FACT SHEET Agriculture and Natural Resources OAM-1-12 Depreciation of Farm Drainage Tile Wm. Bruce Clevenger OSU Extension Educator and Assistant Professor Introduction Agriculture is one of Ohio s largest industries. 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, but this expense can be written off over time as. Depreciation The term is used in accounting to spread the cost of an asset over the span of the asset s 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 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 is the allowable business expense for IRS purposes. It may or may not be close to the economic. Farm drainage tile that has a zero or salvage value for tax may be efficient and productive on the farm if having been properly installed and well maintained. Eligibility Issues To be eligible for, property must meet all of 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.
Depreciation of Farm Drainage Tile page 2 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, you determine (a) the system, (b) property class, (c) recovery period, (d) method, (e) basis amount, (f) placed-in-service date, and (g) convention. Depreciation System, Property Class, Recovery Period, and 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) methods under the 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) methods are as follows. 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 if the owner meets the requirements. 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. For 2012, the Section 179 limit is $139,000 (inflation adjusted) and a phase-out threshold of $560,000. For 2013, unless Congress amends the statute, the limit drops to $25,000. If requirements are met, farm drainage tile may qualify for Section 179 property expensing, regular, and bonus when available by the IRS. Depreciation, Section 179 property expensing, and bonus are subject to recapture (Section 1245 Property) upon the sale of the asset prior to the expiration of the recovery period. Determining Basis A (e) basis amount is the beginning or adjusted value used to calculate the annual dollar amount deducted as a expense for each asset item. Any IRS Section 179 expense deduction and/or bonus 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. Previously Installed Drainage Systems 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 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
Depreciation of Farm Drainage Tile page 3 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 from free online computer software (i.e., 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 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, such as 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 and 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 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 and 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 1.5 months of is allowed for the quarter the property is placed in service or disposed of. Half-Year Convention Use this convention if neither the mid-month convention nor the mid-quarter convention applies. Under this convention, you treat all property placed in service or disposed of during a tax year as placed in service or disposed of at the midpoint of the year. This means that one-half year of is allowed for the year the property is placed in service or disposed of. Bonus Depreciation Over the past decade, Congress has repeatedly allowed faster of capital assets to stimulate business investment by providing a Special Depreciation Allowance or bonus allowance in the year the asset is purchased. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 extended the bonus for 2011 and 2012 to encourage new equipment purchasing. The additional first-year rules allowed farmers to deduct on their 2011 income tax returns 100 percent of the cost of qualifying assets purchased in 2011 and 50 percent of the cost of qualifying assets in 2012. Farm Drainage Tile Depreciation Example Assume that a crop-share rental landlord installs farm drainage tile costing $50,000 on his property
Depreciation of Farm Drainage Tile page 4 in July 2012. Assuming he meets the other requirements of Section 179 Expense Deduction and uses the GDS 150 percent declining balance method, his record could look like the following for the first 5 years. Original Basis $50,000 Section 179 $12,000 50% Bonus (2012) Remaining Basis $19,000 2012 2013 2014 2015 2016 $19,000 ($50,000 - $12,000 x.50) $950 ($19,000 x 5.0%*) $1,805 ($19,000 x 9.5%*) $1,625 ($19,000 x 8.55%*) $1,463 ($19,000 x 7.7%*) $1,317 ($19,000 x 6.93%*) *Percentage tables are available in IRS Publication 946, How to Depreciate Property. Total for 2012 for this farm drainage tile could be $31,950 ($12,000 + $19,000 + $950). Common Questions and 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 meaningfully participating according to earned income rules, and meet Section 179 requirements. 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 as ordinary income if I sell the farm before the end of the (recovery) period? Answer: Yes, farm drainage tile falls in Section 1245 property. So expensing, special, and regular must be recaptured to the extent it exceeds straight line 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 percent 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 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. They qualify as Section 1245 property, are eligible for Section 179, and have a 7-year class life. Summary Landowners install farm drainage tile because doing so helps remove excess soil water, improve soil productivity, and reduce erosion. Farm drainage tile has a positive benefit-cost ratio ranging from 1.3 to 3.1 for corn and soybean 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 increases yields. However, the cost of installing, major improvements, or original basis may be written off as in an IRS-approved method. References Brown, L. C., B. M. Schmitz, M. T. Batte, C. Eppley, G. O. Schwab, R. C. Reeder, and D. J. Eckert. Historic Drainage, Tillage, Crop Rotation, and Yield Studies on Clay Soils in Ohio. pp. 456-464 in Drainage in the 21st Century: Food Production and Environment. Proc. 7th International Drainage Symposium. Brown, L. C., ed. Vol. 7:02-98. St. Joseph, MI: ASAE, 1998.
Depreciation of Farm Drainage Tile page 5 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 23, no. 2 (January 20, 2012). Internal Revenue Service. Publication 225, Farmer s Tax Guide. Department of the Treasury, 2011. Internal Revenue Service. Publication 946, How to Depreciate Property. Department of the Treasury, 2011. McEowen, Roger. Farmland Acquisition-Allocation of Value to Depreciable Items. Iowa State University, Center for Agricultural Law and Taxation, February 2011. http://www.calt.iastate.edu/briefs/calt%20 Legal%20Brief%20-%20DEPRECIATION%20 OF%20DRAINAGE%20TILE.pdf Schwab, G. O., D. D. Fangmeier, W. J. Elliot, and R.K. Frevert. Soil and Water Conservation Engineering. New York: Wiley and Sons, 1993. Visit Ohio State University Extension s web site Ohioline at: http://ohioline.osu.edu Ohio State University Extension embraces human diversity and is committed to ensuring that all research and related educational programs are available to clientele on a nondiscriminatory basis without regard to age, ancestry, color, disability, gender identity or expression, genetic information, HIV/AIDS status, military status, national origin, race, religion, sex, sexual orientation, or veteran status. This statement is in accordance with United States Civil Rights Laws and the USDA. Keith L. Smith, Associate Vice President for Agricultural Administration; Associate Dean, College of Food, Agricultural, and Environmental Sciences; Director, Ohio State University Extension; and Gist Chair in Extension Education and Leadership. For Deaf and Hard of Hearing, please contact the College of Food, Agricultural, and Environmental Sciences using your preferred communication (e-mail, relay services, or video relay services). Phone 1-800-750-0750 between 8 a.m. and 5 p.m. EST Monday through Friday. Inform the operator to dial 614-292-6891.