Tax Treatment of Water District Assessments

April 24, 2017


Introduction

Water districts in Iowa assess landowners in the district for the costs the district pays to build and maintain improvements such as drainage ditches, dams, terraces, water ways, and tile lines. Because these improvements benefit the land in the water district and not the public in general, landowners cannot deduct their assessment as a tax on real property.[1] However, I.R.C. §§ 164(c)(1) and 175(f) allow landowners to claim one the following income tax benefits for part or all of water district assessments.

  1. A deduction for the tax year in which he or she paid the assessment
  2. A deduction spread over ten years beginning with the tax year in which he or she paid the assessment, or
  3. An addition to the basis of the taxpayer’s land that is in the water district.

The tax benefit the landowner can claim depends on the water district’s purpose for the assessment and whether the landowner is in the business of farming for purposes of the I.R.C. § 175 soil and water conservation deduction.

Repairs, Maintenance, or Interest

 Landowners can deduct their assessment to the extent the water district used it to pay for

  1. the cost of maintaining or repairing improvements that benefit the land, such as cleaning out a drainage ditch or repairing a tile line, or
  2. interest on a loan to purchase those improvements.[2]

Maintenance expenses do not include expenses such as operating expenses, planning expenses, organization and administration expenses, the cost of engineering and legal services, the cost of office equipment, or the cost of billing.[3]

Because this deduction is allowed by I.R.C. § 164 rather than I.R.C. § 175, landowners can claim this portion of the assessment as a deduction whether or not they are in the business of farming for purposes of the I.R.C. § 175 soil and water conservation deduction (discussed later in this article). However, the landowner has the burden of showing the allocation of the amounts assessed for repairs, maintenance, or interest. If the landowner does not meet this burden, none of the amount is deductible.[4] Landowners must receive an itemized statement from the water district to have a basis for claiming a deduction.[5]

Non-depreciable Improvements

Generally, landowners cannot deduct the cost of assessments for amounts imposed because of and measured by some benefit inuring directly to the property assessed, such as streets, sidewalks, and other like improvement.[6] Those assessments are added to the basis of the property.[7] Water district assessments fall within this general rule.

However, there are some exceptions to the general rule. One exception is for assessments that cover the cost of repairs, maintenance, or interest paid by the assessing authority. As discussed in the previous section of this article, those assessments can be deducted in the year they are paid.

Another exception allows landowners who are in the business of farming to deduct a water district assessment if it covers expenditures that, if paid directly by the taxpayer, would have been deductible as a soil and water conservation expense under I.R.C. § 175.[8] This provision allows landowners to deduct assessments for the cost of the following[9] activities in the year they pay the assessment if the landowner and the expenses meet the requirements of I.R.C. § 175, which are discussed later in this article.

1. The treatment or movement of earth, such as:

a. Leveling,

b. Conditioning,

c. Grading,

d. Terracing,

e. Contour furrowing, and

f. Restoration of soil fertility.

2. The construction, control, and protection of:

a. Diversion channels;

b. Drainage ditches;

c. Irrigation ditches;

d. Earthen dams; and

e. Watercourses, outlets, and ponds.

3. The eradication of brush.

4. The planting of windbreaks.

Depreciable Property

Although farmers cannot deduct the cost of depreciable property used in their farming business as a soil and water conservation expense, I.R.C. § 175(f) allows landowners to deduct water district assessments for the cost of depreciable property used by the water district. This includes items such as pumps, locks, concrete structures (including dams and weir gates), draglines, and similar equipment.[10] However, the following limits apply to these assessments.

Total Assessment Limit

The landowner’s deduction is limited to 10% of the total assessment levied on all the members of the district for the depreciable property.[11] The landowner adds the amount over 10% to the basis of the land.[12] If the assessment is paid in installments, each payment must be prorated between the conservation expense and the capital expense.[13]

Yearly Assessment Limit

In any one year, landowners can deduct no more than 10% of their deductible share of the assessment for depreciable property (after applying the total assessment limit) plus $500. If landowners pay an amount equal to or less than that limit, they can deduct it in the year it is paid or incurred. If they pay or incur more than that limit, they can deduct in that year only 10% of their deductible share of the cost. They can deduct the remainder in equal amounts over the next 9 tax years. This deduction for an assessment that covers the cost of depreciable property plus the landowner’s other section 175 deductions for the year are subject to the 25% of gross income from farming limit, which is discussed later.[14]

Soil and Water Conservation Expenses

As discussed earlier in this article, landowners can deduct water district assessments as a soil and water conservation expense under I.R.C. § 175 if the water district used the assessment to purchase non-depreciable improvements or depreciable property, but only if the landowner meets the requirements of I.R.C. § 175. The requirements are:

  1. The expenditures must be consistent with a soil and water conservation plan approved by the Soil Conservation Service or a comparable state agency,[15]
  2. The land must be used in farming by the landowner or his or her tenant at some time before or at the same time as, the landowner makes the expenditures for soil or water conservation,[16]
  3. The expenditure must not be deductible as a current expense,[17] and
  4. The landowner must be in the business of farming in the year he or she pays or incurs the expenses.[18] Treas. Reg. § 1.175-3 defines “the business of farming” as follows:

“A taxpayer is engaged in the business of farming if he cultivates, operates, or manages a farm for gain or profit, either as owner or tenant. For the purpose of section 175, a taxpayer who receives a rental (either in cash or in kind) which is based upon farm production is engaged in the business of farming. However, a taxpayer who receives a fixed rental (without reference to production) is engaged in the business of farming only if he participates to a material extent in the operation or management of the farm. A taxpayer engaged in forestry or the growing of timber is not thereby engaged in the business of farming. A person cultivating or operating a farm for recreation or pleasure rather than a profit is not engaged in the business of farming. For the purpose of this section, 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 taxpayer is engaged in ‘the business of farming’ if he is a member of a partnership engaged in the business of farming.”

25% of Gross Income from Farming Limit

The landowner’s total I.R.C. § 175 expenses (from water district assessments and from his or her own conservation expenses) may not exceed 25% of his or her gross income from farming.[19] The excess can be carried over and deducted in subsequent years, subject to the 25% of gross income from farming limit.[20]

Sale of the Land

If the landowner sells the land before the end of the 10-year period for deducting water district assessments for depreciable property under the yearly assessment limit (discussed earlier in this article), the remaining deductions are added to the basis of the land before calculating the gain or loss from selling the land.[21]

If the landowner sells the land before deducting all the deduction carried over due to the 25% of gross income from farming limit, the remainder is neither deducted in the year of the sale nor added to the basis of the land. However, landowners who have gross income from farming in a year after selling the land can deduct the remaining carried over section 175 deductions subject to the 25% of gross income from farming limit.[22]

If the landowner sells land within 10 years of acquiring it, part or all the section 175 deduction for that land is recaptured[23] by treating part or all the gain from the sale as ordinary income. If the landowner sells the land within 5 years of acquiring it, the lesser of the gain realized or 100% of the section 175 deductions for the land is treated as ordinary income. If the landowner sells the land within the 6th through 9th year after acquiring it, the portion of the conservation deduction that is recaptured is reduced by 20% a year for each year or part of a year the landowner held the land after the 5th year. If the landowner disposes of the land 10 or more years after he or she acquired it, none of the conservation deduction is recaptured—the entire gain is a section 1231 gain.

Death of the Landowner

If the landowner dies before the end of the 10-year period for deducting water district assessments for depreciable property under the yearly assessment limit (discussed earlier in this article), the remaining deductions are deducted in the tax year the landowner died.[24]

If the landowner dies before deducting all the deduction carried over due to the 25% of gross income from farming limit, the remainder is neither deducted in the year of the landowner’s death nor added to the basis of the land. No one gets the benefit of the remaining deductions.[25]

Assessments Paid by Tenants

If a tenant pays a water district assessment for the rented land, the payment is treated as rent that is included in the landowner’s income and deducted by the tenant.[26] Because the landowner includes the payment in income as rent, he or she can deduct the payment or add it to the basis of land as if he or she had paid the assessment directly to the water district.[27]

Examples

The following examples illustrate the rules discussed in this article.

Example 1: Farming Landowner

Dandy Lion inherited his 600-acre farm from his mother when she died in 2005. The fair market value of the farm on her date of death was $900,000, which is his basis in the farm ($1,500 per acre). 150 acres of the farm are in the Weedy Water District. In 2016, the Weedy Water District assessed Dandy $6,350 for his share of the cost of the water district’s expenses shown in Figure 1.

Figure 1: Dandy’s 2016 Assessment

Project

Water District’s Cost

Dandy’s Assessment

Cleaning drainage ditches

$  5,000

$   450

Repairing tile lines

15,000

1,200

Building a new earthen dam

18,000

2,000

Building a new concrete dam

24,000

2,700

     Totals

$62,000

$6,350

 

Dandy can capitalize and deduct his assessment as follows:

Cleaning and Repairing

Dandy can deduct his $450 share of the cost of cleaning drainage ditches and his $1,200 share of the cost of repairing tile lines on his 2016 Schedule F (Form 1040). Because these costs are deductible under I.R.C. § 164 rather than I.R.C. § 175, they should not be reported on line 12 as a conservation expense. IRS Publication 225, Farmer’s Tax Guide, and the Schedule F (Form 1040) instructions do not give any guidance on where the IRS wants taxpayers to report these deductions. Dandy could arguably include these deductions on line 25 as repairs and maintenance. However, the IRS may want taxpayers to report only business expenses allowed by I.R.C. § 162 on line 25. Lines 32a through 32f should be an appropriate place to report the deductions, labeled as “Water district assessment for cleaning ditches” and “Water district assessment for repairing tile” respectively.

New Earthen Dam

Because the cost of the new earthen dam would qualify as a conservation expense if the water district qualified for the deduction, Dandy can deduct his $2,000 share of the cost of the dam as a conservation expense on line 12 of Schedule F (Form 1040), subject to the 25% of gross income from farming limit.

New Concrete Dam

The concrete dam is depreciable, which means Dandy can deduct his share of the cost of the dam as a conservation expense, subject to the total assessment limit and the annual assessment limit.

The total assessment limit allows Dandy to deduct only $2,400 (10% of $24,000) of his $2,700 share of the cost of the dam. He adds the remaining $300 ($2,700 – $2,400) to the basis of the 150 acres in the Weedy Water District.

Because his $2,400 deductible assessment for the concrete dam is greater than $740 (10% of his $2,400 deductible assessment plus $500), the yearly assessment limit allows Dandy to deduct only $240 (10% of $2,400) in 2016 and in each of the succeeding 9 years. Dandy should include his $240 deduction as a conservation expense on line 12 of Schedule F (Form 1040), subject to the 25% of gross income from farming limit.

Question 1.

What if the Weedy Water District assessed Dandy’s share of the cost of the concrete dam in $540 installments paid each year for 5 years?

Answer 1.

Each of the $540 annual assessment is less than $740 (10% of his $2,400 deductible assessment plus $500). Therefore, Dandy can deduct his entire $540 assessment for the concrete dam each year.

Question 2.

What is Dandy’s gain if he sells his 600 acres for $3,000,000 ($5,000 per acre) in 2020?

Answer 2.

 Dandy’s gain on the 450 acres that are not in the Weedy Water District is $1,575,000 [($5,000 – $1,500) × 450 acres].

Dandy’s basis in the 150 acres in the Weedy Water District is $226,740—his original $225,000 ($1,500 × 150 acres) basis plus the $300 excess of his assessment over the total assessment limit and the $1,440 ($240 × 6) deductions for the remaining 6 years in the 10-year period for the yearly assessment limit. His gain on those 150 acres is $523,260 [($5,000 × 150 acres) – $226,740].

Note that because he sold the land more than 10 years after he acquired it, none of the I.R.C. § 175 conservation expenses are recaptured.

Question 3.

What are the tax consequences if Dandy died in 2020 before he sold the land?

Answer 3.

The $1,440 ($240 × 6) deductions for the remaining 6 years in the 10-year period for the yearly assessment limit can be deducted on Dandy’s final return. The basis in all his land is adjusted to its $5,000 per acre date-of-death fair market value.

Question 4.

Instead of inheriting the land 2005, Dandy inherited it on February 15, 2012, when its fair market value was $2,400,000 ($4,000 per acre). What are Dandy’s tax consequences if he sells the farm for $3,000,000 ($5,000 per acre) on January 31, 2020?

Answer 4.

Dandy’s gain on the 450 acres that are not in the Weedy Water District is $450,000 [($5,000 – $4,000) × 450 acres].

Dandy’s basis in the 150 acres in the Weedy Water District is $601,740—his original $600,000 ($4,000 × 150 acres) basis plus the $300 excess of his assessment over the total assessment limit and the $1,440 ($240 × 6) deductions for the remaining 6 years in the 10-year period for the yearly assessment limit. His gain on those 150 acres is $148,260 [($5,000 × 150 acres) – $601,740].

Because Dandy sold the farm during the eighth year after he acquired it, he must recapture 40% of the I.R.C. § 175 conservation expenses that he deducted. In 2016, he deducted $2,000 for his share of the cost of the earthen dam. In each year 2016 through 2019, he deducted $240 for 10% of his share of the cost of the concrete dam for a total of $960. Therefore, $1,184 [($2,000 + $960) × 40%] of his gain from the sale of the 150 acres in the Weedy Water District is ordinary income and the remaining $147,076 ($148,260 – $1,184) is section 1231 gain.

Example 2: Share Rent Landowner

The facts are the same as in Example 1, except that Dandy rents his land to Milk Weed under a crop share lease. Because Dandy does not materially participate in the farming activity, he reports his share of the revenue and expenses on Form 4835, Farm Rental Income and Expenses.

Dandy capitalizes and deducts his water district assessment the same as in Example 1. He reports his share of the cleaning and repair expenses on line 30 and his conservation expenses on line 10 of Form 4835.

Example 3:  Flexible Cash Lease Landowner

The facts are the same as in Example 1, except that Dandy rents his land to Milk Weed under a flexible cash rent lease. Dandy’s rent is based on the price and quantity of commodities produced on his land. Because Dandy does not materially participate in the farming activity, he reports his rental income and expenses on Schedule E (Form 1040), Supplemental Income and Loss.

Dandy capitalizes and deducts his water district assessment the same as in Example 1. He reports his water district assessment for cleaning and repair expenses and his conservation expenses on line 19 of Schedule E (Form 1040), labeled as “Water district assessment for cleaning ditches,” “Water district assessment for repairing tile,” and “Conservation expenses” respectively.

Example 4: Fixed Cash Lease Materially Participating Landowner

The facts are the same as in Example 1, except that Dandy rents his land to Milk Weed under a fixed cash rent lease. The lease requires Dandy to materially participate in the farming activity on his land and he does materially participate. Therefore, he reports his rental income and expenses on Schedule F (Form 1040).

Dandy capitalizes and deducts his water district assessment the same as in Example 1. He reports his share of the cleaning and repair expenses on line 32 and his conservation expenses on line 12 of Schedule F (Form 1040) as in Example 1

Example 5: Fixed Cash Lease Non-Materially Participating Landowner

The facts are the same as in Example 1, except that Dandy rents his land to Milk Weed under a fixed cash rent lease. The lease does not require Dandy to materially participate in the farming activity on his land and he does not materially participate. Therefore, he reports his rental income and expenses on Schedule E (Form 1040), Supplemental Income and Loss.

Cleaning and Repairing

Dandy can deduct his $450 share of the cost of cleaning drainage ditches and his $1,200 share of the cost of repairing tile lines on his 2016 Schedule E (Form 1040). Because these costs are deductible under I.R.C. § 164 rather than I.R.C. § 162, they should be reported on line 19 of Schedule E (Form 1040), Other expenses, labeled as “Water district assessment for cleaning ditches” and “Water district assessment for repairing tile” respectively.

New Earthen and Concrete Dams

Because Dandy is not in the business of farming, he cannot deduct conservation expenses under I.R.C. § 175. Therefore, he cannot deduct his share of the cost of the earthen and concrete dams. He adds $4,700 ($2,000 + $2,700) to the cost of the 150 acres in the Weedy Water District.

 

 

*Visiting Professor, Department of Agricultural Education and Studies and Center for Agricultural Law and Taxation

[1] I.R.C. § 164(c)(1); Treas. Reg. § 1.164-4(a)

[2] I.R.C. § 164(c)(1); Treas. Reg. § 1.164-4(b)(1)

[3] Rev. Rul. 79-201, 1979-1 CB 97

[4] Treas. Reg. § 1.164-4(b)(1)

[5] Rev. Rul. 79-201, supra

[6] Treas. Reg. § 1.164-4(a) (“assessments under the statutes of . . . Iowa relating to drainage . . . are limited to property benefited, and if the assessments are so limited, the amounts paid thereunder are not deductible as taxes.”)

[7] I.R.C. § 1016(a)(1)

[8] Clause (i) of the flush language after I.R.C. § 175(c)(1)(B); Treas. Reg. § 1.175-2(c)

[9] I.R.C. § 175(c)(1); IRS Publication 225, Farmer’s Tax Guide (For use is preparing 2016 Returns), page 27.

[10] IRS Publication 225, Farmer’s Tax Guide (For use is preparing 2016 Returns), page 28

[11] Clause (ii) of the flush language after I.R.C. § 175(c)(1)(B); Treas. Reg. § 1.175-2(c)

[12] IRS Publication 225, Farmer’s Tax Guide (For use is preparing 2016 Returns), page 28

[13] Ibid.

[14] Ibid.

[15] I.R.C. § 175(c)(3)(A)

[16] I.R.C. § 175(a); Treas. Reg. § 1.175-4(a)(2)

[17] I.R.C. § 175(c)(1)(A) and (B); Treas. Reg. § 1.175-1

[18] I.R.C. § 175(a); Treas. Reg. § 1.175-3

[19] I.R.C. § 175(b); Treas. Reg. § 1.175-5(a)

[20] I.R.C. § 175(b); Treas. Reg. § 1.175-5(b)

[21] I.R.C. § 175(f)(2)

[22] Treas. Reg. § 1.175-5(b)

[23] I.R.C. § 1252

[24] I.R.C. § 175(f)(3)

[25] Treas. Reg. § 1.175-5(b)

[26] Treas. Reg. § 1.61-8(c)

[27] Stough v. Commissioner, 144 TC 306 (2008); IRS Publication 17, Your Federal Income Tax (For use in preparing 2016 Return), page 68

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