Conservation Easements Contributions
Heightened IRS Scrutiny
A look into recent Tax Court cases brings to light several issues that are on the IRSâ€™ â€śradar screen.â€ť Past QuickRead articles have highlighted some of the cases, including Section 2036, or â€śbad factsâ€ť cases. Another hot-button issue for the IRS is the proper treatment of conservation easement charitable contributions. Since 2010, courts have published at least 60 opinions addressing issues relating to conservation easements. Practitioners with clients considering conservation easement contributions, or who are defending conservation easement cases must keep current with the influx of rulings and have a good understanding of how these rulings fit within the framework of Section 170(h).
A look into recent Tax Court cases brings to light several issues that are on the IRSâ€™ â€śradar screen.â€ťÂ Past QuickRead articles have highlighted some of the cases, including Section 2036, or â€śbad factsâ€ť cases.Â Another hot-button issue for the IRS is the proper treatment of conservation easement charitable contributions.Â Since 2010, courts have published at least 60 opinions addressing issues relating to conservation easements.Â Practitioners with clients considering conservation easement contributions, or who are defending conservation easement cases must keep current with the influx of rulings and have a good understanding of how these rulings fit within the framework of Section 170(h).
Conservation easement were created by Congress in 1976 in an effort to encourage the preservation of the countryâ€™s natural resources.Â With the enactment of Section 170(h), Congress created an exception to the general rule that taxpayers cannot deduct contributions of partial interests in property.
In a typical transaction, a landowner grants an easement over real property to a charitable donor (generally a land trust) and is thereafter subject to restrictions on the use and development of the property.Â At the same time, the charitable donee is granted the right to enforce these restrictions in furtherance of the conservation purpose set forth in the easement.Â So long as the contribution of the easement is made for prescribed conservation purposes, the donor can take a charitable deduction equal to the value of the easement (often 25 to 50 percent of the value of the unencumbered land).Â The conservation easement runs with the land and the conservation purposes, and the conservation purposes and restricted uses must be protected and enforced into perpetuity.Â Under the right circumstances, the charitable contribution of a conservation easement can result in substantial tax savings without meaningfully affecting a taxpayerâ€™s ownership or use of the property.
In recent years, the IRS has increased its scrutiny of conservation easements; generally focusing on whether the easement furthers specific conservation purposes, whether the easement would in fact be enforced in perpetuity, and whether the parties have overvalued the easement.Â Typical IRS examinations address the following three areas: 1) statutory/regulatory sufficiency; 2) proper substantiation; and 3) valuation.
It is of import to note, a taxpayer may deduct the value of a charitable contribution of a partial interest in property only if the contribution constitutes a â€śqualified conservation contribution.â€ťÂ By definition, a â€śqualified conservation contributionâ€ť is a contribution that is: 1) a qualified real property interest; 2) made to a qualified organization; and 3) exclusively for conservation purposes.Â While the requirement that the contribution be made to a qualified organization is rarely an issue, the â€śexclusively for conservation purposes requirementâ€ť has been the subject of substantial litigation.Â After a few key wins, the IRS seems to have expanded its challenges to include whether the â€śqualified real property interest requirementâ€ť is satisfied.
Requirement for â€śExclusively for Conservation Purposesâ€ť
Contribution easement deductions are only applicable if it, (1) achieves a conservation purpose, and (2) that conservation purpose is protected into perpetuity.
The following are typical conservation purposes: 1) the preservation of land areas for outdoor recreation by, or the education of, the general public; 2) the protection of a relatively natural habitat of fish, wildlife, or plants, or a similar ecosystem; 3) the preservation of open space for the scenic enjoyment of the general public or pursuant to a governmental conservation policy; or 4) the preservation of an historically important land area or a certified historic structure.
Overview of Historic Conservation Easement Cases
The following provides an overview of recent cases where the deductibility of conservation easements was the central issue.
In Glass v. Commissioner, 471 F. 3d 698 (6th Cir. 2006) the taxpayer contributed a ten-acre parcel of land, which was located along the shore of Lake Michigan.Â The IRS took the position that the easement was not exclusively for conservation purposes since it neither protected a relatively natural habitat of wildlife or plants nor preserved open space.Â Petitioners introduced testimony that the property was a famous roosting spot for bald eagles and was suitable to foster growth of Lake Huron tansy and pitcherâ€™s thistle (both threatened plant species).Â The Tax Court ruled that the shoreline of Lake Michigan constituted a â€śrelatively natural habitatâ€ť for these species.Â The Tax Court hence ruled that the easement was contributed for a conservation purpose.Â The IRS appealed the Tax Courtâ€™s ruling, arguing that the easement could not be for conservation purposes due to its small size.Â The Sixth Circuit Court of Appeals did not agree, ruling that there is not statutory or regulatory provision that requires a minimum size for a qualifying conservation contribution.Â The appellate court noted that it is not the size of the easement, but it is whether any retained use undermines the conservation process stated in the easement.
In Mecox Partners, LP v. U.S., 2016 WL 398216 (S.D.N.Y. 2016), a partnership made a charitable contribution of a faĂ§ade easement over a New York City building and reported a deduction of $2.21 million in 2004, the year the partnership delivered the easement to the charitable donee.Â The easement, however, was not recorded until November 2005.Â The New York district court determined that, as a matter of law, the contribution of the easement was not exclusively for conservation purposes in 2004 because it was not protected in perpetuity at the time of contribution.Â As provided under New York law, an easement is not effective until recorded.Â Thus, the delivery of the deed to the charitable donee in 2004 was insufficient to satisfy the perpetuity requirement; the easement could protect conservation purpose in perpetuity only after it was recorded.
In Kaufman v. Schulman, 687 F.3d 21 (1st Cir. 2012), the taxpayer contributed a faĂ§ade easement over a mortgaged Boston row house.Â While the easement itself provided that the charitable donee was entitled to a proportionate share of post-extinguishment proceeds, the mortgage subordination agreement provided that the lender had a superior claim to all insurance or condemnation proceeds so long as the mortgage was outstanding.Â The IRS proposed to disallow the dedication because the mortgagee, although subordinated to the easement, could receive extinguishment proceeds before the charitable donee.Â The First Circuit Court of Appeals ruled in favor of the taxpayer and explained that the extinguishment provision does not require that the charitable donee get the â€śfirst biteâ€ť as against the rest of the world or have an absolute right to the proceeds.Â The court noted that a donor cannot require a mortgagee to give up its own protection against, for example, fire or condemnation proceeds, and pointed out that the regulations do not require such.
In Irby v. Commissioner, 139 T.C. 371 (2012), the charitable donee purchased conservation easements over farmland in Colorado through a bargain sale with funds provided by various federal, state, and local entities.Â As a condition to receiving the funds, the charitable donee agreed to repay the governmental entities if the easements were extinguished.Â The IRS proposed to disallow the deduction on the grounds that the charitable doneeâ€™s obligation to repay the governmental entities violated the requirement that the charitable donee receive extinguishment proceeds.Â The Tax Court disagreed and allowed the deduction based primarily on the fact that none of the extinguishment proceeds could be diverted to the taxpayer.Â In other words, the charitable donee had an absolute right to any extinguishment proceeds that would be required to use any extinguishment proceeds in a manner consistent with the original conservation purposes.
In addition to being contributed exclusively for conservation purposes (cases cited above), the property must constitute a â€śqualified real property interest.â€ťÂ Section 170(h)(2) defines â€śqualified real property interestâ€ť to include a â€śrestriction (granted in perpetuity) on the use which may be made of the real property.â€ťÂ The regulations clarify that the restriction on use must be legally enforceable to limit any use of the land that is inconsistent with the conservation purpose of the contribution.Â This requirement can be satisfied by recording the restriction (the easement) in the records of the jurisdiction where the land is located.
In Bosque Canyon Ranch v. Commissioner, T.C. Memo 2015-130, the Tax Court held that a contribution of a conservation easement did not constitute a qualified real property interest when the taxpayer reserved the right to modify the boundary lines of the easement.Â Similarly, in Balsam Mountain Investments, LLC v. Commissioner, T.C. Memo. 2015-43, the Tax Court concluded that a conservation easement was not a qualified real property interest when, for five years after contributing the easement, the taxpayer reserved the right to change the boundaries subject to two limitations: 1) the total acreage restricted remained the same; and 2) at least 95 percent of the original eased land had to remain within the boundaries of the easement.Â The court confirmed that an easement is a qualified real property interest only if it is an interest in an identifiable, specific piece of real property at the time of contribution.
The IRS recently asserted that the mere existence of an amendment provision in the easement prevents satisfaction of the requirement that an easement constitutes a qualified real property interest, no matter the restrictions and limitations surrounding the amendment.
In conclusion, it is obvious by the sheer number of IRS challenges on the issue, that the IRS is skeptical of conservation easements.Â As such, the IRS will undoubtedly continue to challenge transactions involving the contributions of conservation easements.Â Taxpayers, and more importantly their advisors, should be familiar with the ever-changing legal landscape or else risk an IRS challenge and a potential loss of the deduction.
Peter H. Agrapides, MBA, CVA, is with the Salt Lake City, Utah, and Las Vegas, Nevada, offices of Western Valuation Advisors. Mr. Agrapidesâ€™ practice focuses primarily on valuations for gift and estate tax reporting. Mr. Agrapides has experience valuing companies in a diverse array of industries. These engagements have ranged from small, family owned businesses to companies over $1 billion.
Mr. Agrapides can be reached at (801) 273-1000 ext. 2, or by e-mail to firstname.lastname@example.org.