Taxing Lessons From Court Decisions

Decisions — Springing for repairs

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We had a kettle, we let it leak…According to the poem by Rudyard Kipling, having a kettle and letting it leak without repair made the problem worse. In this week’s Taxing Lesson, the taxpayer made the repair and still has a problem–the IRS says she created new assets and the costs are not currently deductible.

In T.C. Memo. 2018-11 (Wells), the taxpayer made what she considered deductible repairs. The IRS disagreed, saying the work was not currently deductible and instead had to be treated as an asset (capitalized).

The taxpayer owned 265 acres in Colorado. She grew grapevines on a portion of the land, and leased another portion for horse and cattle grazing. During 2010, she spent a total of $199,031 for labor, equipment, and materials for various projects on the property. During 2011, she spent $47,630 to rehabilitate a grazing area after a wildfire.

Here’s the information on three of the expenditures.

1. Water line

In 1965, the taxpayer’s father installed an underground pipe to carry water from a spring on the southern part of the property to other areas of the property. The pipe runs downhill from south to north for about 3,800 feet and supplies, among other things, the grazing pasture and an irrigation system in the fields where the taxpayer grows grapes.

The water line was originally constructed of 2-inch black polyethylene pipe (black pipe), but at least 1,800 feet of the line was replaced in 2010 with 2-inch blue pure-core pipe (blue pipe). Sections of black pipe are connected with joints that fit together and are then secured with a hose clamp. Sections of blue pipe are connected with compression fittings and can withstand higher pressures. Blue pipe is more expensive, higher quality pipe.

The taxpayer said that the water line was entirely replaced in 2009 with new black pipe. She testified that after the first replacement

[t]he black poly pipe began leaking the first year it was put in [i.e., 2009] and we replaced a section of it in the fall of 2009. And then when spring [2010] came along there were also new leaks that cropped up in the new black poly and we replaced those three locations. So it just was an ongoing problem with the new black poly[. It] was not holding. * * * There was water bubbling out of the ground[.] * * * We dug out from the point the water was bubbling out of the ground until we found * * * [the source of the leak,] which was at [the] joints.

The taxpayer was not sure of the cause of the leaks, and speculated that the joints between the pipe sections were not secured to the pipe sections well enough to withstand the water pressure through the line.

While there was some dispute over when the black pipe was installed, after reviewing the record, the court found that the whole water line was replaced at least once over the course of 2009 and 2010.

The taxpayer argues that the life of the asset was not extended and that the value of the water line was not increased. She says that replacement of the line was a repair (or a repair in part) because floods destroyed parts of the line in 2009 and 2010, and replacement was her only option. She also says that the complete replacement was merely a conglomeration of repairs deferred from years in which she did not have the funds to complete repairs.

The IRS says the expenses are not currently deductible and must be treated as an asset.

 

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2. Storage Yard

The taxpayer spent $16,202.50 on construction of a storage yard. The storage yard did not exist before the construction, though the taxpayer used the bare patch of earth where the storage yard now sits as a parking area.

The taxpayer says that because the property is used for the same purpose, the expenses should be deductible.

The IRS says the expenses must be capitalized.

 

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3. Burned area rehabilitation

In 2007, a wildfire burned approximately 26 acres of the property (burn area). Before the fire, the taxpayer used a small part of that land for grazing, and for “shade and privacy for the property. Shade and a little bit of grazing for horses or cattle.”

In 2011, the taxpayer determined–after consulting a friend who had experience restoring burned land–that the fire had rendered the land hydrophobic, i.e., the heat of the fire had decreased or destroyed the land’s capacity to absorb water.

The taxpayer paid $47,630 to remove burned tree stumps and boulders and turn the soil so that the entire 26-acre area could be used for forage. According to the taxpayer, the burn area rehabilitation project “is going to be a long-term process. Decades before it even grows forage as it would normally do in that area.”

The taxpayer claimed the expenses as a deduction on her 2011 return. She argues that the expenditures did not improve the land or the value of the land. She says the work was not extensive, and was not directed at adapting the burn area to a new or different use, and should be considered deductible repairs.

The IRS says the 2011 expenditures are part of a plan of rehabilitation and should be capitalized.

 

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Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.

This information should not be considered legal, investment, or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment, or tax advice. Always consult your legal, investment, and/or tax advisor regarding your personal situation.

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Sorry, wrong answer :(
Right answer!

For the IRS – the expenses should be capitalized.

If there was only one replacement of the spring line, then the work completed in 2010 was part of a “‘general plan’ of rehabilitation, modernization, and improvement” to completely replace the water line, a project the taxpayer took up in 2009 and completed in 2010, the costs of which must be capitalized.

This is clear because (1) the relevant asset, i.e., the water line, was completely replaced, (2) the use of blue pipe to replace the old black pipe extended the life of the asset well beyond 2010, and (3) the value of the line was increased (because of the use of a new and better pipe with better joints).

The taxpayer argues that the life of the asset was not extended and that the value of the line was not increased. Yet it is difficult to understand how asset life and value could remain the same considering that the old, crumbling, and leaky pipe was entirely replaced with new and higher quality pipe.

The taxpayer argues that–even if the line was completely replaced only once–replacement of the line was a repair (or a repair in part) because large discharges of water destroyed parts of the line in 2009 and 2010, and replacement was her only option.

But even if the complete replacement of the line described above was occasioned by a flood or a series of floods, it would not change the result. Whether the line ceased to work because of a flood or merely because of the passage of time, the taxpayer ultimately decided to replace, rather than repair, the whole line with a different and sturdier pipe of greater value and useful life than the pipe that was removed.

In the alternative, the taxpayer contends that the complete replacement was merely a conglomeration of repairs deferred from years in which she did not have the funds to complete repairs.

But this alternative argument fails for the same reason as the argument just addressed. If the taxpayer did defer repairs for many years, nevertheless she ultimately decided that complete replacement of the asset was the proper course of action. Therefore replacement of the line was a capital improvement.

Sorry, wrong answer :(
Right answer!

For the IRS – the expenses should be capitalized.

The taxpayer has not offered any argument that construction of the storage yard was anything other than a capital improvement. Moreover, nothing in the record supports a finding that the cost of work done to the storage yard was for any kind of repair or other deductible expense.

The taxpayer’s implication appears to be that because she used the bare patch of earth where the storage yard now sits as a parking area before the new construction, the newly constructed yard is not a capital improvement because it is now used for the same purpose.

But new construction on top of previously unimproved land is necessarily an “improvement,” and consequently the costs must be capitalized. Therefore, the taxpayer may not deduct under section 162 the $16,859.30 for the storage yard project.

Sorry, wrong answer :(
Right answer!

For the IRS – the expenses should be capitalized.

The evidence in this case clearly shows that the taxpayer has developed a plan of rehabilitation for the burn area; she said as much.

Second, the taxpayer clearly thinks that the expenditures will improve (over a very long period) both the land and the value of the land; it is difficult to understand why she would have spent $47,630 otherwise.

Third, the work was clearly extensive as it involved removal of stumps and boulders, at significant expense, from the entire burn area, which the taxpayer testified comprises about 26 acres.

Fourth, the taxpayer testified that before the fire the burn area was used for “shade and privacy for the property. Shade and a little bit of grazing for horses or cattle.” The court understands this statement to mean that a small portion of the burn area was used for grazing before the fire and the rest of the burn area had no relation to her business.

After the fire the taxpayer cleared the whole 26-acre area for future use in the production of forage. That is, before the fire, a small portion of the area was used for grazing and forage, whereas after the fire, the whole area was converted to that use.

On these facts the court is unable to conclude that the taxpayer’s expenditures did not adapt a significant portion of the land to a new use.

Accordingly, the court rejects the taxpayer’s argument that her plan of rehabilitation did not adapt the area to a new or different use.

The court sustains the IRS’s determination that the taxpayer may not deduct under section 162 any of the $47,630 of 2011 deductions.

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