31.7 Granting of an Easement

Granting an easement presents a practical problem of determining whether all or part of the basis of the property is allocable to the easement proceeds. This requires an opinion as to whether the easement affects the entire property or just a part of the property. There is no hard and fast rule to determine whether an easement affects all or part of the property. The issue is factual. For example, an easement for electric lines will generally affect only the area over which the lines are suspended and for which the right of way is granted. In such a case, an allocation may be required; see Example 1 below. If the entire property is affected, no allocation is required and the proceeds reduce the basis of the property. If only part of the property is affected, then the proceeds are applied to the cost allocated to the area affected by the easement. If the proceeds exceed the amount allocated to basis, a gain is realized. Capital gain treatment generally applies to grants of easements. The granting of a perpetual easement that requires you to give up all or substantially all of a beneficial use of the area affected by the easement is treated as a sale. The contribution to a government body of a scenic easement in perpetuity is a charitable contribution (14.10), not a sale.

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image Planning Reminder
Basis Allocation
In reviewing an easement, the IRS will generally try to find grounds for allocating part of a property owner’s basis to easement proceeds, especially where the allocation will result in a taxable gain. In opposition, a property owner will generally argue that the easement affects the entire property or that it is impossible to make an allocation because of the nature of the easement or the particular nature of the property. If he or she can sustain that argument, the proceeds for granting the easement reduce the basis of the entire property; see the Examples in 31.7.
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Condemnation.

If you realize a gain on a grant of an easement under a condemnation or threat of condemnation, you may defer tax by investing in replacement property (18.19).

EXAMPLES
1. The owner of a 600-acre farm was paid $5,000 by a power company for the right to put up poles and power lines. The right of way covered 20 acres along one boundary that the owner continued to farm. The cost basis of the farm was $60,000, or $100 an acre. The IRS ruled that he had to allocate the basis. At $100 an acre, the allocated basis for the 20 acres was $2,000. Thus, a gain of $3,000 was realized ($5,000 − $2,000).
2. The owner of a tract of unimproved land gave a state highway department a perpetual easement affecting only part of the land. He wanted to treat the payment as a reduction of the basis of the entire tract and so report no gain. The IRS ruled that he had to allocate basis to the portion affected by the road.
3. The owner of farmland gave a transmission company a 50-foot right of way for an underground pipeline that did not interfere with farming. During construction, the right of way was 150 feet. The owner received payments for damages covering loss of rental income during construction and for the 50-foot permanent right of way. The IRS ruled that the damage payment was taxable as ordinary income; the payment for the right of way was a taxable gain to the extent that it exceeded the basis allocated to the acreage within the 50-foot strip.

Release of a restrictive covenant.

A payment received for a release of a restrictive covenant is treated as a capital gain if the release involves property held for investment.

EXAMPLE
You sell several acres of land held for investment to a construction company subject to a covenant that restricts construction to residential dwellings. Later, the company wants to erect structures other than individual homes and pays you for the release of the restrictive covenant in the deed. You realize capital gain on receipt of the payment. The restrictive covenant is a property interest and a capital asset in your hands.
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