Legal Aspects of Conservation Easements: A Primer for Transportation Agencies (2013)

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41 APPENDIX A: IDENTIFYING THE TAX ISSUES RELATED TO CONSERVATION EASEMENTS Landowners place conservation easements on their property for a number of reasons including the desire to preserve family property in its current condition for future generations. Also, the considerable tax bene- fits that may result from the donation of a conservation easement provide an incentive for their use. This section discusses how conservation easements may, in some instances, be used to achieve tax savings, namely, through income and estate tax deductions and property tax savings. The discussion of income and estate taxes focuses on federal tax law, but many state tax laws include benefits for conservation easement donations. Examples will be presented as appropriate. Note: The intent of this section is to identify and summarize the major tax implications of conservation easements as they existed at the time of writing—not to provide tax or legal advice. Therefore, readers are advised to consult legal and tax professionals in their states for questions involving particular situations and controversies and to confirm the current status of tax legislation. A. INCOME TAX The federal income tax deduction for donated conservation easements offers an exception to the general rule that donations of partial interest in property are not eligible for charitable deductions.233 Section 170(h) of the Internal Revenue Code provides an exception for qualifying conservation easement donations. To qualify, the property owner must carefully follow detailed federal procedural and substantive requirements. A donor needs to realize that satisfying state property requirements is only a necessary—not a complete— condition for obtaining federal tax benefits. Not only must a donor follow the rules generally applicable to charitable contributions, but also those specifically governing conservation easements, principally Section 170(h) and its accompanying regulations at 26 C.F.R. § 1.170A-14.234 To qualify for the deduction, the conservation easement must be a qualified conservation contribution, meaning it must satisfy the following four elements of federal tax law: 1. The contribution is of a “qualified real property interest.” 2. The contribution is made to a “qualified organization.” 3. The contribution is exclusively for “conservation purposes.” 4. The conservation purposes are protected in perpetuity.235 233 See I.R.C. § 170(f)(3). 234 But see Trout Ranch v. Commissioner, 2012 U. App. LEXIS 17198 Tax CAS P 50524 (Aug. 16, 2012) (private partnership pur- chased land to develop home sites. It preserved 85 percent by conservation easement and claimed a 26 U.S.C. § 1.170 charitable deduc- tion in the amount of $2.2 million. IRS, stating that charitable easement did not reduce property value, appraised charitable deduction at zero. Tax Court eventually allowed a $560,000 charitable deduction.). 235 See I.R.C. § 170(h); Treas. Reg. § 1.170A-14(a); 26 C.F.R. § 1.170A-14(a).

42 A qualified real property interest is defined to include a “perpetual conservation restriction,” 236 which in turn is defined as “a restriction granted in perpetuity on the use which may be made of real property— including an easement or other interest in real property that under state law has attributes similar to an easement (e.g., a restrictive covenant or equitable servitude).”237 As a result, “compliance with all of the state statutory requirements for creating an easement is essential if the easement is to qualify under federal tax law as a ‘perpetual conservation restriction.’”238 A qualified conservation contribution must be donated to a qualified organization, which must meet each of the following conditions to constitute an eligible donee: 1. The organization must be either a local, state, or federal government agency, or a public charity qualified under IRC Section 501(c)(3); 2. The organization must have a commitment to protect the conservation purposes of the donation; and 3. The organization must have the resources to enforce the restrictions imposed by the easement.239 Private land trusts commonly assume the role of qualified organization, but as the above definition makes clear, public agencies—presumably including transportation agencies—may be eligible as well. However, one commentator has noted that merely being a public agency is insufficient to satisfy the “commitment to protect the conservation purposes,” given the potential for changed circumstances and conflicting values and objectives.240 The regulations also require that the conservation easement itself include a provision limiting any future transfer or termination of the easement as follows: 1. The easement must prohibit the holder of the easement from transferring it to any organization that not an “eligible donee” as described above. 2. The easement must require that any transferee organization agree in writing to carry out the con- servation purposes of the easement. 3. The easement must require that, if a later unexpected change in the conditions surrounding the easement property makes impossible or impractical the continued use of the property for conservation purposes, any proceeds received by the easement holder resulting from the later sale or exchange of the easement property must be used in a manner that is consistent with the conservation purposes of the easement.241 The third requirement is that the conservation easement be used exclusively for at least one of the follow- ing four conservation purposes: 1. The preservation of land areas for outdoor recreation by, or the education of, the general public. 2. The protection of a relatively natural habitat of fish, wildlife, or plants, or similar ecosystem. 236 I.R.C. § 170(h)(2)(c) 237 Treas. Reg. § 1.170A-14(b)(2); 26 C.F.R. § 1.170A-14(b)(2). 238 Lindstrom, supra note 152, at 441, 449. 239 Id. at 450 (citing Treas. Reg., 26 C.F.R. § 1.170A-14(c)(1)); 26 C.F.R.). 240 Id. at 451. 241 Id. at 452 (citing Treas. Reg. 26 C.F.R. § 1.170A-14(c)(2)).

43 3. The preservation of open space (including farmland and forest land) where such preservation is (a) for the scenic enjoyment of the general public, or (b) pursuant to a clearly delineated Federal, State, or local governmental conservation policy, and will yield a significant public benefit. 4. The preservation of a historically important land area or a certified historic structure.242 It is important to keep in mind that the conservation easement must be exclusively for conservation pur- poses, which amounts to a general prohibition on inconsistent uses that “would permit destruction of other significant conservation interests” aside from the stated purpose of the conservation easement.243 Finally, it bears noting that in recent years the IRS has applied increased scrutiny to claimed qualified conservation contributions, and has challenged several based on failure to satisfy the exclusively for conservation pur- poses test.244 Furthermore, the IRS may attach a penalty when the value of a qualified conservation contri- bution is overstated, 245 unless good faith is demonstrated.246 The last requirement for qualified conservation contributions is that the conservation purposes be pro- tected in perpetuity. The law in many states allows conservation easements to be established for a term of years. Such easements, though valid as a matter of state law, would be ineligible for an income tax deduc- tion. The regulations recognize the potential for termination down the road as a matter of law (such as in consideration of marketability of title), but this appears not to bear on the perpetuity factor.247 Moreover, the potential for the parties to a conservation easement to consent to amendment or termination does not violate the perpetuity requirement.248 A recent case, Kaufman v. Shulman,249 addressed the issue of perpetuity with regard to the priority rights of those with interest in the property to proceeds from extinguishment or through condemnation actions or from insurance. In Kaufman, which dealt with post-extinguishment proceeds from the conservation ease- ment on a historic property in Boston, the mortgage lien holder subrogated its rights to proceeds to the con- servation easement holder except in certain circumstances, which included condemnation. The tax court con- cluded that this provision, with its exceptions, failed to meet the requirement of perpetuity because the holder did not have an absolute, guaranteed priority right to proceeds.250 251 The First Circuit reversed this decision on appeal, concluding that if the subrogation provision were to be construed to defeat the tax treatment of the conservation easement, then it “would appear to doom practically all donations of ease- ments, which is surely contrary to the purpose of Congress.” In addition to the discussion above, the tax deduction will not be allowed where surface mining rights are reserved to the landowner, although some other forms of mining are permissible.252 Finally, the conservation 242 I.R.C. § 170(h)(4). 243 Treas. Reg. § 1.170A-14(e)(2); 26 C.F.R. § 1.170A-14(e)(2). However, activities that do not impair significant conservation interests (including existing uses) or those that are necessary to protect the stated conservation purposes of the easement are not inconsistent uses. Treas. Reg., § 1.170A-14(e)(3); 26 C.F.R. § 1.170A-14(e)(3). 244 See, e.g,. Glass v. Commissioner of Internal Revenue, 471 F.3d 698 (6th Cir. 2006) (challenging sufficiency of habitat preservation). 245 See Whitehouse Hotel, Ltd. P-ship v. Commissioner, 139 T.C. No. 13, 2012 U.S. Tax Ct. LEXIS 40 (filed Oct. 23, 2012); Kiva Dunes Conservation v. Commr, T.C. Memo 2009-145, 2009 Tax Ct. Memo LEXIS 144 (2009). 246 Edgar Corp. v. Commissioner, Docket Nos. 23676-08, 23688-08, 23689-08, U.S. Tax Ct. Memo 2012-35, 103 T.C.M. 1185 (filed Feb. 6, 2012). 247 Treas. Reg., § 1.170A-14(g)(3); 26 C.F.R. § 1.170A-14(g)(3). 248 Lindstrom, supra note 152, at 441, 476. 249 Kaufman v. Shulman, 687 F.3d 21 (1st Cir. 2012). 250 Kaufman v. Commissioner, 136 T.C. No. 13 (2011). 251 Treas. Reg. § 1.170A-14(g)(2); 26 C.F.R. § 1.170A-14(g)(2). 252 Treas. Reg.§ 1.170A-14(g)(4)(i); 26 C.F.R. § 1.170A-14(g)(4)(i).

44 easement must include a written “natural resource inventory” if the donor reserves any development or use rights, allow the holder to enter the property to monitor and enforce (based, in part, on the inventory), and require the donor to notify the holder prior to exercising any rights reserved in the easement that may im- pair conservation values.253 Having summarized the eligibility requirements for the federal income tax deduction, the mechanics of the deduction will now be discussed. As a starting point, the total value of the conservation easement may be deducted.254 However, the law governing charitable deductions (including conservation easements) limits the deduction that can be taken each year. For the grantor to claim the deduction, the conservation easement must be valued. Federal law places the responsibility to perform an appraisal on the donor, while regulating how it must take place. The value of a conservation easement donation, like all other charitable contributions exceeding $5,000, must be backed by a “qualified appraisal”255 conducted by a “qualified appraiser.”256 In the wake of reported widespread abuses of the conservation easement tax deduction,257 the regulations governing appraisals were stiffened as part of the 2006 Pension Protection Act. 258 However, implementing regulations have yet to be finalized as of this writing.259 Finally, Form 8283, “Noncash Charitable Contributions,” which must be filed along with all claims for a conservation easement donation, requires, among other things, additional substantiation of the appraisal and heightened reporting thresholds for donations greater than $500,000. As for the appraisal itself, valuation of conservation easements for tax purposes based generally on the before and after approach, which subtracts the post-easement value of the property from the pre-easement value.260 The law requires that the following factors be taken into consideration when proceeding with this approach: 1) current use of the property; 2) an assessment of the development potential of the property; and 3) any effect on property values brought about by existing zoning or conservation restrictions.261 Various ap- proaches to the before and after methodology exist. For example, the “development methodology” assumes the before value to represent the highest development potential under current law.262 However, all of these valuation approaches involve some degree of subjectivity and assumptions, especially those relying heavily on questionable, long-term development projections.263 Finally, before turning to a discussion of the federal estate tax benefits associated with conservation easements, it is important to recognize that some states provide income tax benefits of their own. For exam- ple, South Carolina offers a tax credit towards state income tax, in addition to the federal income tax deduc- tion, equal to 25 percent of the value of a conservation easement donation that meets the federal require- ments.264 As with the federal tax rules, South Carolina limits the tax benefits that can be taken each year 253 Treas. Reg. § 1.170A-14(g)(5); 26 C.F.R. § 1.170A-14(g)(5). 254 Treas. Reg. § 1.170A-14(h)(3)(ii); 26 C.F.R § 1.170A-14(h)(3)(ii). 255 Treas. Reg. § 1.170A-13(c)(3); 26 C.F.R. § 1.170A-13(c)(3). 256 Treas. Reg. § 1.170A-13(c)(5); 26 C.F.R. § 1.170A-13(c)(5). 257 Joe Stephens & David B. Ottaway, Developers Find Payoff in Preservation, WASH. POST, Dec. 21, 2003, http://www.washingtonpost.com/wp-dyn/content/article/2007/06/26/AR2007062601176.html (Accessed Jan. 1, 2013). 258 I.R.C. § 170(f)(11)(E). 259 In the meantime, IRS Notice 2006-96 provides interim guidance on the new definitions of “qualified appraisal” and “qualified appraiser.” 260 Treas. Reg. § 1.170A-14(h)(3); 26 C.F.R. § 1.170A-14(h)(3). 261 Treas. Reg. § 1.170A-14(h)(3)(ii); 26 C.F.R. § 1.170A-14(h)(3)(ii). 262 Lindstrom, supra note 152, at 441, 500. 263 See, e.g,. Josh Eagle, Notional Generosity: Explaining Charitable Donors’ High Willingness to Part with Conservation Easements, 35 HARV. ENVTL. L. REV. 47 (2011). 264 S.C. CODE ANN. § 12-6-3515.

45 and provides for limited carry-forward provisions.265 Arkansas, California, Colorado, Connecticut, Delaware, Georgia, Iowa, Maryland, Massachusetts, Mississippi, New Mexico, New York, North Carolina, and Virginia have provided state tax credits of their own, which are similar to South Carolina’s approach in various re- spects, such as the reference to federal regulations for eligibility determination.266 B. ESTATE TAX The federal estate tax provisions, though currently in flux, have provided two separate estate tax benefits for conservation easements. The first recognized the value reduction of the taxable estate due to develop- ment restrictions imposed by the conservation easement. The second involved an exclusion for qualifying conservation easements. As a general rule, contractual restrictions on the use of real property cannot be taken into account in de- termining an estate’s value, however, an exception has been made for conservation easements.267 Conserva- tion easements created during the decedent’s life that satisfy the requirements of IRC Section 170(h) were eligible for the exemption.268 Also eligible were conservation easements created by will that satisfied Section 170(h), but the conservation purposes test need not be met.269 More generally, for conservation easements not meeting the requirements of Section 170(h), the law still allowed a reduction in the value of the estate as long as the following requirements were met: 1. The restrictions are the result of a “bona fide business arrangement.” 2. The restrictions are not a device to transfer property to family members for less than adequate con- sideration. 3. The terms of the restriction are comparable to similar arrangements entered into by persons in an arm’s length transaction.270 For the last category of conservation easements, it is important to recognize that the conservation ease- ment need not be donated; instead, the conservation easement may be sold or given in exchange for devel- opment approval and the property owner would still be entitled to the reduction in estate value based solely on the reduced value of the property. In addition to the reduction in estate value, IRC Section 2031(c) provided an additional exclusion for a “qualified conservation easement” created during the decedent’s life, pursuant to the will, or in some cases by the executor or the heirs. To meet the requirements of a “qualified conservation easement,” the require- ments of IRC Section 170(h) including the conservation purposes test must be satisfied. Note, however, that “qualified conservation contribution” (for income tax deduction purposes) and “qualified conservation ease- ment” are not the same, as the latter imposes additional requirements.271 One of the requirements was that the decedent must have owned the property for at least 3 years prior to his or her death.272 In addition, the exclusion was available only to the family of the original donor, but could be taken by his or her spouse and 265 Id. 266 For up-to-date summaries of each of these programs, visit the Land Trust Alliance’s “State and Local Tax Incentives” Web site at http://www.landtrustalliance.org/policy/tax-matters/campaigns/state-tax-incentives. 267 Treas. Reg. § 25.2703-1; 26 C.F.R. § 25.2703-1. 268 Treas. Reg. § 25.2703-1(b)(4); 26 C.F.R.§ 25.2703-1(b)(4). 269 I.R.C. § 2055(f) 270 Lindstrom, supra note 152, at 527 (citing Treas. Reg., § 25.2703-1(b)(1) and (2); 26 C.F.R. § 25.2703-1(b)(1) and (2)). 271 Id. at 530. 272 I.R.C. § 2031(c)(8)(A)(ii).

46 subsequent generations.273 Also, the exclusion could not be given for conservation easements whose sole con- servation purpose was historic preservation.274 Finally, conservation easements that allow anything more than de minimus commercial recreational uses were disqualified for the purposes of the IRC Section 2031(c) exclusion.275 Other case-specific requirements needed to be satisfied for the purposes of the estate tax exclu- sion and should be evaluated on a case-by-case basis, by state. Those estates qualifying for the IRC Section 2031(c) exclusion received a 40 percent reduction of the conservation easement-restricted land value, up to a maximum of $500,000.276 Aside from the estate tax benefits described above, conservation easements of course have the capacity to control the use of land into the future. Taken together, conservation easements make for a powerful and ap- pealing estate planning option for many landowners, especially those that are land rich and cash poor. C. PROPERTY TAX Conservation easements may lower the market value of the property it burdens, because of development and use restrictions limiting its full economic potential. As a result, one might expect that in addition to fed- eral and state tax benefits for income and estate taxes, reductions in property tax (based on diminished ap- praised values) should follow as well. However, whether or not property tax savings result varies from state to state and sometimes between local governments within the same state. As a result, the best advice for determining the property tax benefits associated with conservation easements calls for a case-by-case ap- proach. Some state statutes expressly require property tax adjustments based on the presence of conservation easements. For example, Colorado requires that “[r]eal property subject to one or more conservation ease- ments in gross shall be assessed, however, with due regard to the restricted uses to which the property may be devoted.”277 Similarly, in Georgia, the recordation of a conservation easement “shall be notice to the board of tax assessors…and shall entitle the owner to a revaluation of the encumbered real property so as to re- flect the existence of the encumbrance on the next succeeding tax digest of the county.”278 However, Georgia goes a step further than Colorado by expressly authorizing property owners to appeal the easement-adjusted valuation.279 In states like Colorado and Georgia the property tax issue is straightforward. Unfortunately, states with such clarity in regards to the property tax issue are the exception rather than the rule. In some states, the conservation easement enabling legislation is silent or ambiguous on the issue of prop- erty tax valuation, and this leads to uncertainty from jurisdiction to jurisdiction within those states. To take just two examples, neither Arizona’s280 nor Michigan’s281 enabling statutes address property taxes. Else- where, property tax reductions based on conservation easements are authorized, but not required, which can lead to intrastate variations.282 For this category of states, appraised values may reflect the existence of con- servation easements, but this comes not as the result of express statutory mandate, but rather due perhaps 273 I.R.C. § 2031(c)(8)(C). 274 I.R.C. § 2031(c)(8)(B). 275 I.R.C. § 2031(c)(8)(B). 276 To qualify for the full 40 percent reduction, the conservation easement must have reduced the value of the property by at least 30 percent. I.R.C. § 2031(c). 277 COLO. REV. STAT. § 38-30.5-109. 278 GA. CODE ANN. § 44-10-8. 279 Id. 280 See ARIZ. REV. STAT. ANN. §§ 33-271 et seq. 281 See MICH. COMP. LAWS §§ 324.2140 et seq. 282 MASS GEN. LAWS ch. 59, § 11.

47 to the assessor’s office’s liberal implementation of the general requirement that property taxes reflect actual market value. Additionally, property tax appeals by a landowner, which are generally permitted in most states, may be another means of obtaining property tax reductions in states without an express require- ment. However, as previously stated, in states where the law is unclear, care must be taken to ascertain lo- cal practices and applicable laws. While the laws in the majority of states fall into the categories previously discussed, the laws in Idaho, Oregon, and Florida are worth mentioning separately since they take quite different approaches. Idaho’s enabling legislation expressly provides that conservation easements must be ignored for property tax pur- poses.283 Oregon allows a property owner, prior to creating the conservation easement, to receive a formal report from the county assessor’s office as to the effect on valuation.284 In 2008, voters in Florida approved a constitutional amendment that authorized the legislature to completely exempt “[l]and that is dedicated in perpetuity for conservation purposes and that is used exclusively for conservation purposes,” subject to other eligibility requirements on size of property and authorized uses.285 283 IDAHO CODE ANN. § 55-2109. (“The market value shall be computed as if the conservation easement did not exist.”) 284 OR. REV. STAT. § 271.715. 285 FLA. STAT. § 196.26. For more information on the constitutional amendment, see The Florida Senate Interim Report 2010-117, http://archive.flsenate.gov/data/Publications/2011/Senate/reports/interim_reports/pdf/2011-117ep.pdf.