Tax Treatment of Right-of-Way Payments for Shale Leases

Written by about Taxes on September 17, 2014

Over the last few years many landowners have begun receiving cash bonus payments for land leases related to the Marcellus and Utica Shale boom. In our work with clients in the Marcellus and Utica Shale regions, we have seen a recent uptick in landowners receiving offers to sign “pipeline right-of-way” agreements, as the need for pipelines has escalated due to the increasing maturity of the industry.

The payment for this right-of-way is considered an easement. The tax treatment of easements may result in income, a reduction in basis of all or part of the land, or both. The amount a landowner receives for granting an easement is generally considered to be a sale of an interest in real property. If the amount received is more than the basis of the part of the property affected by the easement, the basis is reduced in that part to zero and the excess is treated as a recognized capital gain.

Usually easement contracts describe the affected land using square feet. A landowner’s basis may be figured per acre, which equals 43,560 square feet. In a 1968 ruling, for example, the IRS held that a taxpayer receiving $5,000 from a power company for an easement to construct and maintain electric poles across a 600-acre farm with a basis of $60,000 could use only $2,000 — the portion of the cost basis allocable to the 20 acres directly affected by the easement. As a result, the taxpayer realized a $3,000 gain.

Where it was impossible or impractical to allocate the taxpayer’s cost basis between the property affected by the easement and the rest of the land, the tax courts treated the amount received as a return of capital in its entirety. The leading case in this area, Inaja Land Company v. CIR, has been accepted by the IRS. This case allowed the taxpayer to reduce the basis in the whole property by the payment for the easement, since it was impractical to separate the basis for the part of the property affected by the easement.

Sometimes the payment will also serve to compensate the land owner for surface damages, e.g., a farmer’s damaged crops. This payment would be considered ordinary income and would not reduce the basis in the property.

Considering all of the above, I’m often asked what advice I have for landowners when they receive a right-of-way payment? The best answer I can give is to consult with your tax advisor, as we have seen situations in which the payments are incorrectly reported on a 1099, indicating ordinary income to the landowner. The most favorable treatment for the taxpayer would be to indicate capital gains, resulting in a lower tax rate.

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About Lisa Loychik

Lisa M. Loychik is a CPA and partner at Cohen & Company. Lisa has significant experience with medical, professional services and advertising companies—with even deeper expertise in the real estate industry. She represents many large commercial real estate developers. She also has seen more activity with oil & gas transactions, due to Marcellus and Utica shale. In the area of oil and gas, Lisa recently assisted in a lease negotiation structuring a multi-million dollar transaction to obtain more favorable tax rates.