What is an easement?
In short, an Easement is a right granted or reserved to a particular person, in or over, land which belongs to another.
In real estate, "an Easement" is a right that permits the holder to use the land of another. Thus, it is a right to do something on another’s land or deprive another of the same (also known as a negative easement). These rights generally run with the land (meaning that it binds future owners), and are generally perpetual in nature. In legal terms, an Easement is a non-possessory interest (right) in the land of another. By contrast, possession is a more common interest (even ownership) in land.
Types of Easements
There are several common types of Easements that exist (and generally fall into these categories):
Easements Appurtenant: This is the most common type of Easement, and generally exists when the Easement is a part of the land itself. An Easement Appurtenant "runs" with the land, and usually benefits the land (dominant) for which it is created by making it more useful and valuable. Oftentimes, an Easement Appurtenant will also burden another piece of land owned by another individual (servient) when a specific use is required from that servient land. In the picture below, the lot on the left has an Easement (in favor of the landlocked lot) that allows for driveway access across the lot on the right .
Dominant Estate Land
Servient Estate Land
Easement Appurtenant
An Easement in Gross: An Easement in Gross is not connected to the land itself, but rather generally runs with the individual (not the land). This is a right to use the land of another by a particular individual. The most common types of Easements in Gross include: (i) utility companies with powerlines (or sewer lines) and/or (ii) government (public) access roads and ways.
Easement in Gross
An Easement by Necessity: This is a common law doctrine that permits the owner of landlocked property to exit only by using a portion of another’s land. This Easement is a type of Appurtenant Easement, but does not need to be so because of its necessity. These rights evolved because of a desire to promote public policy (such as for the safety of power lines) and evident landlocked properties. Most states follow the general rule that an Easement by Necessity must generally exist at the time the landlocked parcel was divided (i.e. at the time of severance of title).
Types of Easements
Easements by Prescription: These rights are similar to an Easement Appurtenant, and are typically entrenched in the concept of "adverse possession." In order to award an Easement by Prescription, you generally must establish the following:
Tax implications of selling an easement
In order to determine what type of income a landowner may be reporting when she sells an easement, it is important to know how courts and the IRS characterize a transaction in order to classify it. A recent case in the U.S. Court of Appeals for the Eighth Circuit provides helpful guidance on how easement sales should be categorized for tax purposes.
When a transaction generates gain or income, it can be characterized in one of four different ways: ordinary, capital, 1231, or 1245. The character of the gain or income from a transaction is significant because it determines which tax rate applies and how gain will later be characterized when the property is sold at some future date. The characterization of the income will also determine whether a gain may qualify for certain tax benefits.
Property characterized as ordinary income will be taxed as compensation income (generally at the highest marginal tax rate in the income tax bracket). Property characterized as capital gain will be taxed as investment income (with the rate determined by the holding period and taking into account other provisions of the tax code like the recently enacted 3.8% Net Investment Income Tax). Like property held for investment, property characterized as 1245 property will be taxed as capital gain but depreciation deductions taken while the property was owned are "recaptured" (taxed as ordinary income) up to the amount of depreciation. Property characterized as 1231 property can be taxed as capital gain or ordinary income but special rules apply where net 1231 property is deemed to be long-term capital gain; for our purposes we will refer to this as the 1231 Capital Gain Exception.
The general rule is that a property that is merely used to produce rental income is considered to be held by the taxpayer for investment. Such property, if later sold, will generally bear capital gain treatment. Note, however, that this rule applies only to property (land or building) that was rented out for a while, but never depreciated. If the property was depreciated during the time it was rented, it would be characterized as 1245 property for tax purposes. Instead, the special rules noted above would apply and the gain would be treated as capital gain to the extent it exceeded any unrecaptured depreciation.
All of this might sound completely foreign to an average landowner, but property sold pursuant to an easement sale is treated as if it was rented for 5 years and depreciated and therefore is treated as 1245 property. This is the holding in a recent 2008 case decided by the Eighth Circuit Court of Appeals, Underwood Family Trust v. C.I.R., 551 F.3d 1051 (8th Cir. 2008). It has been the law for many years now that conservation easements should be treated as 1245 property. See Rev. Rul. 57-476, 1957-2 C.B. 23, 1957-2 C.B. 23. Furthermore, the IRS has made it clear that it will oppose this treatment in the future. See Technical Termination Notice: Treatment of Gain from Sale of Conservation Easement, Rev. Proc. 2009-43, 2009-31 I.R.B. 211 (July 27, 2009).
If, on the other hand, an easement sale is paired with a donation of an easement, the transaction may be classified as a "composite" transaction consisting of a bargain sale followed by a donation of the remaining value. For the "composite" transaction, the property will be treated first as ordinary income subject to the 1245 recapture rules, and whatever portion of gain not subject to these rules will be considered capital gain.
Basis and gains in easement sales
In determining the amount of gain a taxpayer realizes as a result of the sale of their easement, the cost basis relating to that easement must be determined. The taxpayer should calculate the gain realized as a result of the sale, which is the amount realized on the sale over the basis of the property sold. The basis of the property, for easement purposes, is the current cost of the property and any costs to acquire the property and place it into service. The taxpayer should add any amounts he or she previously deducted or amortized over the life of the property and deduct any depreciation. The basis should not be adjusted for appreciation as it normally would in calculating gain from the sale of real property. As a result, the taxpayer will not get taxed on the appreciation of the land except that the IRS normally treats the amount received for an easement as ordinary income. There are some exceptions where the IRS will treat a grant of an easement over property as a capital gain, but those rules are beyond the scope of this blog and are only applicable, for example, where the underlying property was owned as part of a tax-qualified retirement plan, or is otherwise tax-exempt.
Let’s suppose our client farmed crops on 1,000 acres of their farmland in San Joaquin Valley for many, many years. The client decides that the price of leasing the crop land has risen to the point where it would be beneficial to lease the land out for the next few years rather than farm it themselves. The client sells a conservation easement at fair market value on some of the land to keep it in agricultural production at the same time. The client uses the proceeds from the sale of the easement to purchase mobile field irrigation systems for the leased land in order to continue farming. The fair market value of the easement was $100,000 and the cost basis in the easement was zero. Therefore, the federal income tax owed on the $100,000 would be $35,000, if treated as ordinary income. In California, the tax on this sale of the easement would also be $35,000. However, if the buyer of the easement was a California insurer, pension plan, or deferred compensation plan, the tax would be half of that or $17,500.
For simplicity’s sake we will assume the seller had never taken depreciation. If the seller had taken depreciation deductions over the years, the tax would be even higher, depending on the size of the depreciation. In this case, the client has a recorded easement that is held with the crops. The lease on the crop land is unchanged and the crop land is still in high value agricultural production.
Deductions and exemptions in easement sales
Concessions, like the sale of Line 5 easement, may qualify for exemptions or deductions
In addition to the value of the easement which is considered taxable income (or at least ordinary income), there are potential exemptions and deductions available to a property owner. The concession fee, may be deductible under Code Section 162. City of Pittsburgh v. Comm’r, 118 F.3d 974 (3d Cir. 1997) (payment received from the grant of a permanent easement and restrictive covenant regarding the development of a vacant parcel of land was considered a deductible ordinary business expense). Gulf Power Company v. Comm’r, 112 T.C. 317 (1999) affd. 213 F.3d 1291 (11th Cir. 2000) (an easement with a 99 year term to build and maintain electric transmission and related structures on the transferor’s property was not a sale of an interest in real property under Code section 1001(a), but rather, an agreement that is, in essence, a business rental agreement. Thus, the amount paid was deductible as an ordinary and necessary business expense under Code section 162). Typically, an owner of land has no need to claim the exemption or deductibility of a long-term grant of an easement. However, in the case of the line 5 easement, the deduction or exemption could impact Enbridge’s ability to claim a capital loss due to the potential devaluation of the property with the easement running through it. Under Code Section 1033, property holders have been permitted a tax deferment on the sale of property to a governmental body where there is an involuntary conversion of the real property, such as the granting of a pipeline easement. In this case, the deferment of the taxation of the gain can last as long as the owner still owns property of equal value and similar use as the original property (or the sale proceeds are reinvested into a new property of equal or greater value). As such, in the case of Enbridge, the above described treatment would permit the deferral of the gain on the sale of the easement for such time as the easement holder is using the property for the same business purpose. Although Line 5 runs through Michigan, it also crosses into Wisconsin along the channel between Michigan’s Upper and Lower Peninsulas. As such, there will also be the grant of an easement to whatever entity owns the pipeline in the State of Wisconsin as well.
The effect of an easement sale on property value
While the tax implications of selling an easement are vitally important, also significant to a landowner should be the impact that an easement sale has on the value of the property. The impacts can be both positive and negative, to varying degrees, depending on the parcel of property being sold.
In situations where an owners is in a depressed real estate market, with a poor outlook on the housing and real estate economy for the foreseeable future; getting a lump sum, up front payment for the sale of an easement can often times provide immediate tangible value for the property and enable the owner to reduce their expenses (i.e. maintenance, taxes, etc.) on the unencumbered property.
Good examples of these types of situations include a conservation easements over property on the coast of Maine, as discussed earlier, or a wind energy easement over an uncultivated piece of land located in a predominately agricultural area of the Midwest. For such property owners, the relief from the responsibility of maintaining the lands collectively, along with the ability to generate turn-key, immediate income will often work in favor of the landowner.
However , that is not to say that easement sales are always beneficial to a property owner. Again the location and market conditions for property will have the biggest impact on how an easement relates to the overall value of the property. For example if a federal government agency proposed to a landowner that they would like to obtain an easement over a portion of their property as part of a proposed federal project and that easement would have little to no significant impact on the property; then that easement transaction may benefit the property owner and all parties involved. On the other hand, if that same federal government agency proposed to acquire a similar easement and the proposed easement would have a direct impact upon the landowner by limiting development opportunities in the near term; then the result may be quite different, and might result in a net loss of overall value in relation to the subject property. Similarly, if that agency proposed to take an easement on a smaller tract of land, in a depressed real estate market with little to no potential for future growth or development; then the sale of that easement may have very little impact on the overall appraised value of the property.
Particular attention must be paid to the effect that an easement or particular easement type will have on your property value so that the landowner can make the best decision for their particular situation.
Tax reporting of easement sales
It is not uncommon to have an easement be classified for federal tax purposes as a partial sale or exchange of real property. This means that any gain from the easement sale becomes taxable income. In these situations, you will be responsible for filing IRS Form 4797. Any gain you report will depend on how the payment was allocated between the various types of property flowing through the easement.
As a starting point, the proceeds from the easement sale must be allocated between "Section 1245" property (a.k.a., depreciable or business property such as equipment or machinery) and "Section 1250" property (a.k.a., land or structures on land). Only Section 1245 property can be recaptured. In other words, only Section 1245 property can be taxed as having been sold in a partial like-kind exchange or as having been otherwise sold.
If a portion of a payment for the easement is designated as compensation for Section 1245 property but the property was never depreciated, then this portion is not taxable as income and it is not taxable as a capital gain. To avoid hassles with the IRS, however, we recommend that all agreements for easement sales and/or renewals clearly state how the payment is allocated between the various types of property. Documenting or specifying how the sale proceeds are allocated at or before the time of sale is crucial.
Any payments you receive from the easement sale are subject to income tax as a capital gain. The amount of the proceeds that represent a capital gain is determined by subtracting your basis in the property sold from the total proceeds of the easement sale. In some cases, there may be multiple property interests subject to easement touches, i.e., multiple strips or uses of land. A thorough review of the pro forma assessment ratios should show whether the property interests were assessed differently. If they were assessed using different ratios then the value attributable to the higher rate can be identified. Having said that, if at the time of acquisition only a portion of the whole was assessed then only the fractional part of that property that was acquired should be included.
Legal guidance and considerations
It is essential to obtain legal advice from an attorney with experience in easement sales and negotiations before signing an easement agreement or deed with a utility. After almost 20 years of practice focusing on "taking" cases, I have seen a significant number of easements go bad. Often, clients spend months negotiating a compensation package with a transmission utility only to find out too late that the negotiations and anticipated payment have complicated their tax situation, resulting in either large penalties or unintended tax consequences.
There is no such thing as an "average" easement—each easement has its own specific set of circumstances. Utilities may try to convince you to sign an easement agreement without even first visiting the property to see the scope of the work. For example, a utility company may try to negotiate an easement for a new transmission line in your area. They tell you that even though the line is going through your property it will not materially change your property, and you can take their word for it.
Easement documents are "gotcha" documents. If something is not included in the scope of the easement , the utility can take it without compensation. It is therefore critical that you have a lawyer who can accurately estimate the extent of the taking and scope of the work needed to complete the easement. I would highly recommend getting assistance early in the process because easement negotiation is a time consuming process that requires attention to detail.
Taxes are deferred until the easement is sold, the easement expires, or the easement begins to expire. Whenever you start a process with a utility, I recommend consulting a lawyer immediately to discuss the initial offer and any tax implications that might arise from the easement. I advise against signing the easement until you have these issues worked out.
Unfortunately, many times after I have contacted the utility or its attorney, that offer will be substantially reduced or the package will be rescinded entirely until a formal notice of a proposed easement comes from the utility’s right-of-way agent. I have obtained six-figure offers for clients but only after talking with utility representatives about the client’s damage claims and interests. What some utilities offer as an easement negotiation package is actually an invitation for you to sign a number of documents reserving rights that do not exist and limiting things you can do with your land in favor of the utility. Most importantly, they are expecting you to close on the easement quickly and without independent legal or tax advice.