Condemnation of pipeline easements: the landowner's perspective.

• Author: Kebodeaux, Keith

The reinvigorated U.S. oil and gas industry and the growing need to transport oil, gas, and liquid hydrocarbons has caused a boom in pipeline construction.(1) Constructing pipelines requires that property be acquired for rights of way and valve and compressor surface sites. Property may be acquired through eminent domain (condemnation) proceedings, by sale under threat of condemnation, or by negotiated sale where the power of eminent domain does not exist. Conveying easements and surface sites to install pipelines and related facilities can trigger various federal income tax consequences, which makes coordination between legal counsel and the tax planner essential to achieve the best tax outcomes.

This article examines income tax issues that commonly arise in connection with the conveyance of easements and surface sites and identifies planning opportunities. Although it focuses on pipeline condemnation prtHxcdings, many of the issues and planning suggestions also apply to the conveyance of surface rights and easements for oil and gas exploration and production activities.

Overview

When a property owner grants a pipeline company rights to use property or a company obtains those rights through condemnation, determining the tax effects requires a careful analysis of the terms of the transaction. The transaction alternately can be rreated for tax purposes as a sale of land, a sale of an easement, or a lease of or license to use land. In addition, a typical transaction may include payments to the property owner for damages to easement land or to land retained by the property owner, which are treated differently for tax purposes.

Multiple opportunities to defer gain exist. Allocation of the proceeds from the transaction between payments for the easement and payments for damages is critical to lessen tax. Where the property owner can substantiate severance damages, opportunities to offset basis against the retained property exist. The property owner also can offset payments for damages to real property resulting in the ordinary' course of casement construction against basis. In addirion, a voluntary conveyance of an easement may qualify for elective deferral of gain under Sec. 1031, and a conveyance made as a result of condemnation proceedings may qualify for elective deferral of gain under Sec. 1033.

Eminent Domain

The power of eminent domain is the right of the federal or state government to acquire private property for public use, subject to the payment of compensation. Condemnation is treated as a sale for tax purposes.(2) Developers of pipelines that will carry oil or gas as common carriers are often delegated the authority to condemn property.

The Texas statute(3) is representative of state eminent domain procedures and is consistent with the Uniform Law Commissioners' Model Eminent Domain Code.(4) Texas provides an accelerated procedure for condemnation. Once negotiations have occurred and a monetary offer has been extended, the condemnor may commence an action in which the commissioners make an administrative determination of the value of the property taken, the benefits to the landowner, and the reduction, if any, in the value of the landowner's remaining property. Diminution in value of the remaining property is called ""severance" damage. Upon depositing funds in the amount of the damages, the condemnor may take possession of the property. While the landowner may further litigate the value of the property taken, possession of the property and preliminary damages are adjudicated in the administrative proceeding.

In some states, withdrawing deposited funds acts as an election of remedies and waiver of further recourse. If withdrawal does not act as an election and waiver, subsequent litigation or appeals can result in the property owner's receiving compensation over a period of years. An unfettered right of withdrawal raises issues of constructive receipt and timing of gain recognition.

The owner is entitled to the fair market value I FMV) of the property taken. In appropriate circumstances, severance damages for the portion of the property not taken, compensation lor personal property and fixtures, compensation for temporary space needed for construction, damage to growing crops, relocation expenses, and interest on these amounts may be recovered. Legal procedures may require only a finding of a lump sum of damages, leaving open the constituent elements of recovery or settlement.

Defining the Nature of the Interest Conveyed

Pipeline rights of way usually take the form of perpetual easements. An easement is a real property interest that is subject to sale. A conveyance of a perpetual easement where the grantor retains no significant beneficial rights is considered a sale of the underlying tract of land.(5) Property owners commonly retain beneficial rights to use the subservient property, provided they do not interfere with the use of the casement. The retention of those rights connotes the sale of an casement rather than ot the underlying tract.

Transactions that are labeled as a sale of an easement are often intentionally or unintentionally structured as a lease of or license to use the land in question. This negates sale treatment, resulting in the recognition of ordinary income and precluding basts offset, losses, capital gains, and gain deferral under Sec. 1033.

Recognition of Gain or Loss on Sale Transaction

Recognition ot gain or loss varies depending on whether the transaction is considered a sale of the underlying land or merely a sale of an easement with the grantor retaining rights to the land. Il the property owner granting the easement retains no beneficial rights, the property owner recognizes gain or loss. If the grantor retains significant beneficial rights, the property owner applies pnxreeds against basis in the tract and recognizes gain to the extent the proceeds exceed basis. Loss is not recognized.(5) Whether or not the property owner retains beneficial rights, gain may be eligible for Sec. 1033 deferral.(7)

The property owner must allocate basis to the easement tract to determine the amount of gain or loss realized. Allocation of basis does not require proration based on acreage, but, instead, must be equitably apportioned.(8) If the easement tract fronts a street or highway, it may be appropriate to allocate a greater portion of the basis per acre.(9) Allocation is generally based on FMV, and occasionally on assessed value, at the time of purchase.(10)

The nature of the asset (or assets) conveyed must be ascertained. Land may be a capital asset held for investment or personal use. Sec. 1231 property (which is property used in a trade or business, including property subject to involuntary conversion), or stock in trade. Improvements may be property subject to Sec. 1250 depreciation recapture and gain. If the property is Sec. 1231 property with improvements. Sec. 1250 ordinary income recapture and gain must be determined before Sec. 1231 gain or loss is calculated. Sec. 1231 gains and losses are subjected to the "hotchpot" process (i.e., put into a pool and netted) and treated as cither capital gains or ordinary losses. Property that is condemned or conveyed under threat ot condemnation is treated as Sec. 1231 property if it is prop-cm- used in a trade or business, or a capital asset held for more than one year in connection with a trade or business or a transaction entered into for profit. In the case of an involuntary conversion, growing crops are treated as Sec. 1231 property rather than as stock in trade.

Opportunities to Offset Proceeds Against Basis of Entire Property

As noted above, the property owner generally is allowed only to offset the proceeds from the sale of an easement against the basis in the easement tract. In limited circumstances, the proceeds of an easement conveyance may be applied to reduce aggregate basis in both the property retained and the casement tract.(11) In Inaja Land Co., which involved a perpetual easement to the city of Los Angeles to flood all of the grantor's...