Needing help in direction to classify the KDPG payments in relation to IRC sections and rulings. Thank you so much.

Martin Noble, age 79, has lived in Jayce County, MS since 1955. He and his father worked together for many years on the family farm. Initially, the land was used as follows: truck crops (250 acres), hay (750 acres), dairy (100 acres), grazing cattle (2,500 acres), and undeveloped (2,400 acres).

In 1969, Martin and his father Vince cleared the undeveloped acreage, realizing $75,000 in proceeds from rough timber. In response to an offer from the U.S. government (Forestry), Vince sold the subsurface rights to minerals and oil & gas, raising another $85,000. They used this $160,000 to build a dairy barn and begin raising timber. Though the timber requires active work, Vince hired out most of the work to professionals. From the beginning, they treated the timber activity as an investment. When his father died in 1979, Martin inherited the property and continued to use it in the same activities.

In January 2012, while out checking the timber, Martin rode up on a group of engineers working on his property. When he challenged their presence on his property, they explained they were hired by the US Forest Service to investigate the subsurface rights. In March 2012, Martin received formal notice that the Forest Service would begin recovery from an interior 1,200 acre tract with significant oil reserves. Most of the tract coincides with the acreage used for cattle, but 400 acres of it coincides with timberland. Martin immediately began to worry about the impact of an oil producing operation on his assets. The pine acreage will provide the best return if not harvested until 2020. Hardwoods will be ready for harvesting in 2025. On April 1, 2012, Martin met with Korcmash Pipeline and Development Company (KPDC) to discuss whether and how to grant access over the surface of his land. After several rounds of discussion, Martin left with the following.

1st KPDG agreed to pay $120,000 for an easement (20 feet wide run to the nearest roadway from the 8 acres to be set as the entryway into the interior tract). KPDG will pay $150,000 in advance for land restoration. If operations continue past 4/1/13, KPDG will pay the same amount in 2013. Martin agreed not to pursue further damages related to the easement.

2nd KPDG agreed to remain 250 feet away from the 50 acre tract used for dairy operations. In exchange for $100,000, Martin agreed not to pursue further damages related to this tract. If operations are incomplete by 4/1/13, KPDG will pay the same amount in 2013.

3rd KPDG bought all of the beef cattle for $225,000. KPDG agreed to pay $25,000 for future damage to fencing, and Martin agreed not to pursue further damages related to fencing.

4th KPDG agreed to structure the extraction operation to avoid using the land surface within the timber acres. KPDG agreed to pay Martin $100,000 for each year of operating to cover any inadvertent timber damages.

5th While the extraction operation is active, KPDG will pay Martin $5,000 per month.

On his 2012 Federal and Mississippi income tax returns, Martin reported the payments from KPDG as shown below. For the first time since 1989, the farming operations yielded a loss for 2012 (($163,000) not including the gain on cattle of $125,000). After talking with a neighbor, Martin is concerned that he should have reported more of the 2012 payments as ordinary income (and less as proceeds from capital transactions). He made an appointment with you to discuss (1) the correct reporting of KPDG payments on his 2012 returns and (2) the tax consequences of his planned sale of the Strawberry working interest.

In reviewing his 2012 returns, you ask about the ($163,000) farm operating loss in 2012. He explains that in August 2012, an EF3 tornado destroyed his dairy barn, equipment, and resulted in the loss of 2/3 of the dairy cows. He used 2/3 of his insurance ($145,000) proceeds to buy more beef/grazing cattle. He hopes to use the rest to re-start the dairy operations once the drilling is finished (basis in lost assets: old barn $26,000, old equipment $24,000 and dairy cows $0). Nothing related to the tornado loss or insurance was reported on his 2012 income tax returns.

In June 2002, Martin's wife Eugenia Strawberry Noble died, and he inherited from her a 1/3 working interest in an inactive oil well (FMV in June 2002 of $77,000) on another tract of land in Jayce County. Since 2005, the well has been in active production. For this activity, Martin has reported $7,000 in cost depletion deductions and intangible drilling cost deductions of $5,500. In June 2013, Martin received an offer to buy his interest in the Strawberry field for $87,000. He can opt to be paid (a) in cash, (b) in ocean front acreage worth $87,000 in Jackson county, or (c) with a working interest in a gas producing property worth $87,000 and located in neighboring Harris County. Martin asks whether the tax consequences vary across options.

Required: Prepare a research memo to address Martin's two questions.