Thursday, August 8, 2019
The Tax Cuts and Jobs Act of 2017 (TCJA) changed the landscape of tax-deferred exchanges under I.R.C. §1031. Personal property trades are no longer eligible for tax-deferred treatment. But, the rules governing tax-deferred exchanges of real estate didn’t change. That makes the definition of “real estate” of utmost importance. In prior posts I have addressed the issue of what constitutes like-kind “real estate” for I.R.C. §1031 purposes. See, e.g., https://lawprofessors.typepad.com/agriculturallaw/2018/10/what-is-like-kind-real-estate.html. But, what about an easement? Or, more specifically, what about a perpetual conservation easement? Do they qualify as “like-kind” to real estate such that the proceeds received from a donation/sale transaction can be used to acquire replacement real estate and the transaction be tax-deferred?
Conservation easements and the like-kind exchange rules – it’s the topic of today’s post
The Definition of “Real Estate”
Under the I.R.C. §1031 rules, “real estate” is defined very broadly. Virtually any real estate used for business or investment can be exchanged for any other real estate if the exchanger continues to use the replacement property for business or investment purposes. The regulations define “like-kind” in terms of reference to the nature or character of the replacement property rather than its grade or quality. Treas. Reg. §1.1031(a)-1(b); see also C.C.M. 201238027
In addition, it doesn’t matter whether the real estate involved in a tax-deferred exchange is improved or unimproved. Treas. Reg. §1.1031(a)-1(b), (c). Thus, agricultural real estate may be traded for residential real estate. However, if bare farmland is traded for farmland with depreciable structures on it, tax issues can arise. Many farm depreciable buildings and structures are “I.R.C. §1245 property.” For example, commodity storage facilities and single-purpose agricultural structures are I.R.C. §1245 property, as are irrigation systems, drainage tile, and other improvements to farm real estate. If property with an I.R.C. §1245 depreciation recapture attribute is disposed of in an I.R.C. §1031 exchange, the I.R.C. §1245 depreciation recapture must be recognized to the extent that the replacement property has insufficient I.R.C. §1245 property. IRS Form 8824 provides a location for reporting the I.R.C. §1245 depreciation recapture if non-I.R.C. §1245 property is received in the exchange. Also, remember, post-2017, the value of personal property associated with the real estate that does not fit within the definition of “real estate” is no longer eligible for tax-deferral under I.R.C. §1031.
Easements. Defined broadly, an easement is a nonpossessory interest in another party’s land that entitles the holder of the easement the right to use the land subject to the easement in the manner that the easement specifies. Conservation easements involve development rights. There is support for the notion that development rights in land are like-kind to real estate. For instance, in Rev. Rul. 55-749, 1955-2 CB 295, the IRS determined that land was like-kind to perpetual water rights. The IRS also has taken the position that a leasehold interest in a producing oil lease that extended until the exhaustion of the oil deposit was like-kind to a fee interest in a ranch. Rev. Rul. 68-331, 1968-1 CB 352.
In addition, Rev. Rul. 59-121, 1959-1 CB 212, the IRS took the position that an easement sold was an interest in real property. Under the facts of the ruling, the taxpayer granted easements to an industrial company over his ranchland that he used for grazing livestock that were raised for sale. The easements granted were for an indefinite duration and he was paid for the easement grants. The easements provided for the construction of a dam across a creek located on the taxpayer's property in order to create a reservoir and impound water and as a depository for waste material produced as a byproduct of the company's industrial process. The easements specified that the taxpayer retained all rights to explore for and produce oil, gas, or other minerals on the land subject to the easements and he could use the land and buildings on it if he didn’t interfere with the easement rights granted. The IRS said that the funds the taxpayer received for the easement grants constituted proceeds from the sale of an interest in real property. Thus, the amount received could be applied to reduce the basis of the land subject to the easement, with any excess (recognized gain) being eligible for investment in like-kind real estate.
Later, in 1972, the IRS determined that a right-of-way easement was like-kind to real estate. Rev. Rul. 72-549, 1972-2 CB 352. In 1971, under threat of condemnation the taxpayer granted an electric power company an easement and right-of-way over part of the taxpayer’s property that he used in his trade or business. The amount received for the easement and right-of-way triggered gain to the taxpayer. The easement and right-of-way were permanent and exclusive, and the company obtained the right to construct, maintain, operate, and repair power transmission lines and electrical towers on the right-of-way. The taxpayer used the funds acquired from the easement and right-of-way grant to acquire other real estate that he would use in his trade or business. The IRS ruled that the acquired property qualified as like-kind replacement property under I.R.C. §1031.
More closely aligned with conservation easements, the U.S. Supreme Court held in 1958 that when a right or interest arises out of real estate and is for a term short of “perpetuity” (which also means a land lease of less than 30 years) and the interest is defined in terms of money, the right or interest is not like-kind to a fee simple interest in real estate. The case was the consolidation of five cases involving the conversion of future income from oil leases into present income in the form of real estate. Comr. v. P.G. Lake, Inc, et al., 356 U.S. 260 (1958). Also, in Priv. Ltr. Rul. 200901020 (Oct. 1, 2008), the IRS determined that development rights that a taxpayer transferred were like-kind to a fee interest in real estate; a real estate lease with at least 30 years remaining at the time of the exchange; and land use rights for hotel units.
On conservation and agricultural easements, the following IRS rulings are helpful guidance:
- Ltr. Rul. 9851039 (Sept. 15, 1998) – The taxpayers sought to convey a perpetual agricultural conservation easement on their farms to the state in exchange for property of like-kind. Under state law, an ag conservation easement constituted an interest in land and was deemed to be the same as covenants that ran with the land. In other words, the easement was deemed to be like-kind to a fee simple and the proceeds received from the easement grant could be reinvested in like-kind real estate under the I.R.C. §1031 rules.
- Ltr. Rul. 200201007 (Oct. 2, 2001) - The IRS concluded that a perpetual conservation easement on a ranch could be exchanged for a fee interest in other ranch property that was subject to a (negative) perpetual conservation easement. Again, one of the keys to the IRS conclusion was that under applicable state law, a perpetual conservation easement constituted an interest in real property.
- Ltr. Rul. 9232030 (May 12, 1992) – The IRS determined that the exchange of a perpetual agricultural conservation easement on a farm for a fee simple interest in other real property qualified as a tax-deferred exchange under I.R.C. §1031.
- Ltr. Rul. 9621012 (Feb. 16, 1996) – In this private ruling, a county sought to acquire a perpetual scenic conservation easement over a ranch to protect a coastline viewshed that the state wanted to protect in perpetuity. While the taxpayer retained the right to use the ranch for ranching and grazing purposes, the portion of the ranch subject to the easement could not be developed. The taxpayer was willing to make the conveyance, but only in return for property of like-kind that qualified for non-recognition treatment under I.R.C. §1031. The IRS determined that the exchange of the easement for a fee simple interest in timberland, farm land or ranch land qualified as an exchange of property that qualified for tax deferral under I.R.C. §1031.
- Ltr. Rul. 200649028 (Sept. 8, 2006) – This private ruling involved transferable rural land use credits under state law. The state was concerned about controlling development and developed a system whereby the owner of credits could develop property in a manner that otherwise wasn’t permissible without the credits (termed “stewardship credits”). Any use or transfer of the credits had to be publicly recorded as an easement that ran with the land in favor of the county, qualified state agency or state land trust. The credits were perpetual in nature, and state law specified that a “stewardship easement” was an interest in real property. The taxpayer involving in the private ruling sought to sell the credits to a buyer and use the proceeds of sale to buy replacement real estate via a qualified intermediary. The taxpayer would use the replacement property for productive use in the taxpayer’s trade or business or for investment purposes. The IRS determined that the transaction qualified for tax deferral under I.R.C. §1031.
- Ltr. Rul. 200805012 (Oct. 30, 2007) -Here, the IRS privately ruled that development rights were like kind, to a fee interest in property that a taxpayer relinquished in an exchange. The trade transaction was quite complex and was accomplished via a qualified intermediary
The IRS has 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
The use of proceeds from a conservation easement donation in a transaction that will qualify as an I.R.C. §1031 exchange can be handled in a rather straightforward manner. In addition, separate exchanges can occur as to the easement and the residual interest in the real estate. Issues, if any present themselves, could occur with respect to the Natural Resource Conservation Service and its option and funding process. But those are separate matters from the deferred tax treatment of the transaction qualifying as an I.R.C. §1031 exchange.