Rev. Rul. 60-386

The Internal Revenue Service has been requested to set forth the proper treatment for Federal income tax purposes of expenditures made by a taxpayer to counteract the effects of land subsidence.

The taxpayer owns a tract of land along the western coastal plain of the United States. Numerous oil and gas wells have been drilled on this tract of land. Originally, the land on which the operations are conducted was a barrier to the sea. Several years ago, however, it became evident that the land was subsiding, a situation which still continues.

In order to prevent the property from becoming inundated, the taxpayer has spent large sums of money to erect sea walls which now constitute a barrier to the sea. In addition to the construction of such sea walls and related bulkheads, the taxpayer has elevated the top of many of its wells and other facilities.

As circumstances required, sea walls were raised and further sea-wall construction was undertaken to counteract the effects of the continued subsidence. The location of the strengthened sea walls in all cases overlay the existing sea walls so that none of the older facilities were removed or abandoned but used to the fullest extent through incorporation into the later construction. Drainage systems, comprising pipes, pumps and related facilities, to dispose of surface and seepage water have been constructed. In addition, the taxpayer has been required to rearrange and move various parts of his equipment and drainage facilities.

Section 162 of the Internal Revenue Code of 1954 provides for the allowance as a deduction of all the ordinary and necessary expenses incurred during the taxable year in carrying on any trade or business.

However, under the provisions of section 263 of the Code, no deductions shall be allowed for (1) any amounts paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate or for (2) any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made.

Section 167 of the Code provides for the allowance as a depreciation deduction of a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence) of property used in the trade or business, or of property held for the production of income.

It is evident that certain expenditures as, for instance, repairs, maintenance and moving costs occasioned by subsidence, constitute ordinary and necessary business expenses currently deductible under section 162 of the Code. On the other hand, expenditures for sea walls, dikes, and bulkheads, as well as pumps and drainage systems, the benefits of which are to be derived by the taxpayer over more than one taxable year, are nondeductible capital expenditures subject to an allowance for depreciation under section 167 of the Code.

There are many cases in which expenditures were made necessary which did not extend the life of the property or increase its value. The expenditures provided protection against future damage, or adapted buildings or operations to new surroundings, or created something new or better by substitution of different materials or structures, or where the expenditures made the property more valuable from either a monetary point of view or for use in the business.

In Parkersburg Iron and Steel Company v. Burnet , 48 Fed.(2d) 163, Ct.D. 360, C.B. X-2, 357 (1937), the taxpayer was the recipient of Government contracts. Army engineers, upon inspection of the plant, suggested that certain physical changes be made therein. The taxpayer complied with these suggestions and, for Federal income tax purposes, contended that the changes constituted ordinary and necessary business expenses on the ground that they did not increase either the productivity, the efficiency, or the value of the plant. The court held that the expenditures were made for permanent improvements and as such had to be capitalized. See also Hotel Sulgrave, Inc. v. Commissioner , 21 T.C. 619, and R.K.O. Theatres, Inc. v. United States , 163 Fed.Supp. 598.

Revenue Ruling 79, C.B. 1953-1, 41, holds that amounts expended for the construction of protective works or for moving houses to prevent storm losses to property abutting the Great Lakes are not allowable deductions but constitute capital expenditures. See also Revenue Ruling 54-191, C.B. 1954-1, 68, relating to the construction of earthen terraces on farm land for the prevention of soil erosion, and Revenue Ruling 57-30, C.B. 1957-1, 109, relating to capitalization and amortization of costs of sheet piling the side of a dock.

On the other hand, in the case of Illinois Merchants Trust v. Commissioner , 4 B.T.A. 103, acquiescence, C.B. V-2, 2 (1926), a sudden lowering of the water level in the south branch of the Chicago River left the upper ends of certain wood piles, upon which the taxpayer's building rested, exposed to the air, causing that part of the piles to decay from dry rot. As a consequence, the wall on the river side of the taxpayer's building settled to a point where it was likely that the entire building would collapse. In order to maintain the building in serviceable condition, it was necessary to saw off the rotted piles at a point below the new water level and to insert concrete supports between the ends of the submerged piles and the floor of the building, thus raising the river wall. This wall was also considerably shored up. The United States Board of Tax Appeals (now the Tax Court of the United States) held that the taxpayer was entitled to deduct the cost of this work as a business expense for repairs since the work did not extend the life of the property or increase its value.

In the instant case, a portion of the taxpayer's lands, which have been a natural barrier to the Pacific Ocean, has been irretrievably lost by subsiding into the ocean. Consequently, new barriers and drainage systems had to be constructed. This construction represents entirely new assets and a complete substitution of structures, utilizing different materials, which adapt the properties to changed surroundings, provide protection from future damage and make the properties more valuable for use in the taxpayer's business.

Accordingly, it is held that expenditures made by the taxpayer in the instant case for sea walls, dikes, and bulkheads, as well as pumps and drainage systems, to counteract the effect of land subsidence constitute capital expenditures within the purview of section 263 of the Code. The cost of the sea wall, dikes, and bulkheads, as well as drainage systems, may be recovered over the expected useful life thereof, depending upon its construction and the rate of subsidence to which it may be subject, through an allowance for depreciation as provided in section 167 of the Code.