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A Deep Dive into Conservation Easements

Conservation Easements have caused quite a bit of a stir at the Tax Court in recent years.  Misunderstandings of the requirements and creativity (and greed) in drafting the easements has led to conservation easements earning a persona non grata status amongst the IRS and Tax Court judges, alike.  In this article, we examine the nuts and bolts of conservation easements and take you on a deep dive of the Code and Treasury Regulations related thereto.

Introduction to Deduction – Why Conservation Easements are Deductible

If a taxpayer makes a charitable contribution of property other than money, the amount of the contribution is generally equal to the FMV of the property at the time the gift is made.[1] However, the Code restricts a taxpayer’s charitable contribution deduction for the donation of an interest in property that consists of less than the taxpayer’s entire interest in such property.[2] There is an exception to this entire interest rule for a “qualified conservation contribution.”[3]

Conservation EasementsThis exception applies where: (1) the taxpayer contributes a qualified real property interest, (2) the donee is a qualified organization, and (3) the contribution is exclusively for conservation purposes.[4] A contribution will not be treated as being made exclusively for conservation purposes unless the conservation purpose is protected in perpetuity.[5] Despite the perpetuity requirement, a subsequent unexpected change in the conditions surrounding the donated property can make impossible or impractical the continued use of the property for conservation purposes.[6]

If there is an unexpected change, the conservation purpose can nonetheless be treated as protected in perpetuity if the restrictions are extinguished by judicial proceeding, and the easement deed ensures that the charitable donee, following sale of the property, will receive a proportionate share of the proceeds and use those proceeds consistently with the conservation purposes underlying the original gift.[7] Thus, the perpetuity requirement is deemed satisfied because the sale proceeds replace the easement as an asset deployed by the donee exclusively for conservation purposes.[8]

For deduction to be allowed IRC § 170(h)(5), at the time of the gift, the donor must agree that the donation of the perpetual conservation restriction gives rise to an immediately vested property right in the donee organization, with a fair market value that is at least equal to the proportionate value that the perpetual conservation restriction at the time of the gift, bears to the value of the property as a whole at that time.[9]

The proportionate value of the donee’s property rights must remain constant.[10] As such, when a change in conditions gives rise to the extinguishment of a perpetual conservation restriction,[11] the donee organization, on a subsequent transfer of the subject property, must be entitled to a portion of the proceeds at least equal to that proportionate value of the perpetual conservation restriction.[12]

The proportionate value is equal to the value of the conservation easement at the time of the gift, divided by the value of the property as a whole at that time.[13] No amount, including that attributable to improvements, may be subtracted out” of the proceeds against which the proportionate value is applied.[14]

Bright Line Rule – Valuation of Conservation Easement Must be Based on Proportionate Value of Proceeds not Fixed Historical Value

A grant of a conservation easement will not satisfy the protected in perpetuity requirement of IRC § 170(h)(5)(A) and Treas. Reg. § 1.170A-14(g)(6) if the donee organization’s share of the proceeds, in the event the property were sold following a judicial extinguishment of the easement, would be (1) determined according to a fixed historical value rather than a proportionate share of the proceeds and (2) reduced by the value of any improvements made by the donor.[15]

Fixing the Boundaries of Development at the Time of the Grant

As Belk v. Commissioner[16] and its progeny establish, if the boundaries of the areas in which the easement allows development are not fixed at the outset, the donor’s retention of development rights can, and will, violate perpetual restriction requirement of IRC § 170(h)(2), even if the retention of rights does not violate the perpetual protection requirement of IRC § 170(h)(5). When the boundaries of the building areas are indeterminate at the time of the grant of the easement, the parcel of property that is subject to a perpetual use restriction is not considered to be “defined.” The Tax Court reasoned that, because the conservation easement permitted the donors to change what property was subject to the conservation easement, the use restriction was not granted in perpetuity. Belk, 140 T.C. at 10.

In response to the donor’s argument in Belk that the donee’s approval of any substitutions of property ensured that conservation purposes would be protected in perpetuity, the Tax Court held that the IRC § 170(h)(5) requirement (that the conservation purpose be protected in perpetuity) is separate and distinct from the IRC § 170(h)(2)(C) requirement (that there be real property subject to a use restriction in perpetuity).

Thus, satisfying IRC § 170(h)(5) does not necessarily affect whether there is a qualified real property interest under IRC § 170(h)(2)(C). The Tax Court notes that there is nothing to suggest that IRC § 170(h)(2)(C) should be read to mean that the restriction granted on the use which may be made of the real property does not need to be in perpetuity if the conservation purpose is protected.

Valuation of Conservation Easement

Moira Charity Deductions

In deciding the easement’s fair market value (or the FMV of any property, for that matter), the Tax Court first took into account the property’s highest and best use.[17] A property’s highest and best use also is the highest and most profitable use for which it is adaptable and needed or likely to be needed in the reasonably near future.[18]

“Comparables,” that is to say examples of comparable sales of properties similar to but not exactly alike to the property at issue, may be used as a metric to evaluate the FMV of a property with regard to a conservation easement.[19] The validity of this metric depends on the choice of “comparables” and, as importantly, the expert’s adjustments to the valuation of the property at issue to account for differences between the comparable and the property itself.[20]

If the expert believes that the subject property is more valuable, he will adjust the value higher, as appropriate. The opposite is true as well, if the comparable is “superior in some fashion” to the subject property.[21] Because of the subjective nature of this analysis, the Tax Court is skeptical of relying on it as the sole basis for establishing the underlying property’s FMV.[22]

Perpetuity Requirement Valid under Administrative Procedure Act (APA) and Chevron

In Oakbrook I,[23] the Tax Court examined whether the perpetuity requirement was valid under the Administrative Procedure act and Chevron, U.S.A., Inc. v. Nat. Res. Def. Council, Inc.,[24] On January 14, 1986, Treasury adopted the proposed amendments to the conservation easement regulations, including the judicial extinguishment portion, with numerous revisions based on voluminous comments.[25] The preamble to the final regulations provides a summary of the law and states that, after consideration of all comments regarding the proposed amendments those amendments are adopted as revised by this Treasury decision.[26]

When reviewing agency actions the scope of a court’s review is narrow, because a court is not empowered to substitute its judgment for that of the agency.[27] The regulations und IRC § 170(h)(5) were promulgated to provide necessary guidance to the public for compliance with the law relating to contributions of partial interests in property for conservation purposes. This was a rational, valid reason, and the administrative record demonstrates that the regulations should be upheld under the APA and Chevron.[28]


Footnotes:

[1] See Treas. Reg. § 1.170A-1(c)(1).

[2] IRC § 170(f)(3)(A).

[3] See IRC § 170(f)(3)(B)(iii).

[4] See IRC § 170(h)(1).

[5] IRC § 170(h)(5)(A).

[6] See Treas. Reg. § 1.170A-14(g)(6)(i).

[7] Id.

[8] See IRC § 170(h)(5)(A).

[9] See Treasury Regulation § 1.170A-14(g)(6)(ii).

[10] Id.

[11] Pursuant to Treasury Regulation § 1.170A-14(g)(6)(i).

[12] Treasury Regulation § 1.170A-14(g)(6)(ii).

[13] PBBM-Rose Hill, Ltd. v. Commissioner, 900 F.3d 193, 207 (5th Cir. 2018); see also Carroll v. Commissioner, 146 T.C. 196, 219 (2016).

[14] PBBM-Rose Hill, 900 F.3d at 208; Coal Prop. Holdings, LLC v. Commissioner, 153 T.C. 126, 136-37 (2019).

[15] See Oakbrook Land Holdings, LLC v. Commissioner (Oakbrook II), T.C. Memo. 2020-54, *36-*37 (May 12, 2020).

[16] 140 T.C. 1, 12 (2013), aff’d, 774 F.3d 221 (4th Cir. 2014).

[17] See Symington, 87 T.C. at 896; Stanley Works & Subs. v. Commissioner, 87 T.C. 389, 400 (1986); Treas. Reg. § 1.170A-14(h)(3)(i); Treas. Reg. § 1.170A-14(h)(3)(ii).

[18] See Olson v. United States, 292 U.S. 246, 255 (1934); Hilborn, 85 T.C. at 689.

[19] See Griffin v. Commissioner, T.C. Memo. 1989-130, aff’d, 911 F.2d 1124 (5th Cir. 1990); Losch v. Commissioner, T.C. Memo. 1988-230.

[20] Wolfsen Land & Cattle Co. v. Commissioner, 72 T.C. 1, 19-20 (1979); Talkington v. Commissioner, T.C. Memo. 1998-412, *9; Estate of Spruill v. Commissioner, 88 T.C. 1197, 1229, n.24 (1987); Butler v. Commissioner, T.C. Memo. 2012-72, *16.

[21] Talkington, *9, n.8.

[22] See Crimi v. Commissioner, T.C. Memo. 2013-51, at *54-*58.

[23] 154 T.C. No. 10 (May 12, 2020).

[24] 467 U.S. 837 (1984).

[25] See T.D. 8069, 1986-1 C.B. 89.

[26] Id. at 90.

[27] Bowman Transp., Inc. v. Ark.-Best Freight Sys., Inc., 419 U.S. 281, 285 (1974).

[28] Accord Wing v. Commissioner, 81 T.C. 17, 31-32 (1983).

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