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IRS Scrutiny of Charitable Conservation Easements

Until recently, conservation easements had received very little IRS attention. However, Notice 2004-41 and Rev. Rul. 2003-123, taken together with recent statements by IRS Commissioner Mark W. Everson (see IR News Release 2004-86), indicate that the Service has apparently noticed the abundance of taxpayers claiming substantial tax benefits from charitable conservation deductions and is concerned about abuse.

 

Notice 2004-41 

The IRS announced in Notice 2004-41 that taxpayers might be claiming improper charitable deductions under Sec. 170 for the following types of contributions:

1. Transfers of real property easements to a charitable organization; and

2. Payments to a charitable organization for a purchase of real property from said organization.

Besides the type of contribution, the Service may also challenge the exempt status of certain charitable organizations participating in these transactions. Further, it may also penalize certain promoters and appraisers of transactions with improper deductions.

 

Rev. Rul. 2003-123

Another example of IRS scrutiny of deductions for conservation easements appeared in Rev. Rul. 2003-123, which disallowed a trusts deduction for a 20-acre parcel that otherwise met the Sec. 170(h) requirements for a qualified conservation contribution. The contribution was deemed to be made from trust principal and, thus, disallowed; for a charitable deduction to be available to a trust or an estate, the contributions source must be gross income, not corpus; see Sec. 642(c). While Rev. Rul. 68-667 had concluded that amounts paid to a charity out of trust corpus did not qualify for a charitable deduction, Rev. Rul. 2003-123 further clarified that this ruling also extends to qualified conservation contributions.

 

IR News Release 2004-81

Further evidence of recent IRS attention to conservation easement abuse is Commissioner Eversons written statement (IR 2004-81) before the Committee on Finance, U.S. Senate: Hearing on Charitable Giving Problems and Best Practices. In his statement, the Commissioner noted that although conservation easements represent a valued part of philanthropy, there were several abuses in this area, including (1) overvaluation of easements, (2) the failure by charities to monitor easement requirements and (3) the potential for inconsistent use by the landowner of the property on which the original deduction was based. He stated that the Administrations FY 2005 Budget includes several proposals to address these problems.

The IRS also enacted a program to begin matching Form 8283, Noncash Charitable Contributions (which is completed by a donor making a noncash charitable contribution over $500) against Form 8282, Donee Information Form (Sale, Exchange, or Other Disposition of Donated Property) (which is completed by a charitable organization accepting a noncash donation over $500). Mr. Everson also noted that, if funded, $300 million of the $490 million proposed budget increase in 2005 would be used to restore and reinvigorate enforcement, including an expected 17% increase in spending for examinations of exempt and government entities.

Contrary to the IRSs position of alleged abuse, in a Dec. 22, 2003 letter to the editor of the Washington Post, Stephen J. Small, an attorney who wrote the income tax regulations on conservation easements (when he worked for the IRS 20 years ago) and who is highly active in the field of private land protection and conservation, wrote:

For the record, and I have been doing this work for more than twenty years, probably 98% of the conservation easement transactions in the mainstream land trust movement are good. Important land is protected, a fair deduction is taken (sometimes no deduction is taken at all). The mainstream land trust movement includes all local, state, and regional land trusts and conservancies so named, as well as national groups like the American Farmland Trust, The Nature Conservancy, Rocky Mountain Elk Foundation, Ducks Unlimited, etc.

However, he implied that the issue with improper easement transactions lies with the underlying appraisal:

Lets cut to the chase. The principal reason for the bad conservation easement transactions is the incorrect, inflated, or fraudulent appraisal that throws off an incorrect, inflated, or fraudulent income tax deduction.

He recommended, [t]he way to deal with these is to tighten the appraisal rules and standards and review process. The letter is available at www.stevesmall.com/art/articles/031223.html.

 

Law

With all of the attention directed at charitable conservation easements, taxpayers who are considering such transactions should be well informed about Sec. 170(h) and Regs. Sec. 1.170A-14, which discuss qualified conservation contributions. To qualify for a charitable deduction, a conservation easement must meet all of the criteria for a qualified conservation contribution; see the Exhibit below.

   

Exhibit: Regs. Sec. 1.170A-14 qualified conservation contribution criteria

1. The property contributed must be a qualified real property interest. Under Regs. Sec. 1.170A-14(b), any of the following interests qualifies:
  • The donors entire interest other than a qualified mineral interest;
  • A remainder interest; or
  • A restriction (granted in perpetuity) on the use that may be made of the real property.

2. The gift must be to a qualified organization. According to Regs. Sec. 1.170A-14(c)(1), only certain qualified organizations (primarily, governmental units and public charities) are eligible to receive qualified conservation contributions; private foundations are ineligible. The organization must have a commitment to protect the conservation purposes of the donation and the necessary resources to enforce the restrictions.

3. The gift must be for conservation purposes. At least one or more of the following Regs. Sec. 1.170A-14(d) purposes must be met:

  • Preservation of land areas for outdoor recreation by, or for the education of, the general public;
  • Protection of a relatively natural habitat of fish, wildlife or plants or similar ecosystem;
  • Preservation of open space (including farmland and forest land) for the general publics scenic enjoyment or pursuant to a clearly delineated governmental conservation policy, provided such preservation will yield a significant public benefit; or
  • Preservation of historically important land or a certified historic structure.

4. The donation must be exclusively for conservation purposes, according to Regs. Sec. 1.170A-14(e) and (g):

  • The conservation purpose of the gift must be protected in perpetuity.
  • No surface mining is permitted, unless the probability of it occurring on such property is so remote as to be negligible.
  • If the taxpayer receives incidental benefits from retained rights (such as timber or hunting rights), the taxpayer is allowed to claim a deduction as long as such benefits do not interfere with the gifts conservation purpose.
  • No deduction is available if the property is used for a purpose inconsistent with the gifts conservation purpose.
  • If the property is encumbered, no deduction is allowed unless the mortgagee agrees to subordinate his or her rights in the property to the right of the donee to enforce the conservation purposes in perpetuity.
  • If the donor reserves exercisable rights for the property, certain additional obligations are imposed. The donor must furnish the donee organization with appropriate documentation to establish the propertys condition at the time of the gift. Further, the donee must have the right to inspect the property at reasonable times to ensure compliance with the conservation purpose. The donor must also agree to notify the donee in writing before exercising any reserved rights.
  • If an easement is extinguished, the conservation purpose may be treated as protected in perpetuity if (1) the restrictions are extinguished by judicial proceeding and (2) all of the donees proceeds from a sale or exchange of the property are used by the donee in a manner consistent with the gifts conservation purpose.

   

Valuations and Related Issues

The rules for valuing an easement are outlined in Regs. Sec. 1.170A-14. Three traditional valuation methods are typically used, as appropriate: comparable sales, capitalization of income and replacement cost. The value of the qualified conservation contribution is based on a before and after valuation calculation (i.e., the contributions value is the propertys fair market value (FMV) before the easement gift, less the FMV after the property restriction. The before value is based on the highest and best use of the property in its current condition (unrestricted by the easement) and may take the following into consideration, under Regs. Sec. 1.170A-14(h)(3)(ii):

1. Current use;

2. Realistic and potential uses;

3. The likelihood that, absent the restriction, the property would, in fact, be developed;

4. The cost of developing or subdividing; and

5. The effect of zoning, conservation or historic preservation laws that already restrict the propertys highest and best use.

The following factors may be relevant in considering the propertys value after a restriction:

1. The effect of any development (however limited) allowed by the terms of the gift;

2. The amount of access to the property permitted by the terms of the gift; and

3. The effect of restrictions that may permit uses of the property that will increase the value above its value at current use.

Importantly, Regs. Sec. 1.170A-14(h)(3)(ii) considers that property may actually increase in value as a result of a conservation easement. If a donor places an easement on a portion of a contiguous piece of property, the contribution value would take into account the value of the entire contiguous piece before and after the easement. If an easement results in an increase in value to other property of the donor or a related person (regardless of whether the property is contiguous), the contribution value would be reduced by the other propertys increased value. If the donor or a related person received substantial economic benefits and such value is less than the transfer value, the deduction would be limited to the excess of the transfer amount over the benefit received. Finally, if the benefit to the public is less than the economic benefit received by the donor or a family member, the deduction would be disallowed completely.

 

Conclusion

Conservation easement transactions, whether proper or not, have caught the IRSs attention and will face increased scrutiny in upcoming years. Nevertheless, they offer strong tax incentives, while also benefiting society. It is unlikely that their demand will decrease. In addition to income tax benefits, they offer other tax incentives (such as lower property taxes) and estate tax benefits (as a result of the lowered property value).

Several proposed tax law changes would increase these incentives and make conservation easements even more favorable, such as allowing a charitable deduction of the appreciated propertys FMV for up to 50% of individuals adjusted gross income, a charitable deduction of up to 20% of corporations taxable income and a longer carryforward period of any disallowed deduction. Accordingly, it is imperative to emphasize proper structuring of such transactions, including compliance with the law and regulations on deductions for such contributions, adherence to substantiation requirements and use of appropriate valuations and appraisals.

From Victoria L. McCollum, CPA, Bennett Thrasher PC, Atlanta, GA

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2004 AICPA