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The U.S. Department of Agriculture (“USDA”) has established provisions under which eligible owners of commercial citrus groves can, subject to availability of appropriate funds, receive payments to recover production income and recover the costs of the loss of citrus trees as a result of the removal of commercial citrus trees to control the spread of citrus canker. Under the current USDA rules, the owner of an affected commercial citrus grove is eligible for compensation for lost production and for payments for the loss of citrus trees as a result of citrus canker contamination. The amounts to be paid are on a per acre basis for destroyed commercial groves which vary depending on the type of citrus trees within each grove.
What are the federal income tax consequences of the receipt by a citrus grower of lost tree payments?
General. Section 1033 of the Internal Revenue Code of 1986 as amended (the “Code”) provides for the non-recognition of gain if property is compulsorily or involuntarily converted as a result of destruction in whole or in part by condemnation or threat or imminence thereof into property similar or related in service or use to the property so converted. The period during which condemned property must be replaced in accordance with Code Section 1033 begins on the date of threat or imminence of condemnation and ends two (2) years after the close of the first taxable year in which any part of the gain upon the conversion is realized or at the close of such later date as the Internal Revenue Service (“IRS”) may designate on application by the taxpayer. Code Section 1033(g) provides that if real property held for productive use in trade or business or for investment is converted by condemnation or imminence thereof, property of a like kind to be held for the productive use in trade or business or investment shall be treated as similar or related in service or use to the property so converted. In the case of an involuntary conversion described in Code Section 1033(g)(1), the period during which the replacement property must be acquired is extended to three (3) years after the close of the first taxable year in which any part of the gain upon the conversion is realized or such later date as the IRS may designate.
Treas. Reg. § 1.1033(a)-2(c)(3) provides that the application to extend any replacement period under Code Section 1033 should be made before the expiration of the replacement period. Extensions generally are for a period not in excess of one (1) year and are granted if there is reasonable cause for the failure to make the timely replacement. However, the IRS may extend the replacement period even if the request is filed after the end of the replacement period provided the taxpayer has reasonable cause for failing to file the application and the late filing of such application was made within a reasonable time after the expiration of the required period of time.
Code Section 1033(b) provides that if property is acquired as a result of a conversion described in Code Section 1033(a), then the basis of the property acquired shall be the same as in the property converted increased by the amount of any gain or decreased by the amount of any loss recognized upon the conversion. If more than one piece of property is purchased by the taxpayer, the basis is allocated to the purchased properties in proportion to their respective costs.
Replacement Property. The money received by a citrus grower as lost tree payments from the USDA or from an insurance company is entitled to non-recognition treatment pursuant to Code Section 1033(a); provided, the lost tree payment proceeds are reinvested in property which is similar or related in service or use (i.e., replacement citrus groves) within two (2) years after the tax year in which the lost tree payment is received. Notwithstanding the foregoing, regulations require a two (2) year moratorium (although the Citrus Canker Eradication Program Director can approve a replanting after one (1) year in certain circumstances) before replanting of citrus on the affected property can proceed, and, therefore, in most cases, it will be necessary to file an application with the IRS to extend the two (2) year time limit for converting the lost tree payment proceeds into property which is similar or related in service or use pursuant to Treas. Reg. § 1.1033(a)-2(c)(3). Any portion of the lost tree payment which is not invested in qualified replacement property will be recognized as gain by the citrus grower.
Under Florida law, it is clear that trees are considered real property and part of the land upon which they grow. See Zaun v. Commissioner, T.C.M. 1975-166; In re Mahon 1998 WL 953984 (M.D. FL. 1998); and PLR 8851034 (Dec. 23, 1988). Unharvested crops on land classified as interest in real property can be transferred for other land with unharvested crops. Trees which are not planted and are in containers or are separated from the land are not considered real property and therefore, are not like kind property for purposes of Code Section 1033(g). Neither the Code nor the Regulations define the phrase “similar or related in service or use”. However, according to Maloof v. Commissioner, the following requirements must be met for property to be considered “similar or related in service or use”:
1. that reinvestment be made in substantially similar property; 2. that reinvestment be a substantial continuation of the prior commitment of capital, not a departure from it; 3. that the replacement property need not duplicate the converted property, but that the character of the investment not be changed; and 4. that the entire transaction allow a taxpayer, whose enjoyment of property has been interrupted without his consent, to return as closely as possible to its original position.
Consequently, a reinvestment of the lost tree payments in crops or farming business (other than citrus) may possibly qualify as property “similar or related in service or use” to the condemned citrus trees.
Depreciation Recapture. Notwithstanding the foregoing, Code Section 1245(a) provides that in the event Code Section 1245 property is disposed of, then the taxpayer will recognize ordinary income to the extent of the depreciation deductions allowed with respect to such Code Section 1245 property. Code Section 1245(b)(4) provides that if property is disposed of and gain is not recognized in whole or in part under Code Section 1033, then the amount of gain taken into account by the taxpayer under Code Section 1245(a) shall not exceed the sum of the amount of gain recognized on such disposition (without regard to Code Section 1245), plus the fair market value of property acquired which is not Code Section 1245 property. Treas. Reg. § 1.1245-5(a) provides that the basis of the replacement property pursuant to Code Section 1033 is determined under Code Section 1033(b). Any unrecognized Section 1245 gain is transferred to the replacement property and will be recognized upon the future sale or conversion of the replacement property by the taxpayer.
Summary. Generally, no gain will be recognized by a citrus grower on the receipt of lost tree payments in connection with a condemnation action if such lost tree payments are converted into property which is similar or related in service or use or is like kind to the condemned property pursuant to Code Sections 1033(a) and 1033(g). If the citrus grower intends to replant replacement groves on its existing property, the citrus grower will generally have a period of two (2) years after the year in which it realized the gain upon the condemnation to replant the replacement groves. If the citrus grower intends to use the lost tree payments to purchase any improved or unimproved real property constituting like-kind property, the citrus grower will generally have a period of three (3) years after the year in which it realized the gain on the condemnation to purchase such like-kind property.
What are the federal income tax consequences of the receipt by a citrus grower of lost production payments?
Any citrus canker lost production payments received by a citrus grower (either from the USDA or an insurance carrier) would be subject to income inclusion under Code Section 1 at ordinary income rates, and would be eligible for income averaging under Code Section 1301. Depending on the particular facts of each citrus grower, it may be argued that the total amount received from the condemnation (i.e., lost production proceeds and tree replacement proceeds) is less than the impairment to its capital, and as such, that no portion of the amounts received should be allocated to lost profits. Consequently, that portion of the proceeds properly allocable to the destruction of the citrus grower’s business as a whole would be taxable at capital gains rates to the extent not reinvested, and would be eligible for tax deferral under Code Section 1033 to the extent such amounts are reinvested in property similar or related in service or use to the property destroyed. Additionally, it may be argued that a portion of the lost production proceeds should be allocated to the loss of the citrus grower’s goodwill and any payment allocated to a loss of goodwill will be subject to a maximum capital gains rate of fifteen percent (15%).
In the event that the citrus grower elects to replant the citrus trees which were destroyed in the condemnation, how will such replanting costs be expensed?
With respect to amounts used by a citrus grower to replace the citrus trees which were destroyed pursuant to the condemnation with citrus trees bearing the same type of fruit, such amounts generally will be subject to the rules of Code Section 263A. Code Section 263A generally requires the capitalization of the direct or indirect costs that benefit or are incurred by reason of the production of property. However, Code Section 263A(d)(2) provides that if plants bearing an edible crop for human consumption were lost or damaged by reason of disease, drought, pests, or other casualty, then Code Section 263A shall not apply to any costs of the taxpayer of replanting plants bearing the same type of crop (whether on the same parts of land under which such loss or damage occurred or any other parts of land of the same acreage within the United States). While there is no direct authority that the destruction of healthy trees due to the proximity to a diseased tree meets the requirement of this definition, one may conclude that this would meet the requirement for the “by reason of disease” requirement. To be safe, a private letter ruling should be obtained.
Replanting costs must be incurred by the taxpayer that owns the property at the time the plants were lost or damage. In addition, the replanted trees may be planted in a higher density than the destroyed trees as long as the acreage on which the replanted trees lie is not greater than the acreage on which the destroyed trees were located. However, Code Section 263A(d) will apply to a person other than the taxpayer that owns the property at the time the plants are damaged, if the taxpayer that owns the plants at such time owns an equity interest of more than fifty percent (50%) in such plants at all times during the taxable year in which the replanting costs are paid or incurred and such other person (i.e., the person other than the taxpayer) owns any portion of the remaining equity interest and materially participates in the replanting, cultivating, maintaining or developing of such replacement plants during the taxable year in which the replanting costs are paid or incurred. Replanting costs may be incurred with respect to property other than the property on which the damage or loss occurred to the extent the acreage of the property with respect to the replanting costs incurred is not in excess of the acreage of the property on which the damage or loss occurred.
Therefore, assuming that Section 263A(d)(2) is applicable, any replanting costs incurred in replanting the citrus trees [other than the cost of the replacement trees themselves] will not be subject to capitalization under Code Section 263A and will be eligible to be expensed by the citrus grower in the year they are incurred pursuant to Code Section 162. A citrus grower may avoid the capitalization requirements of Section 263A for replanting costs, regardless of whether the citrus grower replants the same or some other parcel of land. In addition, a special provision for replanting after a casualty allows not only the farmer to take advantage of this rule, but also his new partners, so long as the citrus grower retains an equity interest of more than 50 percent in the grove, and the new partners materially participate in the activity. Material participation for this section is governed by Section 2032A(e)(6), which is a lesser standard than that required under the passive activity loss rules of Section 469.
Will any of the amounts allocated to lost production be subject to Code Section 451(d)?
Code Section 451(d) provides that in the case of insurance proceeds or payments received by a taxpayer under the Agricultural Act of 1949 as amended or Title II of the Disaster Assistance Act of 1988 as a result of the destruction or damage to crops caused by drought, flood or any other natural disaster or the inability to plant crops because of such natural disaster, any cash method taxpayer may elect to include such proceeds in income for the taxable year following the taxable year of destruction or damage if the taxpayer establishes that under his prior practice, income from such crops would have been reported in the following taxable year. If the taxpayer receives the insurance proceeds or payments in the taxable year following the taxable year of the destruction or damage then the taxpayer must include the proceeds in gross income for the taxable year of receipt without having to make an election under Code Section 451(d).
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