Monday, February 10, 2020
Conservation Easements and the Perpetuity Requirement
I have done prior posts on conservation easements. In one post I dealt with the perpetuity requirement that must be satisfied for the donor to obtain a tax deduction for the easement that is donated to a qualified charity. In that post, I discussed perpetuity in the context of subordination agreements and deed recordation. But what if the easement is extinguished by a court or there are conditions on the grant or there is a merger of property interests involving the easement. All of these can impact the perpetuity requirement and cause the donor to lose out on the anticipated tax deduction.
Conservation easements are clearly in the “bulls-eye” of IRS scrutiny and the perpetuity requirement is causing practitioners and donors trouble.
Drilling down deeper on the perpetuity requirement associated with the donation of a permanent conservation easement – it’s the topic of today’s post.
The Perpetuity Requirement
A taxpayer that donates a “qualified real property interest” to a “qualified organization” can receive a charitable contribution deduction upon satisfying numerous technical requirements. A primary requirement is that the easement donation be exclusively for conservation purposes. That requirement, however, can only be satisfied if the conservation purposes are protected in perpetuity. I.R.C. §170(h)(5)(A). Essentially, that means that legally enforceable restrictions must be in place that will bar the use of the portion of the property that the taxpayer retains from being used in a manner that is inconsistent with the conservation purposes of the donated easement.
The “dirt” is in the details concerning the technical requirements that must be satisfied for the easement donation to meet the perpetuity requirement and generate a charitable contribution deduction for the donor. What are some of those details?
Mortgage. If the donated easement is subject to a mortgage, the mortgagee must subordinate its rights in the property to the rights of the easement holder. In Palmolive Bldg. Investors, LLC v. Comr., 149 T.C. 380 (2017), the IRS disallowed a $33.41 million charitable deduction attributable to the donation of a façade easement over a historic building in Chicago because the mortgage holders were entitled to insurance proceeds in preference to the land trust. The Tax Court agreed, holding that the preference given to the motgagees on the insurance proceeds violated the perpetuity requirement. See Treas. Reg. §§1.170A-14(g)(2); (g)(6)(ii).
Changes and court orders. If some future unanticipated change in the conditions surrounding the easement makes the conservation use of the property impossible or impractical, a court may extinguish the conservation purposes and require the property to be sold. In that event, to preserve the tax deduction for the donor, the donee organization must receive a certain part of the sale proceeds as established by a formula. This requirement is to ensure that the donation is “perpetual” even in the event the easement is extinguished.
For example, in Carroll, et al. v. Comr., 146 T.C. 196 (2016), 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 donees were entitled to a proportionate share of extinguishment proceeds not to be less than 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)-(ii), 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 was tied to 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.
More recently, the Tax Court decided Railroad Holdings, LLC, et al. v. Comr., T.C. Memo. 2020-22. In the case, the petitioner donated a permanent conservation easement to a qualified entity and claimed a $16 million charitable deduction. The deed granting the easement contained a clause specifying the result if the easement were extinguished as the result of a court order. The IRS pointed out that in the event of a forced judicial sale, Treas. Reg. §1,70A-14(g)(6)(ii) requires the charity to receive an equal proportionate value of the sale proceeds that extinguishes the interest to the value of the easement as compared to the value of the property at the date of the donation. The language of the deed at issue held the charity’s payment constant, equal to the value as of the date of the contribution. It did not tie the charity’s payment to a percentage of the value of the property at the time of the forced sale equal to the percentage of value the easement was to the property at the time of the donation. The IRS denied the entire $16 million donation and the Tax Court agreed.
The Tax Court noted that the deed language did not create a proportion or fraction representing the donee’s share of the property right and a corresponding fraction of the proceeds to which the donee was entitled in perpetuity. Rather, the Tax Court noted, the language gave the charity a “proportionate value…at the time of the gift” which guaranteed only that a fixed dollar amount would go to the charity. The Tax Court also held as irrelevant a declaration of intent executed by an officer of the charity that the deed language reflected the charity’s intent to be in full compliance with the Code. What mattered was the donor’s intent, not the charity’s intent. Even so, the deed language failed to conform to the Code. The Tax Court also determined that the deed language was not ambiguous. Thus, the easement was not protected in perpetuity and the full deduction was disallowed.
In Coal Property Holdings, LLC v. Comr., 153 T.C. No. 7 (2019), the petitioner donated to a qualified charity an open space conservation easement over property which was previously subjected to surface coal mining and which was also subject to oil and gas leases and certain improvements. The IRS denied a charitable deduction because the easement wasn’t protected in perpetuity, and the Tax Court agreed. The conservation purpose of allowing the land subject to the easement to continue to recover from and provide scientific insight into the long-term effects of mining didn’t entitle the charity to a proportionate part of the proceeds if the subject property were sold upon a judicial extinguishment of the easement. As such, the easement wasn’t perpetual in nature as required by I.R.C. §170(h)(5)(A) and I.R.C. §1.170A-14(g)(6). While the petitioner claimed that the deed language contained a “regulation override” mandating that the deed be interpreted to satisfy the perpetuity requirements of the Code and Regulations, the Tax Court rejected that argument because it was a condition subsequent constituting a savings clause that the court would not enforce.
On this issue, the IRS also argues that when an easement deed’s proceeds allocation formula deducts (from the proceeds allocable to the done) an amount attributable to “improvements” made by the owner after the donation, no charitable deduction is allowed. The IRS position is that the deduction violates Treas. Reg. 1.170A-14(g)(6)(ii), making the charitable deduction unavailable. See, e.g., Priv. Ltr. Rul. 200836014 (Sept. 5, 2008); PBBM-Rose Hill, Ltd. v. Comr., 900 F.3d 193 (5th Cir. 2018). This is perhaps the most common audit issue for IRS when examining permanent conservation easement donations.
Amendments. A very common clause in deeds granting permanent conservation easements is one that allows the parties to agree to amend the deed at some point in the future. However, the IRS position is that such deed language violates the perpetuity requirement, even if the right to amend is designed to protect the conservation purposes and ensure that they remain perpetual by making the donated easement flexible to respond to changed circumstances.
Merger. A dominant estate can merge with a lesser estate if the two estates become commonly owned. When that happens, the lesser estate is extinguished. Thus, for example, if a land trust acquires the fee simple interest in conservation easement property, the easement is extinguished. The IRS views the possibility of merger as allowing the parties to extinguish the easement without a judicial proceeding if permitted under state law. In the IRS view, that is a violation of the perpetuity requirement, and raises a question whether contractually prohibiting the dominant and lesser estates to merge is permissible under state property law. The IRS position raises a question as to the possibility of drafting deed language that avoids problems with the IRS on this issue.
Miscellaneous. Recent court decisions and IRS rulings have also touched on other aspects of the perpetuity requirement. For example, in C.C.A. 202002011 (Nov. 26, 2019), the IRS stated that a conservation easement deed may contain a clause specifying that if the easement holder fails to respond within a certain time to a request by the property owner regarding a proposed use that the request is considered to be denied. The IRS noted that because a constructive denial is not a decision by the easement holder based on the merits of the property owner’s request, it is not final or binding on the easement holder, and the property owner can resubmit the same or a similar request for approval. The IRS determined that such clause language does not violate the perpetuity requirements of I.R.C. §170(h).
In TOT Property Holdings, LLC v. Comr., Docket No. 005600-17 (U.S. Tax Ct. Dec. 13, 2019), the petitioner engaged in a syndicated easement transaction whereby it claimed a $6.9 million charitable contribution deduction for an easement on 637 acres of a 652-acre parcel donated to a land conservancy. The IRS denied a charitable deduction due to the easement deed not satisfying the perpetuity requirement and imposed a 40 percent gross valuation misstatement and negligence penalties. The Tax Court agreed, determined that the actual value of the easement donation was less than 10 percent of what was originally reported on the petitioner’s return. In the process, the Tax Court gave more credibility to the approach of the appraiser for the IRS.
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. IRS is definitely is on the look-out for what it believes are abusive transactions involving charitable contributions of easements.
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