July 12, 2001
More brownfield incentives in the pipeline
By JONATHAN R. FLORA
Short Cressman & Burgess
A complex issue facing many communities is the redevelopment of brownfields, abandoned or under-used properties with real or perceived environmental contamination. One aid to redevelopment has been through federal tax incentives. Section 198 of the Internal Revenue Code of 1986 (IRC) was designed to spur contamination cleanup by treating certain environmental remediation costs as currently deductible rather than as capitalized expenditures.
A bill introduced on July 21, 2001, by Senator Robert Torricelli (D-N.J.) proposes amending section 198 to make financing brownfield redevelopment easier as well as to motivate developers to redevelop and sell contaminated sites. How would the proposals accomplish these goals?
The benefits of expensing
The IRC and the Internal Revenue Service require taxpayers to capitalize expenditures that produce long term benefits. The purpose is to match the timing of the deduction with the production of the income produced. When an expense is capitalized, a taxpayer may not deduct it currently (known as expensing) but instead must capitalize the cost and add it to its basis in the property. The taxpayer then recovers the cost either gradually over the asset’s useful life using the appropriate depreciation schedule or when the property is sold.
Absent an election under IRC section 198, environmental cleanup costs are treated as any other trade or business expenditure. Generally, taxpayers may expense incidental repairs that maintain the property in operating condition. On the other hand, expenditures that materially add to the value of property, prolong its useful life, or make the property adaptable to a new or different use must be capitalized.
Tax treatment of remediation costs
These principles have been applied to environmental remediation costs. When a taxpayer’s own operations cause contamination, a taxpayer may expense remediation costs on the theory that the costs maintain property in its current operating condition. On the other hand, when a taxpayer cleans up contamination existing when the property was acquired, costs are capitalized because they improve the value of the property or adapt it to a new use.
Applying these principles has proven challenging. In a series of rulings, the IRS has reached differing results in deciding whether cleanup efforts either increase the property’s value or restore the property to its condition before the taxpayer contaminated it. For example, in one ruling the IRS allowed a taxpayer to expense costs incurred to encapsulate asbestos on the theory that the work kept the property in normal operating condition without prolonging its life. In another ruling, the IRS required a taxpayer to capitalize the costs of removing asbestos and replacing it with less efficient insulation on the theory the property was more valuable without asbestos.
Brownfield redevelopers typically incur environmental costs to clean up contamination existing when they purchased the site, to improve the property value, and often to adapt the property to a new use. These costs commonly fall within the capitalization requirement.
Added to the IRC in 1997, section 198 overrides capitalization requirements for qualified environmental cleanup costs. To spur clean up of brownfields, the statute allows taxpayers to elect to expense certain environmental cleanup costs even though the current deduction will not match income the property will generate in the future. Expensing the entire cost creates a significant tax benefit. The deduction can be used to offset other current income or to carry back or forward as net operating losses.
An election to expense under section 198 only applies to “qualified environmental remediation” (QER) expenditures. QER expenditures are costs which are otherwise capitalized and incurred in connection with the abatement or control of hazardous substances at a qualified contamination site. When an election is not made or section 198 does not apply, general principles of capitalization control.
A “qualified contamination site” is an area (i) held for use by the taxpayer in a trade or business or as inventory, (ii) within a specified “targeted area,” (iii) not on the national priorities list of the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), and (iv) on which there has been a release or threat of release of a hazardous substance.
The statute only covers cleanup costs of “hazardous substances,” which section 198 defines by reference to section 101(14) of 102 of CERCLA. The definition excludes any substance with respect to which remediation is not authorized under CERCLA section 104(a)(3). As a consequence, cleanup costs of asbestos, petroleum contamination and naturally occurring substances that infiltrate water supplies are not covered under current law.
Expensing a cleanup cost under section 198 also affects the tax treatment on a later sale of property. Subject to various rules, a taxpayer is often entitled to favorable capital gain rates on the sale of realty used in a trade or business. Section 198 overrides these rules and characterizes a portion of gain from the sale of redeveloped property as ordinary income. Gain is “recaptured” as ordinary income to the extent of section 198 deductions the seller previously has taken. As a result of this recapture provision, a seller who makes a section 198 election may incur a larger tax liability when redeveloped property is sold than if the election were not made.
Section 198 contains a sunset provision which prevents its application to costs paid or incurred after Dec. 31, 2001.
The effect of the proposed bill
The proposed amendment would expand the application of section 198 in three ways.
First, the amendment would eliminate the sunset provision and allow deductions for QER expenditures incurred after Dec. 31, 2001.
Second, the amendment would broaden the current reach of QER expenditures beyond “hazardous substances” to include “toxic substances.” In particular, the amended statute would cover qualified cleanup costs for (i) any of the many substances listed as an “extremely hazardous substance” under section 302(a) of the Emergency Planning and Community Right-to-Know Act of 1986, as well as (ii) asbestos, oil, pesticide, radon and lead-based paint.
Third, the amendment would facilitate sales of redeveloped property by striking the statute’s recapture provision. The amendment eliminates the requirement that gain on the sale of redeveloped property be characterized as ordinary income to the extent of previous section 198 deductions. As a result, redevelopers may elect to expense cleanup costs without undercutting their ability to benefit from more favorable capital gains treatment when the property is sold.
The proposed amendment would apply prospectively to expenditures paid or incurred after the date of enactment.
Following the bill’s June introduction, the proposal was referred to the Senate Committee on Finance.
Jonathan Flora is an attorney with Short Cressman & Burgess PLLC, and a member of the firm’s business planning and taxation practice group.
Copyright ©2009 Seattle Daily Journal and DJC.COM.
Comments? Questions? Contact us.