How Will My Pipeline Easement Payment Be Taxed?
The recent oil and gas drilling boom in southeastern Ohio, Pennsylvania and West Virginia has brought about an unexpected visitor for many landowners, including some far removed from where shale wells are being drilled—pipelines. Pipeline companies are acquiring easements (also called rights of way) from landowners in order to construct transportation pipelines. They may be acquired through negotiation between the pipeline company or (under certain circumstances) eminent domain (condemnation) proceedings. If you are considering a potential pipeline easement offer, make sure you consult your attorney and tax professional before you sign! Proper planning and negotiation with the pipeline company can minimize and possibly defer the tax generated by the sale of the easement.
Payments for pipeline easements can be categorized in different ways. Different categorizations can have different tax consequences to the landowner. Whether the easement payment qualifies as a capital gain or ordinary income depends upon whether the pipeline company obtains a permanent easement or a temporary right to use the land. The maximum capital gains tax rate for an individual is generally lower than the maximum ordinary income tax rate. Temporary work space payments and payments for lost profits (such as crops) generally are taxed as ordinary income. Under certain circumstances, a permanent easement payment may qualify as capital gain income. (A landowner generally is allowed only to offset the proceeds from the sale of a permanent easement against the landowner’s cost basis in the easement tract. In limited circumstances, the proceeds of the easement payment may be applied to reduce the aggregate basis in both the easement tract and the landowner’s remaining property.)
Pipeline easements also frequently include payments for damages. Damage payments are intended to compensate the landowner for damages caused by current construction as well as a release for future loss of use and damages to the surface, fences and crops. Payments for current damages may generally be offset against the landowner’s cost basis. The IRS characterizes payments for future damages as a rental and thus ordinary income. The law on taxation of damages is murky and the IRS closely scrutinizes payments for damages. Good drafting requires distinguishing between upfront payments for construction damages and payments for future damages.
Under certain circumstances, easement payments which would be taxable may qualify for like-kind exchange treatment under Section 1031 of the Internal Revenue Code. This may allow the landowner to defer the income and tax generated from the sale of an easement by re-investing the proceeds in other real estate. The tax free exchange requirements are stringent and the transaction should be properly structured before the easement is signed and any payments are received.
There is a special rule for landowners who receive easement payments as a result of eminent domain or threat of eminent domain. Certain pipeline companies may acquire easements by eminent domain if they qualify as a common carrier. Section 1033 of the Internal Revenue Code allows qualifying landowners to avoid taxable gain by reinvesting their proceeds in qualifying property during the replacement period, which can be as long as three years.
The landowner must make sure that the amount and type of various easement payments are specifically detailed in the written easement document. The pipeline company is responsible for sending the landowner a Form 1099-S or Form 1099-Misc for income tax reporting purposes. If the written easement document does not include sufficient detail regarding how payments should be categorized, the pipeline company will unilaterally allocate the payments in a manner which is most advantageous to the pipeline company. Once a Form 1099 is issued, it will be difficult for the landowner to reverse or challenge the allocations set forth in that Form 1099.
For landowners considering a pipeline easement "an ounce of prevention is worth a pound of cure". Proper professional advice and advance planning can save you thousands of dollars. Find out your exact tax consequences before you sign. If you fail to heed this warning, Uncle Sam may end up with a larger share of your easement payment than you anticipated.