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Tax Court: Interest and Property Taxes Relating to Growing of Trees Must Be Capitalized

(Parker Tax Publishing December 2016)

The Tax Court held that three related partnerships had to capitalize interest and property taxes that related to the purchase and cultivation of land on which the partnerships were growing almond trees. The Tax Court disagreed with the partnerships' proposition that the applicability of Code Sec. 263A turned on whether the partnerships produced the land themselves, concluding that the partnerships' growing of the almond trees was a production of those trees within the reach of the capitalization rules of Code Sec. 263A. Wasco Real Properties I, LLC v. Comm'r, T.C. Memo. 2016-224.


A group of individuals involved in the business of almond farming were partners, either directly or indirectly, in three related partnerships. The partnerships separately purchased land and each partnership thereafter planted and grew almond trees on its land. The partnerships paid interest relating to debt incurred to purchase the land, and they deducted the interest during the years at issue. Part of the interest deductions also related to interest paid to a third party with respect to funds that two of the partnerships contemporaneously lent to the third partnership. One of the partnerships also deducted property taxes that it paid with respect to its land.

The IRS issued separate notices of final partnership administrative adjustment (FPAAs) to the tax matters partners (TMPs) of the three partnerships, disallowing the interest and property tax deductions because, in the IRS's view, Code Sec. 263A required those expenses to be capitalized. The IRS also concluded that the interest relating to the funds lent by two of the partnerships to the third partnership had to be capitalized because the loans to that partnership were related party transactions subject to the anti-abuse rule in Reg. Sec. 1.263A-15(c). The IRS also made adjustments under Code Sec. 481 because capitalizing the interest and property taxes resulted in each partnership's changing its accounting method as to the costs.

Code Sec. 263A generally requires taxpayers who produce real property to capitalize the direct costs of such property, and the property's proper share of those indirect costs (including taxes) which are allocable to such property. Code Sec. 263A(f)(1) provides that interest is capitalized where:

(1) the interest is paid during the production period; and

(2) the interest is allocable to real property that the taxpayer produced and that has a long useful life, an estimated production period exceeding two years, or an estimated production period exceeding one year and a cost exceeding $1 million.

Reg. Sec. 1.263A-8(a) provides that capitalization of interest under the avoided cost method described in Reg. Sec. 1.263A-9 is required with respect to the production of "designated property." The term "designated property" generally includes any real property that is produced. Code Sec. 263A(f) does not require that the debt be directly attributable to the produced property.

Reg. Sec. 1.263A-8(c)(2) provides that growing crops and plants are real property only if the preproductive period of the crop or plant exceeds two years. The partnerships and IRS both agreed that almond trees had a preproductive period exceeding two years.

The partnerships argued that Code Sec. 263A did not apply with respect to their situation because the interest and the property taxes they deducted related to the land, which the entities did not produce.

Tax Court's Opinion

The Tax Court held that Code Sec. 263A(a)(2)(B) requires that the partnership that deducted the property taxes had to instead capitalize the portion of the property taxes corresponding to the portion of the land on which it grew almond trees since that portion of the taxes was an allocable, indirect cost of growing (and thus producing) the almond trees. Almond trees are real property, the court said, because the preproductive period of the trees exceeds two years. Further, the court held, Code Sec. 263A(a) and Code Sec. 263A(f)(1) and (2) requires that each partnership capitalize the interest corresponding to the portion of its land on which it grew almond trees because that portion of the interest is allocable to the almond trees.

The Tax Court disagreed with the partnerships' proposition that the applicability of Code Sec. 263A turned on whether the partnerships produced the land themselves. The partnerships' growing of the almond trees is a production of those trees within the reach of Code Sec. 263A, the court said. The land itself need not be produced because the land and the almond trees are sufficiently intertwined in the sense that the almond trees cannot grow without the underlying land and the partnerships' placing in service of the almond trees required that they also place in service the underlying land. Thus, while the property taxes and the interest may have been more closely connected with the land than with the almond trees, the court said, the payment of those costs was both necessary and indispensable to the growing of the almond trees so as to be considered a cost of producing those trees.

The court noted that the uniform capitalization rules apply to real property produced by the taxpayer for the taxpayer's use in a trade or business or in an activity conducted for profit. While the Code does not define the term "real property" for purposes of Code Sec. 263A, Reg. Sec. 1.263A-8(c)(1) and (2) define the term to include "land" and "unsevered natural products of land" and provides that "unsevered natural products of land" generally include growing crops and plants where the preproductive period of the crop or plant exceeds two years. The court found that this definition, although included in the regulations explicitly made applicable to the capitalization of interest but not included in the regulations explicitly made applicable to the capitalization of other costs, was consistent with the term's ordinary meaning. The court concluded that because the partnerships were producing real property (i.e., growing almond trees), they had to capitalize their direct and indirect costs.

The Tax Court also held that the anti-abuse rule in Reg. Sec. 1.263A-15(c) applied and that the two partnerships that lent funds to the third partnership had to capitalize the interest they paid to the third party because their loans were related party transactions that avoided the interest capitalization rules of Reg. Sec. 1.263A-8 through Reg. Sec. 1.263A-15 and did not carry out the purposes of Code Sec. 263A(f).

Finally, the court also sustained the IRS's adjustments under Code Sec. 481 to the extent that the partnerships had to change their methods of accounting to capitalize the taxes and the interest in lieu of deducting those items currently.

For a discussion of the uniform capitalization rules relating to farming businesses, see Parker Tax ¶242,440.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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