What Is Section 126 Property? Basis Reduction and Section 1255 Recapture

Section 126 property is land or a land improvement that received a government conservation cost-sharing payment which the owner elected to exclude from gross income under Internal Revenue Code Section 126. Once you make that election, the property carries two lasting consequences: its basis is reduced by the excluded amount, and any gain on a sale within 20 years is subject to ordinary-income recapture under Section 1255. Those two features are what make the label matter.

What Turns Property Into Section 126 Property

The classification is not automatic. Property becomes Section 126 property only when three things line up: the payment came from a qualifying conservation program, the payment meets the statutory tests for exclusion, and you actually elected to exclude it on your return.

The qualifying programs include those written into the statute by name, such as the agricultural conservation program, the water bank program, the emergency conservation measures program, and the rural clean water program, along with any small watershed program the Secretary of the Treasury finds substantially similar.¹ The IRS has separately identified additional qualifying programs in Publication 225, including the Environmental Quality Incentives Program, the Wetlands Reserve Program, the Wildlife Habitat Incentives Program, and the Forest Health Protection Program.² State and local programs qualify if they make payments primarily for conserving soil, protecting or restoring the environment, improving forests, or providing wildlife habitat.

One boundary worth naming: Conservation Reserve Program annual rental payments are ordinary taxable income and do not qualify. Only CRP cost-share payments tied to installing conservation practices can qualify, and only if they meet the other requirements.²

Even when the program qualifies, each payment must pass three tests before any portion is excludable:

The Secretary of Agriculture must certify that the payment was made primarily for conserving soil and water resources, protecting or restoring the environment, improving forests, or providing wildlife habitat.¹
The Secretary of the Treasury must determine that the payment does not substantially increase the annual income you derive from the property.¹
The payment must fund a capital improvement, not a currently deductible expense. Brush clearing, sediment removal from existing ditches, and annual cover crops are deductible expenses, so cost-share payments for those items are taxable income offset by the corresponding deduction, not excludable payments.²

Miss any of the three, and there is no Section 126 property to worry about. The payment is simply taxable income.

How the Excludable Amount Is Calculated

The excludable amount is not the full government check. It is capped by a present-value formula tied to how much the improvement could raise the property’s income.³

An income increase is “substantial” if it exceeds the greater of 10% of the average annual gross receipts from the affected acreage over the three years before the improvement, or $2.50 times the number of affected acres.⁴ Whichever figure is larger becomes the annual income threshold. You then compute the present value of receiving that threshold amount annually, using an appropriate discount rate for long-term investments. The IRS does not prescribe a single national rate. Publication 225 describes the excludable portion as the “present fair market value of the right to receive annual income” at the threshold level.²

That present-value figure is the ceiling. If the government payment is less than the ceiling, you can potentially exclude the entire government payment. If it is more, only the amount up to the ceiling qualifies. The gross income you must report equals the value of the improvement, minus the excludable portion, minus your own out-of-pocket share.³

To claim the exclusion, you attach a statement to your return for the year you received the last government payment for the improvement, showing the government’s Section 126 cost, the value of the improvement, and the amount excluded.⁵ You can also file an amended return to make the election if you missed it.⁶ Affirmatively electing out, however, has to happen by the filing deadline (including extensions) for the year the payment was received or accrued.¹

Basis Reduction on the Property

Excluding a cost-share payment lowers the basis of the property by the excluded amount. This prevents the same dollars from producing two tax benefits, one now through exclusion and another later through depreciation or reduced gain.

If you exclude $40,000 on an improvement that cost $60,000 total, with $20,000 coming from your own funds, the adjusted basis of that improvement starts at $20,000. If the improvement has a determinable useful life, depreciation is calculated on that reduced basis. When it has no determinable useful life, such as a permanent earthen dam or grading work, the basis reduction applies to the land itself. Land is not depreciable, so the reduced basis simply produces a larger taxable gain when you sell.

Section 126(d) also prohibits any deduction or credit for expenditures associated with the excluded amounts.¹ You cannot exclude the government’s share and then also deduct that same share elsewhere on the return.

Recapture Under Section 1255 When You Sell

The recapture rules are the sharpest teeth in Section 126 property, and the timing matters more than most people expect. If you dispose of Section 126 property within 10 years of receiving the excluded payment, 100% of the excluded amount (or the gain on the disposition, whichever is less) is recaptured as ordinary income. There is no phase-out during the first decade. Sell after one year or after nine, and the full excluded amount is on the table.⁷

After 10 years, the applicable percentage drops by 10 points for each additional year (or partial year) you hold the property:⁷

Years 0 through 10: 100% recapture
Year 11: 90%
Year 12: 80%
Year 13: 70%
Year 14: 60%
Year 15: 50%
Year 16: 40%
Year 17: 30%
Year 18: 20%
Year 19: 10%
Year 20 and after: 0%

Recapture is the lesser of the excluded amount or the gain on disposition, and it is taxed as ordinary income regardless of holding period. A “disposition” includes a sale, exchange, or involuntary conversion. The 20-year tail is the single most important reason to think carefully before making the election in the first place.

Should You Take the Exclusion at All

Section 126(c) lets you elect out of the exclusion and instead treat the payment as taxable income, with any corresponding deduction available under other Code sections.¹ For farmers, the main alternative is Section 175, which allows a current deduction for soil and water conservation expenditures that would otherwise be capital costs, subject to an annual cap of 25% of gross income from farming, with any excess carried forward.⁸

You cannot use both on the same dollars. If you exclude a $50,000 government share under Section 126, that $50,000 is off-limits for a Section 175 deduction. Your own share of the project cost can still be deducted under Section 175 if it qualifies.

Opting out can make sense when the government payment is small relative to the total project, when the current-year deduction against a high marginal rate saves more than the exclusion does, or when there is any real chance the property will be sold within 15 years. The last point often decides the question by itself. Recapture at 100% for a decade, tapering only slowly after that, can claw back most or all of the earlier benefit and tax it as ordinary income. Farmers who have already adopted the Section 175 method must generally keep using it for future qualifying expenditures, which further limits the room to mix and match.⁸

Records to Keep for the Long Haul

Because Section 126 property lives with recapture exposure for 20 years, the paperwork has to live that long too. Keep the agency documentation identifying the program, the conservation practice funded, and the payment amount. Keep the three prior years of gross receipts from the affected acreage. Keep the total project cost, the government’s share, your own share, and the discount rate and present-value math behind the excluded amount. If the IRS reviews the exclusion or the eventual sale, the file needs to show the numbers, not just the result.

When multiple cost-share payments arrive in the same year for different practices, treat each one separately. One practice may create Section 126 property while another produces ordinary taxable income offset by a deduction, depending on whether the underlying work is a capital improvement and whether it substantially raises the property’s income.

1
Office of the Law Revision Counsel. 26 USC 126 – Certain Cost-Sharing Payments
2
Internal Revenue Service. Publication 225 (2025), Farmer’s Tax Guide
3
eCFR. 26 CFR 16A.126-1 – Certain Cost-Sharing Payments in General
4
eCFR. 26 CFR 16A.126-1 – Certain Cost-Sharing Payments in General
5
eCFR. 26 CFR 16A.126-2 – Section 126 Elections
6
eCFR. 26 CFR 16A.126-2 – Section 126 Elections
7
Office of the Law Revision Counsel. 26 USC 1255 – Gain From Disposition of Section 126 Property
8
eCFR. 26 CFR 1.175-1 – Soil and Water Conservation Expenditures