Wednesday, April 10, 2019
The donation of a permanent conservation easement on farm or ranch land can provide a significant tax benefit to the donor. The rules are complex and must be carefully complied with to obtain the tax benefits that are possible – qualified farmers and ranchers can deduct up to 100 percent of their income (i.e., the contribution base). For others, the limit is 50 percent of annual income.
The IRS has a history of not showing a great deal of appreciation for the provision. After all, the donor is getting a significant tax deduction and can still farm or graze the property, for example. So, the technical requirements must be paid close attention to and strictly complied with.
Now legislation has been introduced that would eliminate the tax deduction associated with the donation of permanent conservation easements via a syndicated partnership. In addition, the IRS recently designated syndicated conservation easement transactions as being on its list of the “Dirty Dozen” tax scams of 2019.
The trouble with permanent conservation easement donations – it’s the topic of today post.
Permanent Conservation Easement Donations
In general. The donation of a permanent conservation easement is accomplished via a transaction that involves a legally binding agreement that is voluntarily entered into between a landowner and qualified charity – some form of land trust or governmental agency. Under the agreement, the landowner allows a permanent restriction on the use of the donated land so as to protect conservation characteristics associated with the tract. See I.R.C. §170(h). But, all of the applicable tax rules must be precisely complied with in order to generate a tax deduction. This is one area of tax law where a mere “foot-fault” can be fatal.
IRS Concerns. The key to securing a tax deduction for the donation of a permanent conservation easement is the proper drafting of the easement deed (as well as an accurate and detailed appraisal of the property). That’s the instrument that conveys the legal property interest of the easement to the qualified charity (qualified land trust, etc.). This document must be drafted very precisely. For example, the donor must not reserve rights that are conditioned upon the donee’s consent. This is termed a deemed consent provision and it will cause the donated easement to fail to be a perpetual easement – one of the requirements to get a charitable contribution deduction. See Treas. Regs. §§1.170A-14(e)(2); 1.170A-14(g)(1); 1.70A-14(g)(6)(ii).
Another requirement of securing a charitable deduction for a donated conservation easement is that the charity must be absolutely entitled to receive a portion of any proceeds received on account of condemnation or casualty or any other event that terminates the easement. This is required because of the perpetual nature of the easement. But, exactly how the allocation is computed is difficult to state in the easement deed. The basic point, however, is that the allocation formula cannot result in what a court (or IRS) could deem to be a windfall to the taxpayer. See, e.g., PBBM-Rose Hill, Ltd. v. Comr., 900 F3d 193 (5th Cir. 2018); Carroll v. Comr., 146 T.C. 196 (2016). In addition, the allocation formula must be drafted so that it doesn’t deduct from the proceeds allocable to the donee an amount that is attributable to “improvements” that the donor makes to the property after the donation of the permanent easement. If such a reduction occurs, the IRS presently takes the position that no charitable deduction is allowed because the specific requirements of the proceeds allocation formula are not satisfied. This seems counter-intuitive, but it is an IRS audit issue with respect to donations of permanent conservation easements.
If the donee acquires the fee simple interest in the real estate that is subject to the easement, the donee’s ownership of both interests would merge under state law and thereby extinguish the easement. This, according to the IRS, would trigger a violation of the perpetuity requirement. Consequently, deed language may be included to deal with the merger possibility. But, such language is problematic if it allows the donor and donee to contractually agree to extinguish the easement without a court proceeding. Leaving merger language out of the easement deed would seem to result in the IRS not raising the merger argument until the time (if ever) the easement interest and the fee interest actually merge.
The IRS also takes the position that the perpetuity requirement is not met if a mortgage on the property is not subordinated. For instance, in Palmolive Building Investors, LLC v. Comr., 149 T.C. 380 (2017), a charitable deduction was denied because the mortgages on the property were not subordinated to the donated façade easements as Treas. Reg. §1.170A-14(g)(2) requires. In addition, the deed at issue stated that the mortgagees had prior claims to extinguishment proceeds. That language violated the requirement set forth in Treas. Reg. §1.170A-14(g)(6)(ii). A savings clause in the deed did not cure the defective language because the requirements of I.R.C. §170 must be satisfied at the time of the easement is donated.
The caselaw also supports the IRS position that development rights and locations for development cannot be reserved on the property subject to the easement if it changes the boundaries for the easement. In other words, the IRS position is that the easement deed language must place a perpetual encumbrance on specifically defined property that is fixed at the time of the grant. However, if the easement only allows the boundary of potential development to be changed on a portion of a larger parcel that is subject to the easement restrictions and neither the acreage of potential development nor the easement is enhance, the perpetuity requirement remains satisfied. See, e.g., Bosque Canyon Ranch II, L.P. v. Comr., 867 F.3d 547 (5th Cir. 2017); Treas. Reg. §1.170A-14(f).
Another problem with easement deeds that the IRS watches for is whether the deed language allows the donor and donee to mutually agree to amend the deed. If this reserved right is present, the IRS takes the position that the easement is not perpetual in nature and does not satisfy the perpetuity requirement of I.R.C. §170(h)(2)(C). But, there is an exception. Amendment language is allowed if any subsequent transfer by the donee (via amendment language in the deed) facilitates the conservation purpose of the original transfer to the donee organization. Treas. Reg. 1.170A-14(c)(2); see also Butler v. Comr., T.C. Memo. 2012-72.
Syndicated Easement Donations
The IRS has also been aggressive at auditing donated conservation easements accomplished via a syndicated partnership. These transactions involve either an individual or an entity buying undeveloped property and then transferring it to a partnership. Partnership interests are then sold to “investors.” After the land appreciates in value, the partnership donates a conservation easement on the land to a qualified land trust with the charitable deduction flowing to the investors. This strategy made it on the 2019 IRS list of the “Dirty Dozen” tax scams and the Congress is taking action to eliminate the technique. In the U.S. Senate, The “Charitable Conservation Easement Program Integrity Act of 2019” has been introduced to end syndicated partnership easement donations. It also contains provisions that are effective retroactively and bars deductions when the value of the associated property has appreciated in value more than 2.5 times the initial investment.
I.R.C. §170(h) has been around for almost 40 years. It was enacted with the purpose of incentivizing landowners who wanted to bar development on their land and simultaneously provide a conservation benefit. It wasn’t designed with the intent that it become a profit-making venture. But, in recent years inappropriate and unsupportable property valuations have raised IRS and court scrutiny. In addition, the technical requirements for the deed language are very detailed and must be followed precisely. But, done correctly (and not via a syndicated partnership) the donation of a permanent conservation easement can provide substantial conservation benefits and a tax break for donors.
With the donation of permanent conservation easements it’s wise to remember that, “pigs get fat, but hogs get slaughtered.