(a) Introduction. In general, section 126 provides that recipients of payments made after September 30, 1979 under certain conservation, reclamation and restoration programs may exclude all or a portion of those payments from income if the payments do not substantially increase the annual income derived by the taxpayer from the affected property. For purposes of this section, the term “payment” as used in section 126 means payment of the economic benefit, if any, conferred upon the taxpayer upon receipt of the improvement. An increase in annual income is substantial if it exceeds the greater of 10 percent of the average annual income derived from the affected property prior to receipt of the improvement or an amount equal to $2.50 times the number of affected acres. The amount of gross income which a taxpayer realizes upon the receipt of a section 126 payment is the value of the section 126 improvement, reduced by the sum of the excludable portion and the taxpayer’s share of the cost of the improvement (if any).

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(b) Definitions. For purposes of this section, the term:

(1) “Cost of the improvement” means the sum of amounts paid by a government and the taxpayer, whether or not with borrowed funds, for the improvement.

(2) “Section 126 cost” means the cost of the improvement less the sum of

(i) Any government payments under a program which is not listed in section 126(a),

(ii) Any portion of a government payment under a program which is listed in section 126(a) which the Secretary of Agriculture has not certified is primarily for purposes of conservation,

(iii) Any government payment to the taxpayer which is in the nature of rent or compensation for services.

(3) “Value of the section 126 improvement” means the fair market value of the improvement multiplied by a fraction, the numerator of which is the section 126 cost and the denominator of which is the cost of the improvement.

(4) “Affected acreage” means the acres affected by the improvement.

(5) “Excludable portion” means the present fair market value of the right to receive annual income from the affected acreage of the greater of 10 percent of the prior average annual income from the affected acreage or $2.50 times the number of affected acres.

(6) “Prior average annual income” means the average of the gross receipts from the affected acreage for the last three taxable years preceding the taxable year in which installation of the improvement is commenced.

(7) “Section 126 improvement” means the portion of the improvement equal to the percentage which government payments made to the taxpayer, which the Secretary of Agriculture has certified were made primarily for the purpose of conservation, bear to the cost of the improvement.

(c) Income realized upon receipt of a section 126 improvement—(1) Section 126 exclusion applied. Unless a taxpayer elects not to have section 126 apply, the amount of gross income realized on receipt of the section 126 improvement is the value of the section 126 improvement less the sum of the taxpayer’s share of the cost of the improvement and the excludable portion.

(2) Section 126 exclusion not applied. If a taxpayer elects under section 126(c) not to have section 126 apply in whole or in part, the amount realized on the receipt of the section 126 improvement is the value of the section 126 improvement less the sum of the taxpayer’s share of the cost of the improvement and the excludable portion that applies, if any.

(d) Payments under watershed programs—(1) Programs within section 126(a)(9). Section 126(a)(9) covers certain programs affecting small watersheds.

These programs must be administered by the Secretary of Agriculture and be determined by the Commissioner to be substantially similar to the type of program described in section 126(a) (1) through (8). The Commissioner has determined that section 126 improvements made in connection with small watersheds are within the scope of section 126(a)(9) if they are made under one of the following programs:

(A) The Watershed Protection and Flood Prevention Act, Pub. L. 566, 68 Stat. 666, as amended (16 U.S.C. § 1001, et seq.), as funded by the Act of November 9, 1979, Pub. L. 96-108, 93 Stat. 834.

(B) Flood Prevention Projects, Pub. L. 86-468, sec. 1, 74 Stat. 131, as amended (16 U.S.C. § 1006a); Pub. L. 78-534, sec. 2, 58 Stat. 889 (33 U.S.C. §§ 701a–1); Pub. L. 78-534, sec. 13, 58 Stat. 905;

(C) Emergency Watershed Protection, Pub. L. 81-516, sec. 216, 64 Stat. 184 (33 U.S.C. §§ 701b–1), and

(D) Colorado River Basin Salinity Control Act, Pub. L. 93-320, 88 Stat. 266:

(1) Title 1—Programs downstream from Imperial Dam, and

(2) Title 2—Measures upstream from Imperial Dam.

(2) Other programs. The Commissioner may announce further determinations under section 126(a)(9) from time to time in the Internal Revenue Bulletin.

(3) Small watershed defined. A watershed is a “small watershed” under this paragraph and section 126(a)(9) if the watershed or subwatershed does not exceed 250,000 acres and does not include any single structure providing more than 12,500 acre-feet of floodwater detention capacity, nor more than 25,000 acre-feet of total capacity.

(e) Basis of property not increased by reason of excludable amounts. Notwithstanding any provision of section 1016 (relating to adjustments to basis) to the contrary, basis of any property does not include any amount which is excludable from gross income under section 126.

(f) Cross reference. For rules relating to the recapture as ordinary income of the gain from the disposition (within 20 years of the date of receipt) of property for which an exclusion is claimed for a section 126 improvement, see section 1255 and the regulations thereunder.

(g) Examples. The provisions of this section are illustrated by the following examples:

Example (1).In 1981, 100 acres of the taxpayer’s land is reclaimed under a Rural Abandoned Mine Program contract with the Soil Conservation Service of the U.S. Department of Agriculture. The total cost of the improvement is $700,000. USDA pays $690,000, the taxpayer $10,000. The Secretary of Agriculture certifies that 95% of the $690,000 USDA payment was primarily for the purpose of conservation. Therefore, $34,500 ($690,000 × .05) is a nonsection 126 payment. $150,000 of USDA’s payment is compensation for the taxpayer’s service in the reclamation project and is includable in gross income as compensation for services. The taxpayer has $20,000 of allowable deductions in 1981, $15,500 of which are properly attributable to the USDA payment. Based on all the facts and circumstances, the value of the improvement is $21,000. The taxpayer elects not to have section 126 apply. The taxpayer computes the amount which is included in gross income as a result of receipt of the improvement as follows: