Rev. Rul. 71-27: Tax Treatment for Easement Payments

Landowners are often approached by utility companies, pipeline operators, or government bodies seeking to acquire rights to use a portion of their property. These agreements, known as easements, grant a specific right for a specific purpose, such as laying underground cables. In return for granting this right, the landowner receives a payment. The federal income tax implications of this payment are addressed in Revenue Ruling 71-27, guidance from the Internal Revenue Service (IRS) that provides a framework for these transactions.

The ruling establishes when the payment is considered a sale of a property interest rather than rental income, a distinction that dictates the subsequent tax consequences.

Determining the Tax Treatment of Easement Payments

Revenue Ruling 71-27 establishes that granting a perpetual easement on a piece of property is treated as a sale of an interest in that real property. This separates easement payments from activities that generate rental income. If the payment were considered rent, it would be taxed as ordinary income in the year it was received, so by classifying the transaction as a sale, the proceeds receive a different, and frequently more advantageous, tax treatment.

The ruling applies specifically to situations where the landowner grants a perpetual right-of-way but retains the ability to make use of the land. For example, a farmer who grants a utility easement for an underground pipeline can continue to cultivate the land above it. This contrasts with a temporary easement for a limited term of years, which is considered a lease with payments taxed as rent. The perpetual nature of the easement is what solidifies its classification as the sale of a property right.

Calculating the Impact on Basis

The basis of a property is its original cost, including certain related expenses. When a landowner receives a payment for an easement that is treated as a sale, they do not automatically report the payment as income. Instead, the proceeds are first used to reduce the basis of the specific portion of the property affected by the easement.

A property owner must determine the basis of the acreage directly subject to the easement, which requires an equitable apportionment of the entire property’s cost. For instance, if a 100-acre property was purchased for $200,000, the basis is $2,000 per acre. If a perpetual easement affects 5 acres, the basis allocated to that portion would be $10,000.

Once the basis for the affected area is determined, the payment from the easement is applied against it. If the landowner in the previous example received a $7,000 payment, this amount would be subtracted from the $10,000 allocated basis, resulting in a new adjusted basis of $3,000 for that portion. Because the payment is less than the allocated basis, the landowner recognizes no taxable gain at the time of the transaction, and the financial impact is deferred until a future sale of the property.

Recognizing Gain from Easement Payments

A taxable event occurs when the compensation received for the easement is greater than the allocated basis of the land it affects. The portion of the payment that exceeds the basis is recognized as a capital gain in the year the payment is received. This gain is treated as a long-term capital gain if the landowner has held the property for more than one year, which results in a lower tax rate than ordinary income.

For example, if a landowner has an allocated basis of $10,000 for the affected portion of their property and receives a $15,000 easement payment, the first $10,000 reduces the basis to zero. The remaining $5,000 is a taxable capital gain. This amount must be reported to the IRS for the tax year in which the transaction occurred.

In some easement negotiations, a separate payment may be designated as “severance damages.” These payments are intended to compensate the owner for a decrease in the value of the retained property not directly subject to the easement. These funds are not applied to the basis of the land under the easement but are instead used to reduce the basis of the retained portion of the property that was negatively impacted.

Reporting Easement Transactions

If the transaction results in a recognized capital gain, it must be reported on specific IRS forms. The details are first entered on Form 8949, Sales and Other Dispositions of Capital Assets. The totals from this form are then transferred to Schedule D, Capital Gains and Losses, which is filed with the taxpayer’s Form 1040.

The information required on Form 8949 includes a description of the property interest sold, the dates it was acquired and sold, the sales price, and the cost basis allocated to the affected land. The difference between the sales price and the basis will determine the gain.

If the easement payment is less than or equal to the basis of the affected property, no immediate gain is recognized or reported on Schedule D for that year. However, landowners must maintain detailed records of the transaction. These records should include a copy of the easement agreement and the calculations for both the allocated basis and its subsequent reduction. These documents are necessary to accurately calculate the gain or loss when the entire property is sold in the future.