Code Sec. 179 expensing has become a potent tax saver, thanks to current law's $500,000 deduction ceiling. So it should come as no surprise that taxpayers and their advisers are on the lookout for assets that potentially qualify as Code Sec. 179 property eligible for expensing. One such class of property is vineyards and orchards. IRS has published an Audit Techniques Guide (ATG) turning a thumbs down on expensing for such property, but its conclusion appears to be based on prior law. A more recent ATG leaves the door open to a better result. This Practice Alert presents the case for treating vineyards and orchards as Code Sec. 179 property and covers IRS's current “conflicted” guidance as well.
Background. Under Code Sec. 179, a taxpayer, other than an estate, a trust, or certain noncorporate lessors, can elect to deduct as an expense, rather than to depreciate, up to a specified amount of the cost of qualifying new or used tangible personal property placed in service during the tax year in the taxpayer's trade or business. The maximum annual expensing amount generally is reduced dollar-for-dollar by the amount of Code Sec. 179 property placed in service during the tax year in excess of a specified investment ceiling. The amount eligible to be expensed for a tax year can't exceed the taxable income derived from the taxpayer's active conduct of a trade or business. And any amount that is not allowed as a deduction because of the taxable income limitation may be carried forward to succeeding tax years.
For tax years beginning in 2010 or 2011: (1) the dollar limitation on the expense deduction is $500,000; and (2) the investment-based reduction in the dollar limitation starts to take effect when property placed in service in a tax year exceeds $2,000,000 (beginning-of-phaseout amount). Amounts ineligible for expensing due to excess investments in expensing-eligible property can't be carried forward and expensed in a subsequent year. Rather, they can only be recovered through depreciation. For tax years beginning in 2012, the maximum expensing amount under Code Sec. 179 is $125,000 and the investment-based phaseout amount is $500,000. The $125,000/$500,000 amounts will be indexed for inflation. However, for tax years beginning after 2012, the maximum expensing amount drops to $25,000 and the investment-based phaseout amount drops to $200,000. (Code Sec. 179(b))
In general, property is eligible for Code Sec. 179 expensing if it is:
... tangible property that's Code Sec. 1245 property depreciated under the MACRS rules of Code Sec. 168, regardless of its depreciation recovery period;
... for any tax year beginning in 2010 or 2011, up to $250,000 of qualified real property (qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property); and
... off-the-shelf computer software, if placed in service in a tax year beginning before 2013. (Code Sec. 179(d)(1))
Eligibility of vineyards and orchards for expensing. Back in '67, IRS ruled in Rev Rul 67-51, 1967-1 CB 68, that fruit orchards or groves don't qualify for Code Sec. 179 treatment. However, when that ruling was issued, former Code Sec. 179 defined section 179 property as tangible personal property of a character subject to the allowance for depreciation under Code Sec. 167, bought for use in a trade or business or for income production, and with a useful life of 6 years or more. (Code Sec. 179(d) before amend by §202(a), P.L. 97-34) The '67 ruling also cited to Reg. §1.179-3(b), which provided in part that tangible personal property did not include land. IRS reasoned in the ruling that because “trees are part and parcel of the land in which they are rooted,” trees of a fruit orchard or grove bought and held for production of income were not tangible personal property for Code Sec. 179 purposes.
In a Farmers ATG originally published several years ago, but last reviewed or updated on Mar. 16, 2011, IRS again says that trees or vines do not qualify under Code Sec. 179, citing to the '67 ruling.
Time for a rewrite? The definition of section 179 property has undergone a major transformation since the '67 ruling was written. Now, such property (other than certain software) is defined as tangible property to which Code Sec. 168 applies (i.e., it is depreciable), which is section 1245 property (as defined in Code Sec. 1245(a)(3)), and which is acquired by purchase for use in the active conduct of a trade or business. In turn, Code Sec. 1245(a)(3) provides that section 1245 property is any property subject to the depreciation allowance under Code Sec. 167 and which falls into one of six classes, the first of which is personal property (Code Sec. 1245(a)(3)(A)), and the second of which (Code Sec. 1245(a)(3)(B)), in relevant part, is other property (not including a building or its structural components) whose basis has been reduced by depreciation, amortization or the deductions that are treated as amortization under Code Sec. 1245(a)(2), during a period in which the property was used as an integral part of manufacturing, production or extraction.
Vineyards and orchards acquired by purchase for use in the active conduct of a trade or business are depreciable. Thus, the question of whether vineyards or orchards are Code Sec. 179 property comes down to whether they may be treated as “other property” used as an integral part of manufacturing, production, or extraction under Code Sec. 1245(a)(3)(B).
Investment credit rules hold the key. Reg. §1.1245-3(c)(2) provides in part that the terms used in Code Sec. 1245(1)(3)(B) (to the extent discussed above) have the same meaning as when used in Reg. §1.48-1(a), relating to the definition of investment credit property before repeal by P.L. 101-508. Under Reg. §1.48-1(a), the term “section 38 property” means “property (1) with respect to which depreciation (or amortization in lieu of depreciation) is allowable to the taxpayer, (2) which has an estimated useful life of 3 years or more, and (3) which is (i) tangible personal property,” and “(ii) other tangible property (not including a building and its structural components) but only if such other property is used as an integral part of manufacturing, production, or extraction....” And under Reg. §1.48-1(d)(2), for purposes of Reg. §1.48-1(a), the terms “manufacturing”, “production”, and “extraction” include the “cultivation of the soil, the raising of livestock, and the mining of minerals.... Thus, section 38 property would include, for example, property used as an integral part of the... cultivation of orchards, gardens, or nurseries....” Finally, Rev Rul 67-51 specifically says that trees of fruit orchards or groves purchased and held for the production of income qualify as “other tangible property” for former Code Sec. 48(a)(1)(B) purposes and Reg. §1.48-1(d). Thus, under former Code Sec. 48—and therefore by extension under current Code Sec. 1245(a)(3)(B) —farming is a production activity and vineyards as well as orchards qualify as “other property.” And if vineyards and orchards qualify as Code Sec. 1245(a)(3) property, then they are eligible for expensing under Code Sec. 179.
Possible change of heart at IRS? IRS's “Wine Industry Audit Technique Guide,” last reviewed or updated on May 10, 2011, carries the following information about the expensing issue:
In Kimmelman vs. Commissioner, 72 TC 294 (1979), it was held that grapevines are not “tangible personal property” within the meaning of I.R.C. §179(d). Prior to 1981, I.R.C. §179(d)(1), in part, defined I.R.C. §179 property as tangible, personal property, of a character subject to depreciation under I.R.C. §167, used in a trade or business, with a useful life of 6 years or more.
Current tax services [not RIA's Federal Tax Coordinator] reference pre-1981 cites to maintain that vines do not qualify as Section 179 property. Section 179 was amended in 1981 and the definition of qualifying property was substantially changed. The definition now references I.R.C. §1245(a)(3), to include (in part) any property of a character subject to the allowance for depreciation in §167, and is used as an integral part of manufacturing, production, or extraction. Certain practitioners are taking the position that this new definition includes vineyards and are taking I.R.C. §179 deductions.
Observation: The Vineyard Audit Techniques Guide doesn't say it agrees with this position, but it doesn't disagree with it, either. Thus, at worst, it's an open issue as far as IRS is concerned. At best, it may signal that IRS is reconsidering its view on whether orchards and vineyards are expensing-eligible under Code Sec. 179.