The “Perpetuity” Requirement For Donated Easements

Overview

A popular tax technique for certain taxpayers, including farmers and ranchers, involves the donation of a permanent conservation easement.  A conservation easement is a voluntary restriction on the use of land that a landowner negotiates with a private charitable conservation organization (commonly referred to as a "land trust") or government agency that the landowner chooses to "hold" the easement.  That means that the donee organization has the right to enforce the restrictions that the easement imposes. 

Normally, the donation of a partial interest in property does not generate a tax deduction for the donor.  However, a deduction can be obtained for a “qualified conservation contribution.”  I.R.C. §170(f). Thus, a donor can receive a charitable deduction for the donation if the transaction is structured properly.  But, those rules must be strictly satisfied to get the desired tax benefit.  Numerous cases have been litigated that illustrate how closely the rules must be followed.  Indeed, in Notice 2004-1, 2004-28, IRB 31, the IRS announced that it was increasing its scrutiny of conservation easement transactions.  The audit activity and the litigated cases have picked up steam since that time

Today’s post summarizes some of the most recent cases involving donated easements and one particular issue – the need that the easement be protected in perpetuity.  That’s what a “permanent” easement donation means. 

Basics

For qualified conservation contributions (i.e., contribution of a qualified real property interest to a qualified organization exclusively for conservation), a 50 percent limit on the contribution base, less all other contributions, applies, and the carryforward period is 15 years.  I.R.C. §170(b)(1)(E)(ii).  However, for qualified farmers and ranchers (as defined by I.R.C. §2032A(e)(5) – see I.R.C. §170(b)(1)(E)(v)) the limit is 100 percent of the contribution base less all other contributions. For property in agriculture or livestock production to be eligible for the 100 percent limit, the qualified real property interest has to include a restriction that the property remains generally available for such production.

A qualified conservation contribution is one that is of a “qualified real property interest” donated to a “qualified organization” exclusively for “conservation purposes” where the donee is barred from making certain transfers.  I.R.C. §170(h)(1)(A-C). In addition, as noted above, the donated easement must also be perfected in perpetuity.  If these requirements are satisfied, the starting point for determining the deductible amount of the donation is determined by the difference between the value of the burdened property before and after the donation. 

But, as noted above, the IRS requires strict compliance to all of the rules governing the donated easement so as to generate a deduction.  Recent cases highlight the need to protect the easement in perpetuity.

The Perpetuity Requirement

Under I.R.C. §170(h)(2) and (h)(5)(A), to be deductible, the donated easement must be granted in perpetuity.  These perpetuity Code sections have been at issue in a few recent cases.

Subordination requirement.  The easement must be granted in perpetuity at the time of the grant.  The Tax Court made that point clear in Mitchell v. Comr., 138 T.C. 324 (2012).  In that case, the petitioner did not subordinate an underlying mortgage on the property until two years after the easement grant.  That fact, the Tax Court held in a case of first impression, barred a charitable contribution deduction.  The Tenth Circuit later affirmed the Tax Court’s decision.  Mitchell v. Comr., 775 F.3d 1243 (10th Cir. 2015)

In a more recent case, the Tax Court continued to strictly apply the subordination requirement.  In Palmolive Building Investors, LLC v. Comr., 149 T.C. No. 18 (2017), the petitioner transferred a façade easement via deed to a qualified charity.  The easement deed placed restrictions on the petitioner and its successors with respect to the façade easement and the building.  The building was subject to two mortgages, but before executing the easement deed, the petitioner obtained mortgage subordination agreements from banks holding the mortgages.  But, the easement deed provided that if the easement were eliminated due to the government’s exercise of its eminent domain power, the banks would have claims to any condemnation award in order to satisfy the underlying mortgage before the charity had any rights to the award.

The petitioner claimed a charitable contribution deduction for the tax year of the easement contribution.  The IRS disallowed the deduction, claiming that the easement deed failed to satisfy the perpetuity requirements of I.R.C. §170 and Treas. Reg. §1.170A-14(g)(6)(ii) because it provided the mortgagees with prior claims to the extinguishment proceeds in preference to the donee.  Specifically, the lender had agreed to subordinate the debt to the charity’s claims, but the easement deed said that the lender would have priority access to any insurance proceeds on the property to the extent that the donor had insurance on the property.  The easement deed also said that the lender would have priority to any condemnation proceeds. 

The petitioner claimed that the First Circuit’s decision in Kaufman v. Comr., 687 F.3d 21 (1st Cir. 2012) applied.  In that case, the First Circuit rejected the view that a subordination agreement must remove any preferential treatment of the lender in all situations.  Instead the First Circuit created an exception for “unusual situations” that had the potential to occur at some future point.  The First Circuit claimed that the Tax Court’s strict reading of what is necessary to grant a perpetual easement would eliminate easement donations because an easement represented only a partial interest in property.  In addition, the First Circuit reasoned that the Tax Court’s rationale was improper because, for example, a tax lien could arise if the donor failed to pay property tax when they became due. 

However, in the present case, the Tax Court rejected the First Circuit’s view, noting that the Tax Court’s decision in the present case would be appealable to the Seventh Circuit.  That meant that the Tax Court was not bound by the First Circuit’s decision.  The Tax Court reasoned that because the lender had superior rights in certain situations, the mortgages did not meet the subordination requirement of Treas. Reg. §1.170A-14(g).  Thus, the donated easement did not meet the perpetuity requirement of I.R.C. §170(h)(5). 

The Tax court also pointed out that other Circuits did not agree with Kaufman, and noted a difference concerning what must be done to subordinate an existing liability at the time of the donation (such as a mortgage) as opposed to a possible future liability that was not yet in existence.  The Tax Court also noted that the Treasury Regulations specifically mentioned mortgages in the list of requirements necessary to satisfy the perpetuity requirement, but made no mention of tax liens.   

The subordination requirement was also at issue in RP Golf, LLC v. Comr., 860 F.3d 1096 (8th Cir. 2017), aff’g., T.C. Memo. 2016-80.  In this case, the petitioner made a charitable contribution of a permanent conservation easement on two private golf courses in the Kansas City area in 2003 valued at $16.4 million.  The IRS challenged the charitable contribution deduction on numerous grounds, and in an earlier action, the petitioner conceded that the donation did not satisfy the open space conservation test, granting the IRS summary judgment on that issue, with other issues remaining in dispute.  At the time of the donation, two banks held senior deeds of trust on the land at issue. 

Subordination agreements were not recorded until approximately three months after the donation stating that they were effective at the time of the donation.  In addition, the petitioner had no power or authority to enforce the easement with respect to a portion of the property due to its lack of ownership of the property.  The Tax Court cited Mitchell v. Comr., 775 F.3d 1243 (10th Cir. 2015) and Minnick v. Comr., 796 F.3d 1156 (9th Cir. 2015) as precedent on the issue that the donor must obtain a subordination agreement from the lender at the time the donation is made.  Here, the court held that the evidence failed to establish that the petitioner and the lenders entered into any agreements to subordinate their interests that would be binding under state (MO) law on or before the date of the transfer to the qualified charity.  As a result, the donated easement was not protected into perpetuity and failed to qualify as a qualified conservation contribution. 

Deed recordation.  Failure to record the deed can also result in the easement not being protected in perpetuity.  In Ten Twenty Six Investors v. Comr., T.C. Memo. 2017-115, the petitioner owned an old warehouse and executed a “Conservation Deed of Easement” that granted a façade easement on the warehouse to the National Architectural Trust (NAT).  The deed was accepted in late 2004, but was not recorded until late in 2006.   On its 2004 tax return, the petitioner, claimed a noncash charitable deduction of $11.4 million in accordance with an appraisal.  The IRS disallowed the deduction in its entirety, and imposed a 40 percent gross valuation misstatement penalty or, alternatively, the 20 percent accuracy-related penalty.  To support the deduction, it is imperative that the donee have a legally enforceable right under state law.  However, because the deed was not recorded until late 2006, the perpetuity requirement could not be satisfied in 2004. Citing prior caselaw based on New York (NY) law, the Tax Court determined that the deed was effective only upon recording and that a deed to create an easement must be recorded to be effective.  Thus, the Tax Court upheld the IRS determination. 

Similarly, in Carroll, et al. v. Comr., 146 T.C. 196 (2016), the Tax Court determined that a conservation easement was not protected in perpetuity with the result that the deduction was limited.  The petitioner contributed a conservation easement on a tract of land to two qualified organizations.  The easement provided that if the conservation purpose was extinguished because of changed circumstances surrounding the donated property, the that donees were entitled to a proportionate share of extinguishment proceeds.  If extinguishment occurred, the donees were entitled to receive at least the amount allowed as a deduction to the donor for federal income tax purposes over the fair market value of the property at the time of the contribution.  The plaintiff claimed a charitable contribution for the year of the contribution and carried forward the remaining balance to tax years 2006-2008.  Under Treas. Reg. §1.170A(g)(6)(i), when a change in conditions extinguishes a perpetual conservation restriction, the donee, on later sale, exchange or conversion of the property, must be entitled to a portion of the proceeds at least equal to that proportionate value of the perpetual conservation restriction.  Because the easement at issue provided that the value of the contribution for purposes of the donees’ right to extinguishment proceeds is the amount of the petitioner’s allowable deductions rather than the fair market value of the easement, the court determined that the easement violated the Regulation and was not protected in perpetuity under I.R.C. §170(h)(5)(A).  The court also imposed an accuracy-related penalty. 

Conclusion

The IRS takes a close look at donated conservation easements.  It simply does not like the granting of a significant tax deduction while the donor continues to use the underlying property in largely the same manner as before the easement on the property was donated.  Thus, all of the requirements necessary to obtain the deduction must be followed.  That includes satisfying the perpetuity requirement.

The IRS has also produced an audit technique guide concerning the donation of permanent conservation easements.  That guide should be reviewed by parties interested in donating permanent easements.  It is accessible here:  https://www.irs.gov/pub/irs-utl/conservation_easement.pdf