179 deduction over the amount that would have been deducted as depreciation.

Special Depreciation Allowance
Farmers are eligible for the special allowance for additional depreciation for certain property acquired after September 10, 2001 and before January 1, 2005. Refer to Pub. 225 for the definitions and tests.  IRC §168(k). 

1245 Property

1. Tangible personal property such as equipment, machinery, tools and trucks (Buildings and structural components are not included).
2. Other tangible properties, for example, are:
   a. Fences in connection with raising livestock
   b. Paved feedlots
   c. Water wells that provide water for poultry, livestock, or irrigation of crops
   d. Drainage tiles
   e. Groves, orchards and vineyards if productive (Exempt from IRC §179 per   Rev. Rul. 67-51)
   f. Bins, gas storage tanks, silos
3. Livestock used for breeding cattle, hogs, sheep, and dairy cattle [purchased, not raised].
4. Single purpose livestock or horticultural structures.

Mineral & Water Rights
Review the schedule of capital assets. If mineral rights, including water rights, are on the schedule, how they were acquired needs to be questioned. Mineral rights can be acquired in various ways. They can be purchased along with the land or they can be bought and sold separately. If purchased as part of the land, review the allocation.  If an allocation was made, there should be an appraisal from a geologist. Mineral rights are a capital asset similar to land. A farmer who owns an economic interest in producing mines: oil, gas, or geothermal wells, or any other natural deposits may deduct a reasonable amount for depletion. Economic interest exists if the farmer has a legal right to receive income from the sale of natural resources. The farmer does not have an economic interest if there is only a right to buy or process the mineral deposits. The depletion deduction can be figured by either the cost method or the percentage method. Water rights are not depletable but may be subject to amortization in limited situations. As long as a farmer continues to be the owner of the land, then a loss cannot be claimed on worthless mineral rights. Any losses when the land is sold are capital losses.

Cost Depletion
Cost depletion, for water rights,  is allowed when it can be demonstrated that the ground water is being depleted and that the rate of recharge is so slow that once extracted, the water is lost to the farmer and to immediately succeeding generations. [See Rev. Rul. 82-214,1982-2 C.B. 115 and Rev. Rul. 65-296, 1965-2 C.B. 181.]

Percentage Depletion
This method may not be used for standing timber, soil, sod, dirt, water, or turf. The percentage depletion deduction cannot be more that 50% of the property’s taxable income determined without the depletion deduction and any net operating loss deduction.

For tax years beginning before January 1, 2005, the percentage for oil and gas properties is limited to 100% of the taxable income from the property (computed without the allowance for depletion). For tax years beginning after December 31, 2004, the taxable income is computed without the allowance for depletion and without the deduction under section 199. The 50% limitation still applies to all other depletable properties (IRC § 613).  This distinction is important because farmers often have oil and gas interests.

Consider the following when water depletion expense is present:

1. How was the ground water acquisition valued?
2. What is similar land selling for that does not have a good water supply?
3. Has the farmer sold farmland on which water depletion was taken? If so, has the basis of the farmland been adjusted by any cost depletion deductions claimed in prior years.

Commodity Bases
A commodity base is an amount used by the federal government to determine the amount of federal payments a farmer is entitled to receive if he chooses to participate in a federal program (see Chapter 2, Income). Commodity bases are available for most commodities, such as corn, cotton, wheat, and rice. Over the years the types of programs have varied. As of January 1996, the former payment program which included target prices, deficiency payments and acreage reduction payment programs was replaced with a new program (1996 U.S. Farm Bill) based on flexible production (see Chapter 2, Income). In order to qualify for the old programs, the farmer had to establish a production base in each commodity. This production base is a capital asset attached to the land and no amortization is allowed. If a parcel of land is purchased from a farmer who has established various commodity bases, then a part of the purchase price is allocable to the bases (Rev. Rul. 66-58, 1966-1 C.B. 186). Under the old program, the base amount was adjusted yearly based on yield.  A decrease in a base amount does not entitle the farmer to a loss for the decrease [Rev. Rul. 74-306, 1974-2 C.B. 58, explains that a deduction for this kind of a loss is not allowable under IRC § 165(a).]

The 1996 U.S. Farm Bill  programs were replaced by the 2002 Farm Security and Rural Investment Act (FSRIA), which provided for three different types of payments for more farm commodities:

• Marketing Assistance Loans: similar to prior program, including Loan Deficiency Pmts (LDP), Marketing Loan Gains (MLGs), Certificate Exchange Gains and Forfeiture Gains.
• Direct Payments: replaced Production Flexibility Contracts (PFC) and Agricultural Market Transition Act (AMTA) payments.
• Counter Cyclical Payments (CCP): new.

Farmers could decide to:

1. Keep their current program base acres, or update their base acres to
   reflect 1998-2001 cropping patterns.
2. Not update their base acres, and if soybeans are being grown, a 
   soybean base will be created. The farmer can have some other crop base acres shifted into the soybean base.
3. Update base acres and keep old program yields based on 1981-1985 levels or update yields based on 1998-2001 levels.

Program yields cannot be updated unless the base acres are updated. Loan Deficiency Payments or marketing loans have the same rules as in the prior program, but with new average loan rates. They can be taken any time from harvest until May 31 of the following year.  Direct Payments are based on the old program yields and the calculated “old” soybean yield, which become fixed once the base acres are determined. Payments for 2002 will be made as soon as possible after December 1; however, the FSA will deduct advance AMTA payments on 2002 crops first.  In following years, up to 50 percent will be paid in December prior to the crop year, and the rest in October in the harvest year. Counter Cyclical Payments are made when the national average prices are below the target levels specified in the bill by more than the amount of the direct payment rate. They will be paid up to 35 percent in October of the harvest year (based on projected prices), up to 35 percent in February, and the remainder after September 1. 

Basis on Farm Assets - Potential Issues

1. A full year depreciation claimed on assets not held a full year.
2. A full year depreciation claimed on assets purchased at the year end.
3. The most common issue is the allocation of cost to land and improvements. More often than not, an unreasonably low value will be placed on the land.  Land is a non-depreciable asset and is not deductible. (See example below)
4. Cultural expenses included in the sale of a farm with unharvested crops must be capitalized in the year of purchase by the buyer. The cost can be deducted in the year that the income from the crops is received. Look at the purchase escrow to see what the purchaser paid for these unharvested crops. Make sure that the right amount was allocated appropriately
   (See Rev. Rul. 85-82, 1985-1 C.B. 57).

Vinyards and Orchards