Tax Research Memo

Facts: Mr. Stench is in the garbage business. He purchased an old excavation site because it has a large hole in which he can dump garbage. Mr. Stench paid $30,000 for the site and, based on appraisals, estimates that the land site will be worth $10,000 when filled. He also estimates that, when filled to capacity, the hole will hold 50,000 cubic yards, and he expects to deposit somewhere between 9,000 and 11,000 cubic yards per year. Issues: Can Mr. Stench depreciate the cost of the dump site? If so, how much of the cost can he depreciate, and what method should he use? Authorities: §167; §168(f); §168(e)(3)(C)(ii); Rev. Proc. 87-56, 1987-2 CB 674; John J. Sexton, 42 TC 1094 (1964); Sanders v. Comm., 75 TC 157 (1980); Browning-Ferris Industries, Inc., and Subs., TC Memo 1987-147, 53 TCM 397 (1987) Conclusions: Mr. Stench can depreciate $20,000 of the dump site’s cost. This $20,000 is the difference between the site’s cost and its residual value when the hole is filled. He should elect to use the units-of-production method to depreciate this amount using the following formula: Depreciation per cubic yard = $20,000÷50,000 cubic yards = $0.40 per cubic yard. Analysis: In John J. Sexton, 42 TC 1094 (1964), the Tax Court addressed the issue of depreciation of a dump site for a taxpayer who had a factual situation that was almost identical to Mr. Stench. In that case, the IRS argued that the asset purchased was land, and as such, should not be depreciable. The taxpayer, however, contended that he purchased the space for the purpose of dumping, that he could measure the amount of space used for dumping, and that he had determined the residual value of the land. Thus, the taxpayer determined that he should be allowed to depreciate part of the cost in the property. The Tax Court held for the taxpayer and allowed the depreciation, reasoning that “rights in space have been recognized as property subject to transfer separately from the land.” The Tax Court concluded that these rights should be depreciable in the taxpayer’s business. Further, the Tax Court held that the difference between the cost of the property and its salvage value was a reasonable measure of the amount that could be depreciated and that it was reasonable to use a depreciation method based on the depreciable cost divided by the quantity dumped. Regarding whether the taxpayer in Sexton could depreciate the basis in the excavation, the IRS acquiesced in the result but disagreed with the Tax Court’s reasoning (A.O.D. 1969 WL 21099). The IRS believed that the depreciation should be based on the land having a determinable useful life instead of on the idea of air space being separate from the land itself. However, the IRS acquiesced without qualification to the taxpayer’s choice of the units-of-production method of calculating depreciation. Two subsequent cases, Sanders v. Comm., 75 TC 157 (1980) and Browning-Ferris Industries, Inc., and Subs., TC Memo 1987-147, 53 TCM 397 (1987), held similarly to Sexton. These cases also addressed factual differences that are not relevant to Mr. Stench’s situation. The Tax Court and the IRS addressed the issues noted above under §167 prior to the enactment of the Modified Accelerated Cost Recovery System (MACRS) under §168. Section 168(f) states that §168 does not apply if (1) the taxpayer elects to exclude the property from application and (2) the taxpayer uses the units-of-production method in his first year (and subsequent years). Because opting out of §168 is an election, the taxpayer could seemingly use MACRS rather than the units-of-production method. If the taxpayer chooses to use MACRS, the property is likely seven-year property under §168(e)(3)(C)(ii) because it does not have a listed class life under Rev. Proc. 87-56, 1987-2 CB 674. Although MACRS does not use the concept of salvage value, the appropriate depreciation amount would likely still be equal to the cost of the property minus the salvage value because this represents the portion of the cost that is allocable to the space being filled. Thus, Mr. Stench has a depreciable basis of $20,000 (the $30,000 cost minus the $10,000 residual value). Even though MACRS could possibly be applied to the property, I recommend that Mr. Stench elect under §168(f) to use the units-of-production method. Using the units-of-production method, Mr. Stench will recover his cost in approximately five years rather than the seven years cost recovery would take under MACRS. Accordingly, for each cubic yard of space filled, the applicable depreciation amount will be $0.40, calculated by dividing the $20,000 cost basis by 50,000 cubic yards.