Section 198: Expensing Environmental Remediation Costs

A tax deduction once existed for businesses undertaking the cleanup of contaminated properties. This provision, found in Section 198 of the Internal Revenue Code, allowed the immediate expensing of specific environmental remediation costs but expired for expenses paid or incurred after December 31, 2011.

Normally, such costs would have been capitalized, meaning they would be added to the property’s basis and recovered over time through depreciation. Section 198 permitted a full deduction in the year the expenses were paid or incurred, accelerating the tax benefit. This tax treatment was designed to encourage the voluntary cleanup and redevelopment of polluted sites, turning environmental liabilities into productive assets.

Eligibility Requirements for the Deduction

To have claimed the deduction under Section 198, both the property and the expenses had to meet stringent criteria. The rules ensured that the tax benefit was targeted toward specific situations involving contaminated business or investment properties located in designated areas.

Qualified Contaminated Site

The property first had to be classified as a “qualified contaminated site.” This meant the site was property held by the taxpayer for use in a trade or business, for the production of income, or as inventory. A requirement was that the property had to be located within a “targeted area.” Targeted areas included federally designated Empowerment Zones, Enterprise Communities, sites in the Brownfields Economic Development Initiative, and certain population census tracts with specific poverty rate thresholds.

Another condition was the confirmed presence of a hazardous substance, involving a release, threat of release, or disposal on the property. To verify this, the taxpayer had to obtain a statement from the designated state environmental agency confirming that the site met these requirements. This statement had to be received before filing the tax return claiming the deduction. Sites on the National Priorities List under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) were specifically excluded.

Hazardous Substances

The remediation efforts had to focus on the abatement or control of “hazardous substances.” The definition for this term was directly tied to the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA). This federal law lists specific substances considered dangerous to human health or the environment, such as lead, asbestos, and various chemical compounds.

While initially narrow, the definition was eventually expanded. For instance, after a 2006 amendment, the costs to clean up petroleum products also became eligible for the deduction.

Qualified Remediation Expenditures

“Qualified environmental remediation expenditures” were costs that would otherwise have needed to be capitalized and added to the property’s basis. These were expenses paid or incurred for the actual abatement or control of the hazardous substances at the qualified site. This could include activities such as excavation of contaminated soil, removal of hazardous materials, and groundwater treatment.

Certain costs were excluded from this definition. The cost of purchasing depreciable property used in the cleanup, such as new monitoring wells, did not qualify for the immediate deduction. However, the annual depreciation allowance for that equipment allocable to the site could be treated as a qualified expenditure. Any fines or penalties paid to a government agency for environmental violations were not deductible under this provision.

Making the Election

A taxpayer had to formally elect to take the deduction. The election was made on a year-by-year and expenditure-by-expenditure basis, providing flexibility. A taxpayer could choose to expense some qualified costs while capitalizing others in the same year.

To make the election, the taxpayer had to include a specific statement with their federal income tax return for the taxable year in which the remediation costs were paid or incurred. This election had to be made by the due date of the return, including any extensions.

The statement had to clearly state that the taxpayer was electing to apply Section 198. The statement also had to describe the qualified contaminated site, including its location and the dates the expenditures were incurred. It also had to reference the statement from the state environmental agency that certified the property.

Recapture of the Deduction

Taking the Section 198 deduction had future tax implications if the remediated property was later sold at a gain. The tax code required a “recapture” of the deducted amount, meaning a portion of the gain on the sale would be treated as ordinary income instead of capital gain.

The recapture mechanism functioned under the rules of Internal Revenue Code Section 1245. The amount previously deducted was treated as a depreciation deduction. When the property was sold, any gain realized was taxed as ordinary income up to the total amount of the remediation costs that were expensed.

For example, a business bought a property for $200,000 and deducted $50,000 in qualified remediation costs. The property was later sold for $300,000, resulting in a total gain of $100,000. Because of the recapture rule, the first $50,000 of that gain was taxed as ordinary income, and the remaining $50,000 of the gain was treated as a capital gain.