Taxpayer Planting Almond Trees on Purchased Land Must Capitalize Interest on Land Debt and Property Taxes During Preproduction Period for Trees

Three partnerships found that the Tax Court generally agreed with the IRS that the interest they paid to purchase land, as well as property taxes they paid on the land, had to be capitalized under IRC §263A as part of the cost of production for the almond trees they began growing on the land in the case of Wasco Real Properties I, LLC et al v. Commissioner, TC Memo 2016-224.

The three partnerships in this case had purchased land that they planned to use for growing almonds.  After the land was purchased the entities began planting almond trees that would eventually produce a crop of almonds.

The taxpayers purchased the land by borrowing funds and paying interest on the debt.  The partnerships also were billed for and paid property taxes on each parcel of land.  The partnerships claimed a deduction on their income tax returns for the interest and property taxes.

But the IRS objected, arguing that the interest and taxes were indirect costs of the production of real property—that is, the almond trees that the taxpayers were growing.  The Court opinion notes:

The uniform capitalization rules apply to “[r]eal * * * property produced by the taxpayer” for the taxpayer’s use in a trade or business or in an activity conducted for profit. Sec. 263A(b)(1), (c)(1). While the statute does not define the term “real property” for purposes of section 263A, section 1.263A-8(c)(1) and (2), Income Tax Regs., defines the term to include “land” and “unsevered natural products of land” and states further that “unsevered natural products of land” generally include “[g]rowing crops and plants” where the preproductive period of the crop or plant exceeds two years.

The almond trees in question have just such a “greater than two year” preproductive period.

But the taxpayer argued this didn’t matter, since the interest and taxes related to the land, not the almond trees.  But the Court did not agree, as it noted:

Petitioners focus on the fact that the taxes and the interest directly relate to the ownership and the purchase of the land, respectively, to conclude that these expenses may be capitalized only if the land is being produced. Petitioners’ focus is blurred. The entities grow almond trees as part of their businesses, and the almond trees grow on the land. The land itself need not be produced in that the land and the almond trees are sufficiently intertwined in the sense that the almond trees cannot grow without the underlying land and the entities’ placing in service of the almond trees requires that the entities also place in service the underlying land. Thus, while the property taxes and the interest may have been more closely connected with the land than with the almond trees, the payment of those costs, to be sure, was both necessary and indispensable to the growing of the almond trees so as to be considered a cost of producing those trees. Our finding that the land is a necessary and indispensable part of the growing of the almond trees is further demonstrated by WRP I’s phase 1 land preparation costs. That phase, in part, included analyzing the soil, ripping and deep ripping the soil, trenching, and leveling the land.

The taxpayer objected that combining the trees and the land should only apply if the items must be mutually dependent—and the land could be placed into service without having to put almond trees or any other “greater than two year” crop on the land.

The Court disagrees, finding a “one-way” dependence is enough to link the two.  As the Court concludes:

The regulations do not require mutual interdependence. With regard to buildings, the regulations contemplate that a building and its land are components of the same unit of property. See id. para. (b)(1) and (2); see also id. subpara. (6), Examples (1) through (7). Likewise as to the land and the almond trees. For the land and the almond trees to be characterized as a unit of property, the regulations require that the almond trees are growing on the land and that the placing in service of either the land or the almond trees is dependent on the other piece of property’s also being in service. Such is the case here.

The taxpayers next try to argue that the property taxes are clearly associated directly with the land and they would have due regardless of the almond trees, so they should get a current deduction.  The Court again disagrees, noting:

The Wasco land was used to grow the almond trees, and the property taxes assessed as to that land directly benefit the almond trees in that the taxes were incurred in the course of WRP I’s using the land to grow the almond trees. WRP I is obligated to pay the property taxes on its portion of the Wasco land, given that WRP I is the owner of that land for which the tax is assessed. In addition, WRP I could have been precluded from growing the almond trees on the land if the property taxes were not paid. We also bear in mind that the Court has previously required real estate developers to capitalize property taxes as indirect costs properly allocable to their properties. See Von-Lusk v. Commissioner, 104 T.C. 207, 209, 217 (1995) (requiring that a partnership capitalize property taxes where the partnership was organized to manage, hold, and develop property for investment); see also Reichel v. Commissioner, 112 T.C. 14, 19-20 (1999) (requiring that a real estate developer capitalize property taxes on property that was not developed).

Thus, the Court found that the IRS could mandate that the taxpayers change their method of accounting for these costs to comply with this ruling, picking up amounts deducted in prior years that should have been capitalized as an IRC §481(a) adjustment.