Surface damage payments are commonplace in landowner-mineral lessee relations. The tax consequences which attach to these payments must be determined by examining their nature and what they were intended to compensate.
In order to qualify income for capital gains treatment, the taxpayer must prove the income arose from the sale or exchange of a capital asset held for the statutory holding period of time. Payments received as compensation for damage to land, a capital asset, constitute a recovery of basis.
Anticipatory Damages are ordinary income. Burden is on the taxpayer to prove damages are actually incurred. Damages have to be specific. Amounts paid for expected damages, but no damage was done, do not qualify for treatment as return of capital. Damages if prepaid or the property was not injured and not restored can be taxed as ordinary income. So be careful what you wish for here in your negotiations.
If payments are found to compensate a property owner for damage or destruction of his land or property, payments generally are characterized as a recovery of capital for tax purposes.
Did the damage affect the Fair Market Value (FMV) of your property? The landowner must be able to substantiate a change in the FMV when possible damages occur or are negotiated.
Landowners must support damage claims. Burden is on the taxpayer to prove actual damages occurred to substantiate any return of capital. Take before and after digital pictures from lots of angles.
Don’t be fooled by the landman, your neighbor or a non-CPA tax preparer telling you that damages are not taxable. There is nothing wrong with negotiating a damage value on your property but consult your CPA to understand the tax implications.
All types of Damages are reportable on your tax return. The character and written agreements related to these payments will determine where they should be reported on your return. Be prepared to support and document the types of income received and where you correctly reported it on the return. The 1099 reporting by the payer can definitely cause issues even a couple years after filing due to the IRS matching program. Having the proper documentation to support your position will ease this issue with a properly worded response to the IRS to clear up the notice.
Crop damages to a farmer are taxable Farm income on Schedule F. If you have been filing a farm schedule in prior years and negotiate crop damage, this income will be considered farm income and be subject to self-employment taxes.
A return of capital means you have the ability to reduce your Basis in the Property. First, you have to have a basis. So, if you buy 20 acres for $20,000 you have basis of $20,000. If you receive ‘damages’ of $20,000 – you can reduce your $20,000 basis down to $0 and have no taxable income. Basis is not what you ‘think’ your property is worth or what it is appraised at currently. Yourkovich & Associates can discuss your Basis calculations.