Esgar v. Commissioner—10th Circuit Affirms Tax Court: Conservation Easements Were Overvalued, Income From State Tax Credit Sales Was Short Term Capital Gain

In Esgar v. Commissioner, 2014 WL 889614 (10th Cir. 2014) (Esgar II), the 10th Circuit affirmed the Tax Court’s holdings in Esgar v. Commissioner, T.C. Memo. 2012-35 (Esgar I), and Tempel v. Commissioner, 136 T.C. 341 (2011).

Esgar I and Tempel

In December 2004, a partnership owning land in Prowers County, Colorado, a substantial portion of which was leased to a gravel mining company, conveyed approximately 163 of the non-leased acres to three of its partners. Each of the three partners (who were the taxpayers in Esgar) ended up owning approximately 54 acres, and each donated a conservation easement to a nonprofit organization. The taxpayers claimed charitable deductions for the donations on their 2004, 2005, and 2006 tax returns. The taxpayers also received transferable income tax credits from Colorado as a result of the donations and sold portions of those credits to third parties within two weeks. The taxpayers reported the proceeds from the credit sales as long-term capital gain, short-term capital gain, and ordinary income, respectively.

After an audit of the taxpayers’ income tax returns, the IRS determined that the conservation easements had no value and that the proceeds from the sales of the state tax credits should have been reported as ordinary income.

 In Esgar I, the sole issue before the Tax Court was the value of the conservation easements. The parties disagreed over the highest and best use of the subject properties before the easements were donated; the taxpayers argued it was gravel mining, whereas the IRS argued it was agriculture. Both sides introduced reports and testimony from various experts and the Tax Court ultimately sided with the IRS. The Tax Court’s conclusion that agriculture was the properties’ highest and best use before the easements were donated was based, in part, on a finding that, although “it would have been physically possible to mine the properties in 2004 (or in the future),” there was no demand for such use “in the reasonably foreseeable future.” The Tax Court determined that each of the three conservation easements was worth approximately $49,000 (the IRS had asserted a $9,000 value for each easement at trial, and the taxpayers had asserted values of $570,500, $867,500, and $836,500, respectively).

In Tempel, the Tax Court held that the taxpayers’ state tax credits were zero-basis capital assets and, given the short holding periods, income from the sale of such credits was short-term capital gain. Several months later, the IRS released Chief Counsel Memorandum 201147024, which addresses the tax consequences of the sale of state tax credits to both the seller and the buyer. 

Esgar II

Conservation Easement Valuation

In Esgar II, the taxpayers first argued that the Tax Court erred in Esgar I by placing the burden of proving the “before” value of the subject properties on them. They asserted that because the burden was not properly allocated, the IRS was allowed to prevail without presenting any objective evidence that agriculture was the properties’ highest and best use. They also argued that the Tax Court's decision was void of “factual evidence presented by the [IRS]” and instead supported “through negative presumptions of fact improperly inferred” against them.

The 10th Circuit rejected all of those arguments. It found that the rule shifting the burden of proof to the IRS was immaterial to the outcome of the case because there was no evidentiary tie—the Tax Court was justifiied in finding that the preponderance of the evidence favored the IRS. The 10th Circuit noted that the IRS’s position was supported by the expert testimony of a certified general appraiser who had appraised some 150 conservation easements, and much of the taxpayers’ own evidence undermined their position that gravel mining was the properties’ highest and best use. The 10th Circuit also noted that the Tax Court did not rely solely on the missing-evidence inference to find that already existing mines in Prowers County were sufficient to satisfy future increases in demand. Rather, that inference was just one of a number of factors indicating that gravel mining was not the properties’ highest and best use.

The taxpayers next argued that that the Tax Court erred by adopting the properties’ current use as its highest and best use rather than taking a “development-based approach.” The 10th Circuit also rejected this argument. It found that the Tax Court had applied the correct highest and best use standard by looking for the use that was “most reasonably probable in the reasonably near future,” and that the Tax Court did not clearly err by concluding that such use was agriculture.

The taxpayers’ final valuation-based argument was that eminent domain principles are wholly inapplicable when valuing conservation easements. The 10th Circuit also rejected this argument, holding that, in the context of determining a property's highest and best use, there is no material difference between conservation-easement valuation and just-compensation valuation.

Character of Income from State Tax Credit Sales

In Esgar II, the taxpayers argued that their state tax credits, which they held for only about two weeks, were nonetheless long-term capital assets because they held the underlying real properties for longer than one year, they relinquished development rights in those properties through the donation of the easements, and they received the tax credits because of the donations.

The 10th Circuit disagreed, noting that the Tax Court correctly concluded that the taxpayers had no property rights in the tax credits until the easement donations were complete and the credits were granted, and the credits never were, nor did they become, part of the taxpayers' real property rights. The 10th Circuit also agreed with the Tax Court that the taxpayers’ holding period in the credits began at the time the credits were granted and ended when taxpayers sold them, and since the taxpayers sold the credits in the same month in which they received them, the gains from the sale of the credits were short term capital gains.

The 10th Circuit also summarily rejected the argument that the transactions amounted to some sort of like-kind exchange of conservation easements for tax credits that might result in the “tacking” of holding periods. The court further noted that if these were like-kind exchanges it would negate the charitable nature of the taxpayers’ contributions.

Nancy A. McLaughlin, Robert W. Swenson Professor of Law, University of Utah S.J. Quinney College of Law