Section 126 property is any land or improvement whose cost was partly paid by a qualifying government conservation cost-share payment that the owner excluded from gross income under Internal Revenue Code Section 126. The label matters because it carries two long-term consequences: the property’s basis is reduced by the excluded amount, and if the owner disposes of the property within 20 years, part or all of that excluded amount is recaptured as ordinary income under Section 1255.
How Property Becomes Section 126 Property
Property picks up this status only when an owner actually elects the exclusion. Receiving a government cost-share payment is not enough on its own. The payment has to come from a program named in the statute or determined by the IRS to be substantially similar, the Secretary of Agriculture must certify the payment was made primarily for conservation purposes, the Treasury must determine the payment does not substantially increase annual income from the property, and the payment must fund a capital improvement rather than a currently deductible expense.1Office of the Law Revision Counsel. 26 USC 126 – Certain Cost-Sharing Payments
Only the portion of the payment the owner actually excludes creates Section 126 property. The excludable portion is capped by a present-value calculation tied to how much the improvement could increase the property’s annual income, so the excluded amount is often less than the full government check.2eCFR. 26 CFR 16A.126-1 – Certain Cost-Sharing Payments in General Whatever amount you exclude on the return attaches to the improvement (and sometimes the underlying land) as Section 126 property for the next two decades.
Not every conservation payment produces Section 126 property. Annual rental payments under the Conservation Reserve Program, for example, are ordinary taxable income and never qualify for the exclusion; only CRP cost-share payments for installing conservation practices can. And if the funded practice is really a deductible expense (clearing brush, removing sediment from an existing ditch, planting an annual cover crop), the payment is taxable income offset by a deduction, and no Section 126 property is created.3Internal Revenue Service. Publication 225 (2025), Farmer’s Tax Guide
Basis Reduction Is the First Consequence
When you exclude a cost-share payment, the basis of the property improved by that payment drops by the excluded amount. The rule exists to prevent a double benefit: you cannot avoid tax on the payment today and then use that same money to shelter future depreciation deductions or future gain on a sale.
Say a conservation project costs $60,000 total, with $40,000 from a qualifying government program and $20,000 from your own pocket. If you exclude the full $40,000, the improvement’s adjusted basis starts at $20,000. Depreciation deductions, if the improvement has a determinable useful life, run against that reduced basis.
Many conservation improvements have no determinable useful life. A permanent earthen dam, grading, or terracing is not depreciable. In that case the basis reduction applies to the land itself, and because land is not depreciable, the only time you feel the reduction is at sale, when your taxable gain is larger by the amount you excluded years earlier.
Recapture Under Section 1255 When You Sell
The sharpest consequence of holding Section 126 property is the recapture rule in Section 1255. If you dispose of the property, part or all of the previously excluded amount is treated as ordinary income on the sale, regardless of how long the property was held and regardless of what the gain would otherwise look like.
The recapture amount is the lesser of the excluded amount or the gain you realize on the disposition. It is treated as ordinary income, not capital gain. A disposition includes a sale, exchange, or involuntary conversion.4Office of the Law Revision Counsel. 26 USC 1255 – Gain From Disposition of Section 126 Property
The applicable percentage depends on how long you have held the property since receiving the excluded payment. For the first 10 years, the percentage is 100%. After year 10, it declines by 10 percentage points per year, reaching zero at year 20:4Office of the Law Revision Counsel. 26 USC 1255 – Gain From Disposition of Section 126 Property
- 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 later: 0%
There is no phase-out inside the first decade. Whether you sell after two years or after nine, the entire excluded amount (capped by your actual gain) is clawed back as ordinary income. Only after the 10-year mark does the exposure start to shrink, and the full 20 years must pass before the property sheds Section 126 status for recapture purposes.
This long tail is the single most important feature of Section 126 property. A conservation improvement is often made with the expectation that the land will stay in the family or in production for decades, but circumstances change. A sale forced by health, succession, debt, or an unsolicited offer in year seven turns the full excluded amount into ordinary income in the year of sale.
When It Pays Not to Create Section 126 Property
Section 126(c) lets you elect out of the exclusion and instead treat the payment as taxable income.1Office of the Law Revision Counsel. 26 USC 126 – Certain Cost-Sharing Payments An opt-out decision must be made by the filing deadline (including extensions) for the year the payment was received or accrued. Choosing to opt out means no Section 126 property is created: no basis reduction, no 20-year recapture tail.
Opting out can be the better move when a separate deduction is available for the same expense. Section 175 allows farmers to deduct qualifying soil and water conservation expenditures, subject to an annual cap of 25% of gross income from farming, with any excess carried forward.5eCFR. 26 CFR 1.175-1 – Soil and Water Conservation Expenditures You cannot use both tools on the same dollars; Section 126(d) prohibits any deduction or credit for amounts excluded under Section 126.1Office of the Law Revision Counsel. 26 USC 126 – Certain Cost-Sharing Payments So the real choice is often: exclude under Section 126 (creating Section 126 property with its basis and recapture consequences) or report the payment as income and deduct the full project cost under Section 175 (no Section 126 property, no recapture).
If a sale within 15 years is realistic, reporting and deducting usually looks better after tax than excluding and getting most of the benefit clawed back later. If the land will be held well past 20 years, the exclusion keeps its full value.
What to Keep in Your Records
Section 126 property has a 20-year memory, so your files need the same. Hold onto 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, the total project cost and the government share, and the discount rate and present-value calculation that supported the excluded amount. Keep the statement you attached to the return making the election, which must show the Section 126 cost funded by the government, the value of the improvement, and the amount excluded.6eCFR. 26 CFR 16A.126-2 – Section 126 Elections
When the sale eventually happens, whoever prepares the return will need to know the excluded amount, the year it was excluded, and the holding period, to apply the Section 1255 percentage correctly. Without those records, the safe assumption on audit is 100% recapture.
Multiple payments can create layered exposure. If you excluded cost-share payments in different years for different practices on the same tract, each excluded amount has its own clock and its own applicable percentage at sale. Each payment should be tracked separately, because one layer might be fully past its 20-year window while another is still inside the first decade.
The interaction between Section 126, Section 175, and Section 1255 is one of the messier corners of agricultural tax, and the stakes compound over time. A tax professional who handles farm and timberland returns is worth the fee before the election, not just at the sale.