Tax Rules for Implementing Conservation or Climate-Smart Practices
The tax rules associated with implementing conservation and CSAF practices depend on the type of activity, the method of funding, and the involvement of the taxpayer. Most government program payments generate taxable income for producers. Farmers may presently deduct some related expenses as ordinary and necessary expenses associated with a trade or business. The cost of some conservation-related assets are recovered through depreciation deductions. Expenditures for non-depreciable improvements must be generally added to the basis of the land. I.R.C. § 175, however, allows farmers to presently deduct some of these expenses. In some cases, cost-share payments are excludable from income. Non-farming landowners are subject to different rules than producers. This section reviews these general rules.
Government Payments are Reported as Income
Farmers who receive USDA funding for implementing CSAF or conservation practices must generally include the compensation in their taxable income. Some cost share payments are excludable from taxable income, but as described below, excludable payments are limited to those funding capital improvements. Depending on the practice, the farmer may be eligible to deduct a corresponding expense.
Example – CSP Payment
In 2025, Grayson, a farmer, received an IRS Form 1099-G reporting a $8,500 payment from USDA. The payment was made through the Conservation Stewardship Program for (1) reducing tillage to increase soil health and soil organic matter content and for (2) improving nutrient uptake efficiency and reducing risk of nutrient losses. Grayson reports the $8,500 payment as income on lines 4a and 4b of IRS Form 1040, Schedule F. The payment is subject to self-employment tax.
Ordinary and Necessary Expenses
Some conservation and CSAF expenses qualify as (1) trade or business expenses, presently deductible under I.R.C. § 162 or as (2) ordinary and necessary expenses for the management and conservation of income producing property under I.R.C. § 212. To presently deduct these expenses, they must not be incurred to purchase depreciable property or to make non-depreciable property improvements. [I.R.C. § 263].
Examples of conservation or CSAF expenses that may qualify as ordinary and necessary expenses, deductible in the year of expense, include the following:
- The cost of the seed and labor to plant and harvest a cover crop
- The cost of routine brush clearing from land
- The removal of sediment from already-implemented drainage ditches
- Interest (deductible under I.R.C. § 163) and taxes (deductible under I.R.C. § 164) associated with conservation or CSAF projects
Note: Cost-share payments are only eligible for income exclusion under the tax code if the payment is not associated with an otherwise deductible expense. If a farmer receives a cost-share payment to cover the cost of a deductible expense, such as planting a cover crop, the farmer must consider the cost share payment to be ordinary income, subject to self-employment tax.
Example – Trade or Business Expense
Marty raises corn on 400 acres in Western Illinois. In 2024, she received $35/acre cost share payment through a government program to plant cover crops after harvest. Her total expenses were $50/acre. Marty may deduct $20,000 ($50 x 400) as a trade or business expense in 2024. She must include the $14,000 ($35 x 400) government payment in her farm income. She will report this income on IRS Form 1040, Schedule F, lines 4a and 4b.
Depreciation Deduction
Taxpayers may capitalize and depreciate some conservation expenditures. These include the cost to purchase, construct, install, or improve depreciable structures, appliances, or facilities. These include non-earthen items such as those made of masonry or concrete, as well as expenses in respect of depreciable property, such as materials, supplies, wages, fuel, hauling, and dirt moving for making structures such as tanks, reservoirs, pipes, conduits, canals, dams, wells, or pumps composed of masonry, concrete, tile, metal, or wood.
Earthen structures are generally not depreciable. Taxpayers may depreciate organic land improvements only when the improvement is subject to demonstrable and predictable exhaustion, or when it is associated with a depreciable asset in such a way that the land improvement is no longer useful to the taxpayer once the asset with which it is associated has completed its useful life. Everson v. U.S., 108 F.3d 234 (9th Cir. 1997). The cost of improvements inextricably associated with the land is added to the basis in the land, rather than depreciated. As explained below, eligible taxpayers may take an I.R.C. § 175 deduction for these expenses.
Drainage Management
Some water conservation projects may involve drainage water management. Drainage tile modifications or installations are generally depreciable over a 15-year period. [Asset Class 00.3 of Rev. Proc. 87-56]. This includes the cost of most water control structures that are part of the system and the cost of the installation. Materially participating operators would also be eligible for the I.R.C. § 179 expense deduction and bonus depreciation for the cost of new tile installation. Other landowners could generally depreciate the cost of the drainage tile improvements over a 15-year period. Although they would not be eligible for I.R.C. § 179 expensing (since they are not in the trade or business of farming), they would be eligible for bonus depreciation (60 percent in 2024) for the cost of the new tile.
Bioreactors
Denitrifying bioreactors reduce the concentration of nitrates in subsurface agricultural drainage flow via enhanced denitrification. Bioreactors consist of a buried trench with woodchips through which the tile water flows before entering a surface water body. The bioreactor is connected to the tiling system through water control structures.
A bioreactor does not show up on any MACRS table. It would, however, seem to be a component of the overall drainage facility, likely depreciable over 15 years. Bioreactors are permanently installed below ground and connected to the drainage system via water control structures. They are maintained with the periodic addition of new wood chips. Agricultural producers installing a bioreactor should be eligible to expense or depreciate the cost using Section 179 and bonus depreciation. Non-materially participating landowners could likely depreciate the cost of the bioreactor over a 15-year period or claim bonus depreciation.
Anaerobic Digesters
Incentives to implement anaerobic digestion to capture the methane in manure are increasing. Instead of implementing traditional manure management practices, some producers are installing anaerobic digesters to convert the manure to biogas, which can be processed into renewable electricity or natural gas. Several common business models exist. Farmers can own their own anaerobic digester, farmers can share a digester with others, and third-party companies can own the digester, create the biogas, and process it into renewable natural gas or electricity. Digesters can also process wastewater biosolids, food waste, and other organics such as crop residue. Current tax policy incentivizes these activities.
Producers who place an anaerobic digester into service can depreciate it over a seven-year MACRS life. [Rev. Proc. 83-35, 1983-1 CB 745]. If the biogas is used to produce electricity or transportation fuel, the producer may be eligible for the production tax credit [I.R.C. §§ 45, 45Y, or 45Z]. If the producer does not burn off the biogas, they may be eligible for the investment tax credit [I.R.C. §§ 48, 48E]. In other cases, the producer may sell manure or crop residue to the companies that are processing the biomaterial and earning tax credits.
Livestock producers who construct digesters may also be eligible to receive income from carbon credits or offsets.
Soil and Water Conservation Deduction
Many efforts to improve soil or water quality or to reduce carbon emissions require permanent improvements to the land. Under general tax rules, landowners add the cost of these improvements to the basis of the land. [I.R.C. § 263].
Some taxpayers engaged in the business of farming, however, may presently deduct costs paid or incurred (1) for the purpose of soil or water conservation on land used in farming, or (2) for the prevention of erosion of land used in farming, or (3) for endangered species recovery. [I.R.C. § 175]. This deduction is for expenditures that are not otherwise deductible or do not give rise to a deduction for depreciation. The I.R.C. § 175 soil and water conservation deduction—taken in the year the improvements are made—can be elected for conservation expenditures in an amount up to 25 percent of the farmer’s gross income from farming. Excess amounts carry forward to future tax years.
Defining Soil and Water Conservation Expenses
The I.R.C. § 175 deduction applies to expenditures paid or incurred for the purpose of soil or water conservation in respect of “land used in farming,” or for the prevention of erosion of land used in farming, but only if the expenditures are made in the furtherance of the business of farming. [Treas. Reg. § 1.175-2(a)(1)].
Additionally, these expenses must be consistent with a soil or water conservation plan approved by the USDA-NRCS or a comparable state agency for the area in which the land is located. Approved plans include:
- NRCS individual site plans
- NRCS county plans
- Comparable state agency plans (individual site plans or county plans)
Eligible expenses also include expenditures paid or incurred for the purpose of achieving site-specific management actions recommended in recovery plans approved pursuant to the Endangered Species Act of 1973.
Eligible Conservation Expenses
If paid pursuant to an approved plan, expenses eligible for the I.R.C. § 175 deduction include, but are not limited to, expenses for:
- Treatment or moving of earth, such as:
- Leveling
- Conditioning
- Grading
- Terracing
- Contour furrowing
- Restoration of soil fertility
- Expenses for fertilizer and lime for purposes other than soil or water conservation are not deductible under I.R.C. § 175, but farmers may elect to deduct these expenses under I.R.C. § 180.
- Construction, control, and protection of diversion channels, drainage ditches, irrigation ditches, earthen dams, watercourses, outlets, and ponds
- Eradication of brush
- Planting of windbreaks
IRS regulations also include the following specific examples of eligible expenses: (1) Constructing terraces, or the like, to detain or control the flow of water, to check soil erosion on sloping land, to intercept runoff, and to divert excess water to protected outlets; (2) constructing water detention or sediment retention dams to prevent or fill gullies, to retard or reduce run-off of water, or to collect stock water; and (3) constructing earthen floodways, levies, or dikes, to prevent flood damage to farmland. [Treas. Reg. § 1.175-2(a)(2)].
Further examples of conservation expenses, eligible for the deduction, should include those for creating conservation buffers, such as:
- Grassed waterways
- Contour grass strips
- Prairie Strips
- Field borders
- Filter strips
- Riparian buffers
Note: Although I.R.C. § 175 applies specifically to soil and water conservation practices, it should apply to most CSAF practices implemented in accordance with an NRCS plan. CSAF practices such as filter strips, grassed waterways, and field borders, for example, are specifically categorized as “soil health” practices in the USDA CSAF Mitigation Activities List.
Non-Eligible Conservation Expenses
I.R.C. § 175 applies only to expenses for non-depreciable items, which include most earthen improvements. It does not apply to expenditures for the purchase, construction, installation, or improvement of depreciable structures, appliances, or facilities. Nor does it apply to any expenses in connection with the draining or filling of wetlands or land preparation for center pivot irrigation systems.
Additionally, I.R.C. § 175 does not apply to expenditures that are deductible under another provision, such as I.R.C. §§ 162, 212, 163 (interest), or 164 (taxes). [Treas. Reg. § 1.175-2(b)].
Engaged in the Business of Farming
To be eligible for the I.R.C. § 175 deduction, the taxpayer must be “engaged in the business of farming.” IRS rules state that taxpayers are engaged in the business of farming if they cultivate, operate, or manage a farm for gain or profit, either as owner or tenant. [Treas. Reg. § 1.175-3]. Typical crop share or livestock share landowners are eligible for the deduction, even if they do not materially participate in the farming business. Landowners with a fixed rent lease and no material participation, however, are not eligible to take the deduction. Additionally, taxpayers are engaged in “the business of farming” if they are members of a partnership engaged in the business of farming.
The rules state that the following taxpayers are not engaged in the business of farming.
- Owners who receive a fixed rental payment (without reference to production), unless they materially participate in the operation or management of the farm
- A taxpayer engaged in forestry or the growing of timber
- A person cultivating or operating a farm for recreation or pleasure rather than a profit
For the purpose of this deduction, the term “farm” is used in its ordinary, accepted sense and includes stock, dairy, poultry, fish, fruit, and truck farms, and also plantations, ranches, ranges, and orchards. A fish farm is an area where fish are grown or raised, as opposed to merely caught or harvested; that is, an area where they are artificially fed, protected, cared for, etc.
Example – Engaged in the Business of Farming
Ronald is a retired farmer who cash rents his 600-acre farm to Mia. Ronald does not materially participate in the farming operation. He reports his rental income on IRS Form 1040, Schedule E and does not pay self-employment tax on the income. In 2024, Ronald spent $16,000 to establish grassed waterways on the farm. He implemented the improvements pursuant to a state-approved water quality plan. Ronald may not deduct the cost of the grassed waterways on his 2024 return because he is not engaged in the business of farming. Instead, he must add the $16,000 expense to the basis of his land. If Ronald and Mia had entered into a non-materially participating crop share lease, Ronald would have been eligible for the I.R.C. § 175 deduction. He would have reported the deduction, along with his rental income, on Form 4835.
Land Used in Farming
For a taxpayer engaged in the business of farming to deduct otherwise eligible soil and water conservation expenses, the expense must be made on “land used in farming.” [Treas. Reg. § 1.175-3(a)]. IRS regulations state that this means land which is used in the business of farming, and which meets both of the following requirements:
- The land must be used to produce crops, fruits, or other agricultural products, including fish, or for the sustenance of livestock. The term livestock includes cattle, hogs, horses, mules, donkeys, sheep, goats, captive fur-bearing animals, chickens, turkeys, pigeons, and other poultry. Land used for the sustenance of livestock includes land used for grazing such livestock.
- The land must be or have been so used either by the taxpayer or his tenant at some time before or at the same time as the taxpayer makes the expenditures. Taxpayers will be considered to have used the land in farming before making such expenditure if they or their tenant has employed the land in a farming use in the past. If the expenditures are made by the taxpayer in respect of land newly acquired from one who immediately prior to the acquisition was using it in farming, the taxpayer will be using the land in farming if the taxpayer’s use of the land is substantially a continuation of its use in farming. The use does not have to be the same as that of the predecessor. The taxpayer must just continue to use the land for a farming purpose.
Example – Transfer of Ownership
Amie purchases an operating farm from Butch in the autumn after Butch has harvested his crops. Prior to spring planting when the land is idle, Amie makes certain soil and water conservation expenditures on the farm. At the time the expenditures are made the land is used by Amie in farming. Amie may deduct the expenditures under I.R.C. § 175, subject to the other requirements of the provision.
Example – Preparing Land for Farming
Christopher acquires uncultivated land, not previously used in farming, which he intends to develop for farming. Prior to putting this land into production, it is necessary for Christopher to clear brush, construct earthen terraces and ponds, and make other soil and water conservation expenditures. The land is not used in farming when the expenditures are made. Christopher may not deduct these expenditures under I.R.C. § 175. The expenses must be added to the basis of the land.
Example – New Farming Use
Donna acquires several tracts of land from persons who had been using the land for grazing cattle. Donna intends to use the land for growing grapes. To make the land suitable for this use, Donna constructs earthen terraces, builds drainage ditches and irrigation ditches, extensively treats the soil, and makes other soil and water conservation expenditures. The land is used in farming by Donna at the time she makes these expenditures, even though it is being prepared for a different type of farming activity than that engaged in by Donna’s predecessors. Donna may deduct these expenditures under I.R.C. § 175, subject to the other requirements of the section.
If a farmer incurs expenditures that benefit some land which qualifies as land used in farming and some land which does not, the farmer may take a deduction only for the portion of the expenditures that applies to the land used in farming. The deduction should be calculated based upon the proportion of eligible land to all benefitted land. If it is established by clear and convincing evidence that, in the light of all the facts and circumstances, another method of allocation is more reasonable than the proportionate method, the taxpayer may allocate the expenditures under the other method. [Treas. Reg. § 1.175-7(b)].
25 Percent Limitation
The soil and water conservation deduction is limited annually to 25 percent of the taxpayer’s gross income from farming. If the expenses are within this limit, the farmer must deduct all of the expenses.
Gross Income from Farming
For the purpose of I.R.C. § 175, gross income from farming includes income derived in “the business of farming” from the production of crops, fruits, or other agricultural products, including fish, or from livestock (including livestock held for draft, breeding, or dairy purposes). It does not include gains from sales of farm machinery or gains from the sale of land. Taxpayers are to compute their “gross income from farming” using the accounting method they use to determine gross income. [Treas. Reg. § 1.175-5].
Example – Gross Income from Farming
Perry, a cash method farmer, had several types of farm-related income in 2024.
- Proceeds from the sale of corn
- Gain from sale of culled breeding heifers
- Gain from the sale of a tractor
- Gain from the sale of 60 acres of farmland
- Interest on a loan he made to a neighboring farmer
As shown in the following chart, Perry’s total Gross Income from farming is $105,000. That means that his I.R.C. § 175 deduction in 2024 is limited to $26,250 (.25 x $105,000).
Gross Income from Farming
Income
|
Amount
|
Category
|
Sale of Corn
|
$100,000
|
Gross Income from Farming
|
Culled Heifers
|
$5,000
|
Gross Income from Farming
|
Sale of Tractor
|
$10,000
|
Not Gross Income from Farming
|
Sale of Farmland
|
$800,000
|
Not Gross Income from Farming
|
Interest on Loan
|
$10,000
|
Not Gross Income from Farming
|
Excess Carried Forward
If eligible conservation expenses in one year exceed 25 percent of the taxpayer’s gross income from farming, the excess expense may be carried over to be deducted in future tax years, with the deduction not exceeding the 25 percent limit in any year.
Example – 25 Percent Limit
If Perry from the last example had $54,000 in otherwise eligible I.R.C. § 175 expenses in 2024, he could deduct $26,250 of his expenses in 2024, and carry forward the additional $27,750 to 2025. In 2025, he could deduct those expenses, plus any 2025 conservation expenses, in an amount up to 25 percent of his 2025 gross income from farming. If Perry has an excess deduction in 2025, he may again carry it forward to 2026.
Application to NOLs
If the I.R.C. § 175 deduction (calculated by applying the 25 percent limit) creates a net operating loss, the NOL may be carried back or carried forward, as the NOL rules allow. The I.R.C. § 175 deduction included in the NOL is not subject to the 25 percent limit in the year to which it is carried.
Death of the Landowner
If the taxpayer dies before taking advantage of the full deduction carried over due to the 25 percent limit, the excess may not be deducted in the year of the landowner’s death, nor added to the basis of the land. The remaining deductions are lost.
Trust Income
Beneficiaries of farm trusts cannot include the distributive share of trust income in calculating their “gross income from farming” for purposes of the 25 percent limitation. Trusts with excess I.R.C. § 175 expenses cannot pass the excess expenses through to the beneficiaries. When the trust is terminated, any loss carryover resulting from a deduction of I.R.C. § 175 expenses, and any excess deductions, including the allowable I.R.C. § 175 deduction in the last taxable year of the trust, are available to the beneficiaries. Any excess I.R.C. § 175 deduction over the 25 percent limit, however, is not available to the beneficiaries at the termination of the trust, even though the trust would have been able to carry the excess deduction to a future year during its existence.
Sale of the Farm
Landowners who sell their farms cannot adjust the basis of the land at the time of the sale for any unused carryover of soil and water conservation expenses (except for deductions of assessments for depreciable property). If, however, they acquire another farm and return to the business of farming, they can start deductions again for the unused carryovers.
Choosing to Take the Deduction
In the first tax year during which they pay or incur eligible conservation expenses, farmers must choose whether to deduct them under I.R.C. § 175 or to capitalize them. [Treas. Reg. § 1.175-6]. No IRS approval is required to adopt the I.R.C. § 175 method of treating these expenditures as expenses; however, whichever method the taxpayer chooses becomes the required reporting method for future years.
Note: The election to adopt the I.R.C. § 175 method of treating conservation expenditures as expenses is made at the entity level for S corporations and partnerships.
Once a method is adopted, the taxpayer may request the consent of the IRS to change this method of reporting or to treat the expenses for a particular project or a single farm in a different manner. To get this approval, the taxpayer must submit a signed, written request by the due date of the return for the first tax year they want the new method to apply. Form 3115 should not be filed. Rather, the written request should include the following information
- Name and address
- The first tax year the method or change of method is to apply
- Whether the method or change of method applies to all soil and water conservation expenses or only to those for a particular project or farm. If the method or change of method doesn't apply to all expenses, the request must identify the project or farm to which the expenses apply
- The total expenses paid or incurred in the first tax year the method or change of method is to apply
- A statement that the taxpayer will account separately in their books for the expenses to which this method or change of method relates
The taxpayer should send the written request to the following address:
Recapture Requirement
Farmers who sell land that they held for less than 10 years must generally recapture at least a portion of the I.R.C. § 175 deduction they took for improvements made to that land. [I.R.C. § 1252]. If the land was held for five years or less at the time of sale, any gain on the sale of the land is treated as ordinary income, up to the full amount of any I.R.C. § 175 deductions. From years six through nine, the maximum percentage of gain treated as ordinary income phases down, until recapture ceases at year 10. The following chart illustrates these recapture percentages.
I.R.C. § 175 Recapture Percentages
If Land is Sold…
|
Maximum % of Gain Treated as Ordinary Income Is…
|
Within five years after the date it was acquired
|
100 percent
|
Within the sixth year after it was acquired
|
80 percent
|
Within the seventh year after it was acquired
|
60 percent
|
Within the eighth year after it was acquired
|
40 percent
|
Within the ninth year after it was acquired
|
20 percent
|
10 years or more after it was acquired
|
0 percent
|
The gain on sale and recapture of I.R.C. § 175 expenses are reported in Part III of IRS Form 4797, Sales of Business Property.
Cost-Share Exclusion
Generally, if a private company or a government agency pays the costs associated with a conservation project on a farmer’s land, those contributions or payments would be income to the farmer, reported in the year received.
In some cases, however, IRC § 126 provides that recipients of payments under certain conservation, reclamation and restoration programs may exclude all or a portion of those payments from income if the payments do not substantially increase the annual income derived by the taxpayer from the affected property. To qualify for the exclusion, the payments must be made for capital improvements. The payments cannot be made for rent or other services.
I.R.C. § 126 is especially helpful if the government payment is higher than the increase in value of the property because of the improvement. The exclusion is also beneficial if the allowable depreciation for an asset is less than the cost-sharing payment received.
Qualifying Programs
I.R.C. § 126(a) specifically provides that taxpayers’ gross income does not include the excludible portion of payments received from the following programs:
- The rural clean water program authorized by section 208(j) of the Federal Water Pollution Control Act [33 U.S.C. 1288(j)].
- The rural abandoned mine program authorized by section 406 of the Surface Mining Control and Reclamation Act of 1977 [30 U.S.C. 1236].
- The water bank program authorized by the Water Bank Act [16 U.S.C. 1301 et seq.].
- The emergency conservation measures program authorized by title IV of the Agricultural Credit Act of 1978.
- The agricultural conservation program authorized by the Soil Conservation and Domestic Allotment Act [16 U.S.C. 590a].
- The resource conservation and development program authorized by the Bankhead-Jones Farm Tenant Act and by the Soil Conservation and Domestic Allotment Act [7 U.S.C. 1010; 16 U.S.C. 590a et seq.].
- Any small watershed program administered by the USDA determined by the IRS to be substantially similar to the type of programs described above.
- Any program of a State, possession of the United States, a political subdivision of any of the foregoing, or the District of Columbia under which payments are made to individuals primarily for the purpose of conserving soil, protecting or restoring the environment, improving forests, or providing a habitat for wildlife.
The IRS has determined that the following small watershed programs are eligible programs, if the payments meet all necessary requirements:
Environmental Quality Incentives Program (Federal Agricultural Improvement and Reform Act of 1996)
EQIP combined four prior USDA programs: The Agricultural Conservation Program, Water Quality Incentives Program, Great Plains Conservation Program, and the Colorado River Basin Salinity Control Program.
Conservation Stewardship Program (Rev. Rul. 2006-45, 2006-2 C.B. 511)
NRCS typically accepts applications for CSP on a continuous basis. Deadlines are announced as funds become available. CSP contracts vary significantly, but the minimum contract payment is $1,500 per year. CSP has many types of payments. Some of the payments involve traditional cost -share reimbursements for conservation improvements, but others seek to incentivize farmers for implementing CSAF activities such as cover crops, reduced tillage, etc. The latter types of payments would not be eligible for an I.R.C. § 126 exclusion because they do not fund capital improvements.
Conservation Reserve Program (Rev. Rul. 2013-59, 2003-1 C.B. 1014)
Landowners who participate in the Conservation Reserve Program (CRP) enter into one or more 10- to 15-year contracts with the USDA under which they receive annual payments for establishing long-term resource conserving cover on eligible farmland. The taxation of these annual payments is not eligible for the I.R.C. § 126 exclusion. The taxation of these annual payments is discussed below. In addition to the annual payments, however, CRP provides some cost-share payments to farmers and ranchers to implement approved conservation-related practices on the land in return for cost-share payments equal to 50 percent of the actual or average cost of establishing a practice. Typically, cost-share payments range from $20 to $500 per acre. The Conservation Reserve Enhancement Program (CREP) is a component of the CRP program. CREP cost-share payments may be eligible for exclusion.
Agricultural Management Assistance Program (Rev. Rul. 2003-15, 2003-1 C.B. 302)
The Agricultural Management Assistance (AMA) Program supports producers who construct or improve water management structures or irrigation structures; plant trees for windbreaks or to improve water quality; and mitigate risk through production diversification or resource conservation practices, including soil erosion control, integrated pest management, or transition to organic farming. AMA is available in 16 states where participation in the Federal Crop Insurance Program is historically low: Connecticut, Delaware, Hawaii, Maine, Maryland, Massachusetts, Nevada, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island, Utah, Vermont, West Virginia, and Wyoming.
Other Eligible Programs
- Programs under the Watershed Protection and Flood Prevention Act
- The Emergency Conservation Program
- Flood prevention projects under the Flood Control Act of 1944
- The Emergency Watershed Protection Program
- Certain programs under the Colorado River Basin Salinity Control Act
- The Wetlands Reserve Program (replaced by the Agricultural Conservation Easement Program)
- The Soil and Water Conservation Assistance Program
- The Forest Land Enhancement Program
- The Forest Health Protection Program
- The Small Watershed Program
I.R.C. § 126 Eligibility
To be eligible for the I.R.C. § 126 income exclusion, payments must meet the following requirements:
1) The Secretary of Agriculture must certify that the payment was made “primarily for conserving soil and water resources, protecting or restoring the environment, improving forests, or providing a habitat for wildlife.”
2) The Secretary of the Treasury must determine that the payments do not “increase substantially” the annual income the taxpayer derives from the affected property.
- Under IRS rules, the maximum amount of the cost-sharing payment that the taxpayer may exclude from income is the present value of the greater of:
- Ten percent of the average annual income derived (gross receipts) from the affected property for the last three years or
- $2.50 times the number of affected acres.
3) The cost-sharing payment must be for capital improvements. No portion of the payment can be excluded if the payment is for a deductible expense. In that case, the appropriate deduction may be taken to offset that payment. This includes a deduction for trade or business expenses or the I.R.C. § 175 deduction described above.
Calculating Income Associated with I.R.C. § 126 Exclusion
Income Received
If an improvement is eligible for the I.R.C. § 126 exclusion, taxpayers will calculate their income from the improvement using the following formula:
Value of the improvement − [excludable portion of the payment + taxpayer’s share of the cost (if any)]
Value of the Improvement
The value of the improvement is calculated by multiplying the fair market value of the improvement (the amount by which the improvement increases the farm’s value) by a fraction. The numerator of the fraction is the total cost of the improvement (including the total cost paid by the taxpayer and the government), minus the sum of (1) government payments not eligible for the I.R.C. § 126 exclusion, (2) any payment not certified to be primarily for conservation, and (3) any government payment for rent or services. The denominator is the total cost of the improvement.
Example – Income Exclusion Calculation
Cheyenne owns a 300-acre farm in Minnesota. In 2024, Cheyenne participated in a cost-share program with the USDA under which she installed filter strips and a concrete stabilization structure to prevent erosion. Cheyenne received $6,500 for the installation of the filter strips, which cost $12,000. She received $40,000 for installing the erosion structure, which cost $50,000. Cheyenne has received average gross income of $180,000 per year from crop production on the 300 acres, and she determines that 20 acres of her farm are affected by the erosion control structure. The erosion structure, a capital improvement, increases the value of the farm by $35,000. The cost-share program meets all I.R.C. § 126 requirements. What is the tax consequence to Cheyenne if she elects to exclude the cost-share payment under I.R.C. § 126?
Grassed Waterway
Because Cheyenne may deduct the cost of the filter strips under I.R.C. § 175, she must include the cost-share payment ($6,500) in income by reporting it on lines 4a and 4b of IRS Form 1040, Schedule F. She then deducts the entire cost of the filter strips ($12,000) as a conservation expense on line 12.
Concrete Erosion Structure
Because the concrete erosion structure is a capital improvement, Cheyenne must determine whether she can exclude the cost-share improvement from income under I.R.C. § 126.
Cheyenne must first calculate her cost-share income excludable amount, which is the present value of the greater of:
- Ten percent of the average annual income derived (gross receipts) from the affected property for the last three years (.10 x $12,000 [20/300 x $180,000] = $1,200) or
- $2.50 times the number of affected acres (20 x $2.50 = $50).
Assuming a 5.5 percent discount rate, Cheyenne’s excludable amount is:
- $1,200/.055 = $21,818
Cheyenne’s income from the new improvement is $3,182.
Cheyenne’s Income from the Cost-Share Payment
Cost of Improvement
|
$50,000
|
Payments not Eligible for I.R.C. § 126
|
-0
|
Compensation for Rent or Services
|
-0
|
Payments not Certified to be for Conservation
|
-0
|
I.R.C. § 126 Cost
|
$50,000
|
|
|
FMV of Improvement
|
$35,000
|
I.R.C. § 126 Cost ÷ Total Cost
|
× ($50,000 ÷ $50,000)
|
Value of Improvement
|
$35,000
|
Taxpayer Contribution
|
-$10,000
|
Excludible Portion
|
-$21,818
|
Amount Included in Income
|
$3,182
|
If Cheyenne elects out of the I.R.C. § 126 exclusion, her reportable income, reported on lines 4a and 4b of IRS Form 1040, Schedule F, will be:
- Value of improvement ($35,000) – taxpayer contribution ($10,000) = $25,000
Other I.R.C. § 126 Requirements
The taxpayer is responsible to define the “affected” property. The regulations define “affected acreage” as the acres affected by the improvement. The larger the area defined, the greater the income exclusion amount. I.R.C. § 126 applies to operating farmers and crop share or cash rent landowners, as well as rural non-farming landowners.
Note: Because non-farming and timber landowners do not qualify for the I.R.C. § 175 deduction, they may be eligible to exclude income under I.R.C. § 126 for non-depreciable improvements, as well as depreciable capital assets.
Reporting Requirements
The income exclusion is automatic for taxpayers who qualify. They may, however, elect not to exclude the payments. Those claiming the exclusion must attach a statement to their tax return including the (1) dollar amount of the government payment, (2) the value of the improvement, and (3) the amount of the payment the taxpayer is excluding. Cost-share payments are reported on Schedule F, line 4a, with only the taxable amount reported on line 4b.
The amount excluded from income is not added to the basis of the land. Taxpayers may add to the basis the capital contributions to the improvement minus the cost-share payment excluded from income. If a taxpayer elects not to exclude the cost-share payment from income, the payment is income to the taxpayer and the cost-share amount is added to the basis of the affected property.
Taxpayers electing not to exclude any or all of the payments received under a qualified program must make this election by the due date, including extensions, for filing the return. The taxpayer may amend a timely filed return within six months of the due date (excluding extensions) by writing “Filed pursuant to section 301.9100-2” at the top of the amended return.
Recapture
Some or all of the I.R.C. § 126 income exclusion is subject to recapture as ordinary income if the taxpayer sells or otherwise disposes of the property for a gain within 20 years of receiving the excluded payment. [I.R.C. § 1255]. If the property is sold within a 10-year period, the entire excluded portion is reported as ordinary income to the extent there is gain on the sale. If the property is sold more than 10 years after the payment is received, the recapture amount is reduced by 10 percent for each year or part of a year that the property is held more than 10 years. In other words, a sale in the fifteenth year causes the lesser of the gain or 60 percent of the excluded payment to be treated as ordinary income. Sale and recapture amounts are reported on IRS Form 4797, Part III.