Monday, May 25, 2020
Conservation Easements – The Perpetuity Requirement and Extinguishment
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)(2)(C); (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.
But, can anything here on earth really last forever? What if the easement is extinguished by court action? There’s a rule for that contingency and it requires careful drafting of the easement deed. Numerous court opinions have dealt with the issue, including a couple in recent weeks.
Dealing with potential extinguishment of a perpetual conservation easement donation – it’s the topic of today’s post.
The Issue of Extinguishment – Treasury Regulation
While the law generally disfavors perpetual control of interests in land, for a taxpayer to claim a tax deduction for a donated conservation easement, the easement must be granted in perpetuity. But if the conditions surrounding the property subject to a perpetual conservation easement make impossible or impractical the continued use of the property for conservation purposes, a Treasury Regulation details the requirements to be satisfied to protect the perpetual nature of the easement if a judicial proceeding extinguishes the easement restrictions. Treas. Reg. §1.170A-14(g)(6)(i)-(ii).
The regulation requires that, at the time of the donation, the donor must agree that the donation gives rise to a property right that is immediately vested in the donee. Treas. Reg. §1.170A-14(g)(6)(ii). The value of the gift must be the fair market value of the easement restriction that is at least equal to the proportionate value that the easement restriction, at the time of the donation, bears to the entire property value at that time. See Treas. Reg. §1.170A-14(h)(3)(iii) relating to the allocation of basis. The proportionate value of the donee’s property rights must remain constant such that if the conservation restriction is extinguished and the property is sold, exchanged or involuntarily converted, the done is entitled to a portion of the proceeds that is at least equal to that proportionate value of the restriction. The only exception is if state law overrides the terms of the conservation restriction and specifies that the donor is entitled to the full proceeds from the conversion restriction. Treas. Reg. §1.170A-14(g)(6)(ii).
Extinguishment – Cases
The formula language necessary to comply with the regulation must be precisely drafted. The IRS has aggressively audited perpetual easement restrictive agreements for compliance. Consider the following:
- 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.
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.
- In Palmolive Building Investors, LLC v. Comr., 149 T.C. No. 18 (2017), the petitioner acquired a building in 2001 for $58.5 million. In 2004, the petitioner transferred a façade easement on the building via deed to a qualified charity (a preservation council) to preserve the exterior building perimeter. The easement deed placed restrictions on the petitioner and its successors with respect to the façade easement and the building – the petitioner and any subsequent owner couldn’t demolish or alter the protected elements without the charity’s permission. The building was subject to two mortgages, but before executing the easement deed, the petitioner obtained mortgage subordination agreements from its mortgagee banks. However, the easement deed provided that in the event the façade easement was extinguished through a judicial proceeding, the mortgagee banks will have claims before that of the donee charity to any proceeds received from the condemnation proceedings until the mortgage is satisfied.
By the time of the easement donation, the value of the building had increased to $257 million, of which $33.4 million was attributable to the easement. The petitioner claimed a $33.4 million 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 if 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 must remove any preferential treatment of the lender in all situations, creating an exception for unusual situations that could possibly occur at some point in the future. The First Circuit determined that the Tax Court's 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 a broad reading was improper because, for example, a tax lien could arise if the donor failed to pay property tax when they became due which could result in the loss of the property without the charity receiving a pro rata portion of the property value.
In the present case, the Tax Court rejected the view of the First Circuit, noting that its decision would be appealable to the Seventh Circuit and, thus, 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 had agreed with the Tax Court's interpretation of the subordination rule since Kaufman was decided. The Tax Court also 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 a need to have taxing agencies to agree to give up rights to a priority interest that might arise in the future for delinquent taxes when the taxes were not delinquent.
The IRS assessed a gross valuation misstatement penalty in 2008 and additional accuracy-related and negligence penalties in 2014. The petitioner contested the penalties, but the Tax Court, in a later proceeding, determined that there is no requirement that IRS determine the penalties at the same time or by the same IRS agent. The only requirement, the Tax Court held, was that each penalty, at the time of initial determination, was approved in writing by a supervisor before being communicated to the petitioner. That requirement was satisfied. That later proceeding on the penalty issue is at 152 T.C. No. 4 (2019).
- In Salt Point Timber, LLC, et al. v. Comr., T.C. Memo. 2017-245, the petitioner was a timber company that granted a perpetual conservation easement on a 1,032-acre property for which the petitioner claimed a $2.13 million deduction on its 2009 return. The easement preserved the view of natural, environmentally significant habitat on the Cooper River by barring development. The petitioner received $400,000 for the donated easement, and the done satisfied the definition of a “qualified organization” under I.R.C. §170(h)(1)(B). The appraised value of the easement was $2,530,000. The IRS disallowed the deduction on the basis that the easement grant allowed the original easement to be replaced by an easement held by a disqualified entity. In addition, the IRS claimed that the grant allowed the property to be released from the original easement without the extinguishment regulation being satisfied. The petitioner claimed that there was a negligible possibility that the easement could be held by a non-qualified party. The court agreed with the IRS, noting that the grant did not define the term “comparable conservation easement” or what type of organization could hold it, just that an “eligible donee” could hold it. The court noted that an assignment of the easement is different from a replacement of the easement. As such, the grant did not restrict that the holder of the easement had to be a “qualified organization.” The court also determined that the chance that the easement could be replaced was other than negligible as Treas. Reg. §1.170A-14(g)(3) required.
- In PBBM-Rose Hill, Ltd., v. Comr., 900 F.3d 193 (5th Cir. 2018), the petitioner owned a tract of land subject to a use restriction requiring it to only be used for recreational facilities open space for 30 years. At the time of the petitioner’s ownership, the property was a golf course with a clubhouse. The petitioner wanted to sell the property, but before doing so wanted to remove the use restriction. A local buyer expressed interest, but also wanted to block any removal of the use restriction. The sale went through after the buyer agree to allow the removal of the use restriction. However, before the sale closed, the petitioner conveyed a conservation easement of the property to a land trust. The terms of the easement stated that the property was to remain open for public use for outdoor recreation and that fees for such use could be charged. Upon extinguishment of the easement, the land trust would be entitled to a portion of the sale proceeds equal to the greater of the fair market value of the easement at the time of the donation or a share of the proceeds after expenses of sale and an amount attributable to improvements constructed on the property. The IRS denied the charitable deduction.
The Tax Court agreed with the IRS position based on its findings that the easement did not protect the conservation purpose under I.R.C. §170(h)(4)(A) and didn’t satisfy the perpetuity requirement of I.R.C. §170(h)(5)(A) because the easement deed’s extinguishment provision did not comply with Treas. Reg. §1.170A-14(g)(6). As such, the easement donation was not “exclusively for conservation purposes as required by I.R.C. §170(h)(1)(C). The Tax Court held that the easement value was $100,000 rather than the $15.2 million that the petitioner claimed. The Tax Court also upheld the gross valuation misstatement penalty that the IRS had imposed. On appeal, the appellate court affirmed that the petitioner was not entitled to any charitable deduction and upheld the penalty. The appellate court held that when determining whether the public access requirement for a recreation easement is fulfilled, the focus is to be on the terms of the deed and not the actual use of the land post-donation. The appellate court determined that the terms of the easement satisfied the public-access requirement of Treas. Reg. §1.170A-14(d)(5)(iv)(C). However, the appellate court concluded that the contribution was not exclusively for conservation purposes because the requirements of Treas. Reg. §1.170A-14(g)(6)(ii) were not satisfied. The deed, the appellate court noted, allowed the value of improvements to be subtracted from the proceeds before the donee took its share, and that Priv. Ltr. Rul. 200836014 no longer represented the current position of the IRS and could not be used to alter the plain meaning of the regulation which mandates that the donee receive at least the proportionate value of the “proceeds.” The appellate court also agreed with the Tax Court that the gross valuation misstatement penalty applied to the difference between the amount the petitioner deducted on its return ($15 million) and the $100,000 deduction allowed by the Tax Court.
- 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 the extinguishment regulation (Treas. Reg. 1.170A-14(g)(6)(ii)), making the charitable deduction unavailable. See, e.g., Priv. Ltr. Rul. 200836014 (Sept. 5, 2008).
- In Railroad Holdings, LLC, et al. v. Comr., T.C. Memo. 2020-22, 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. §1.170A-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.
Challenge to the Validity of the Regulation
In Oakbrook Land Holdings, LLC v. Comr., 154 T.C. No. 10 (2020), the petitioner challenged the validity of the extinguishment regulation. In 2008, the petitioner donated a permanent conservation easement to a qualified organization and claimed a charitable deduction. The easement deed specified that upon extinguishment of the conservation restriction the donee would receive a share of the proceeds equal to the fair market value of the easement as of the date of the contribution. That value, the deed specified, was to be reduced by the value of any improvements that the donor made after granting the easement. The IRS denied the charitable deduction because (inter alia) violated the extinguishment regulation of Treas. Reg. §1.170A-14(g)(6).
The Tax Court, agreeing with the IRS, upheld the validity of the regulation. The full Tax Court held that the extinguishment regulation (Treas. Reg. §1.170A-14(g)(6)) had been properly promulgated and did not violate the Administrative Procedure Act. The full Tax Court also determined that the construction of I.R.C.§170(h)(5), as set forth in the extinguishment regulation, was valid under the agency deference standard set forth in Chevron, U.S.A. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984).
In a related memorandum opinion, the Tax Court held that the easement deed did not create a perpetual easement because the donee’s share of the extinguishment proceeds was based on fixed historical value, reduced by the value of improvements that the donor made. Oakbrook Land Holdings, LLC v. Comr., T.C. Memo. 2020-54. It was not, as it should have been, based on a proportionate share of extinguishment proceeds that are at least equal to the total proceeds (unadjusted by the value of the petitioner’s improvements), multiplied by a fraction defined by the ratio of the fair market value of the easement to the fair market value of the unencumbered property determined as of the date of the execution of the deed. However, the Tax Court did not uphold penalties that the IRS imposed, finding that the petitioner’s position was reasonable.
The extinguishment regulation is, perhaps, the most common audit issue for IRS when examining permanent conservation easement donations. The clause specifying how proceeds are to be split when a donated conservation easement is extinguished is routinely included in easement deeds. The cases point out that the clause must be drafted precisely to fit the confines of the regulation. A regulation that now has survived an attack on its validity. Many perpetual easement donations will potentially be affected.