It depends on the type of income granted, whether it is damages or rental, and taxed as ordinary income or capital gains.
Income you receive for granting easements or rights-of-way on your farm or ranch for flooding land, laying pipelines, constructing electric or telephone lines, etc., may result in income, a reduction in the basis of all or part of your farmland, or both.
Income you received for granting a temporary construction easement is rental income. Report the income as rent on Part I of Schedule E (Form 1040).
Example
You granted a permanent right-of-way for a gas pipeline through your property for $10,000. Only a specific part of your farmland was affected. You reserved the right to continue farming the surface land after the pipe was laid. Treat the payment for the right-of-way in one of the following ways.
- If the payment is less than the basis properly allocated to the part of your land affected by the right-of-way, reduce the basis by $10,000.
- If the payment is equal to or more than the basis of the affected part of your land, reduce the basis to zero and the rest, if any, is gain from a sale. The gain is reported on Form 4797 and is treated as section 1231 gain if you held the land for more than 1 year. See chapter 9.
The contract also contained a provision for a temporary workspace (temporary easement) to allow for the collection of topsoil and for equipment movement. This temporary easement is only for the construction period (usually a period of months). The gain is reported on Form 4797 as ordinary income and does not affect the basis of the land.
Easement contracts usually describe the affected land using square feet. Your basis may be figured per acre. One acre equals 43,560 square feet.
If construction of the pipeline damaged growing crops and you later receive a settlement of $250 for this damage, the $250 is income and is included on Schedule F. It doesn't affect the basis of your land.
Damage payments are intended to compensate the landowner for damages caused by current construction as well as a release for future loss of use and damages to the surface, fences and crops. Payments for current damages may generally be offset against the landowner’s cost basis. The IRS characterizes payments for future damages as a rental and thus ordinary income. The law on taxation of damages is murky and the IRS closely scrutinizes payments for damages.
IRS Publication 225
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