The following article is the third in a series addressing the federal income tax consequences of the receipt by citrus growers of lost tree and lost production payments under differing scenarios. This article will address the federal income tax consequences of the receipt of such payments when the taxpayer intends to reinvest the proceeds into replacement property (other than replacement citrus groves).
The lost tree payments received by a taxpayer are eligible for non-recognition of gain pursuant to Code Section 1033, if the taxpayer uses such proceeds to purchase property which is “similar or related in service or use” or “like-kind” (where the converted property is real property) to the property involuntarily converted. Depending upon the taxpayer’s circumstances, there is a potential argument that a portion of the lost production payments are also eligible for non-recognition treatment under Code Section 1033. Generally, the taxpayer will have a period of two years after the close of the taxable year in which the taxpayer received the lost tree payments to acquire property “similar or related in service or use,” or three years to acquire “like-kind” property. Extensions of the replacement periods under Code Section 1033 may be granted by the Internal Revenue Service (“IRS”) if the taxpayer shows that there is reasonable cause for the failure to make the timely replacement.
Generally, in order for replacement property to be considered similar or related in service or use, it must meet the following test: (i) the reinvestment must be made in substantially similar property; (ii) the reinvestment must be a substantial continuation of the prior commitment of the capital, not a departure from it; (iii) the replacement property need not duplicate the converted property, but the character of the investment must not be changed; and (iv) the entire transaction must return the taxpayer, whose enjoyment of property has been interrupted without his consent, as closely as possible to his original position. Maloof v. Commissioner, 65 T.C. 263 (1975). For example, it has been held that the replacement of a cattle farm with prune, apricot and walnut orchards qualifies as replacement property which is similar or related in service or use to the converted property. Rev. Rul. 58-254, 1958-1 C.B. 274. The determination of whether replacement property meets the similar or related in service or use test is very fact specific, and therefore, the taxpayer should consider whether requesting a private letter ruling from the IRS is advisable to determine whether specific replacement property or activities qualify under Code Section 1033.
Under Florida law, it is clear that trees planted in the ground are considered real property and part of the land upon which they grow. Zaun v. Commissioner, T.C.M. 1975-166; In re Mahon 1998 WL 953984 (M.D. FL. 1998); and PLR 8851034. “Like-kind” refers to the nature and/or character of the property and not its grade or quality and, therefore the kind of real property that can be exchanged under the “like-kind” rules is very broad. The fact that the real property involved is improved or unimproved is not material. For example, commercial property replacing condemned agricultural land has been held to be “like-kind” property. PLR 8130035.
Notwithstanding the foregoing, Code Section 1245(a) provides that in the event Section 1245 property (citrus trees are considered Section 1245 property) is disposed of (whether voluntarily or involuntarily), then the taxpayer will recognize ordinary income (assuming the taxpayer is otherwise realizing a gain on the transaction) to the extent of the depreciation deductions allowed with respect to such Code Section 1245 property. However, if Code Section 1245 property is disposed of and gain is not recognized in whole or in part under Code Section 1033, and the replacement property includes property which is characterized as Code Section 1245 property, then the taxpayer should be able to defer the recognition of some or all of the ordinary income that would normally be recognized under the Code Section 1245 recapture rules.
Generally, the amounts received for lost production payments will be treated as “ordinary income” subject to the graduated tax rates but would be eligible for income averaging under Code Section 1301 for individuals. Under certain circumstances, it may be possible to argue that some of the lost production payments should be eligible for Code Section 1033 treatment or long term capital gain treatment. These circumstances are fact specific and should be discussed with a competent tax advisor that is familiar with agricultural tax issues.
In conclusion, a taxpayer will be eligible to defer recognition of gain with respect to lost tree payments received if the taxpayer acquires property which is “similar or related in service or use” or “like-kind” to the converted property, subject to the Code Section 1245 depreciation recapture rules. In addition, the taxpayer will recognize the lost production payments as ordinary income, subject to income averaging under Code Section 1301 for individuals, except in certain circumstances where Code Section 1033 or long term capital gain treatment may also be available for a portion of the lost production payments.
The authors are members of Dean Mead, a full-service law firm with offices in Orlando, Fort Pierce and Viera. The firm’s Citrus Canker Task Force assists citrus growers with the legal issues that result when canker is detected in their groves. For more information about Dean Mead and its Citrus Canker Task Force, please visit deanmead.deme.dev.