A Tax Guide to Conservation Easements

ISLAND PRESS

Contents

An Overview of Voluntary Conservation Tools

To understand the operation of the tax law as it pertains to land conservation, a good place to start is by understanding the various types of tools that currently exist for undertaking voluntary land conservation. Following is a brief description of some of the most commonly used land conservation tools, not all of which will result in tax deductions.

I. Fee Interests

A fee interest (more technically an estate in "fee simple," or "fee simple absolute") at common law (the law created by judicial decisions, as opposed to statutory law created by legislative acts) primarily described an estate of inheritance—that is, one that could be passed on to one's heirs, as opposed to an estate limited to a specific term of years, for example. Fee ownership also refers to the ownership of all of the different interests that make up a parcel of real property. Real property is sometimes referred to as a "bundle of twigs." The twigs represent different kinds of interests that can be owned, either together or separately. For example, air rights, water rights, timber rights, mineral rights, and surface rights are all different aspects of the fee ownership. At common law the entire bundle of twigs is referred to as the fee simple absolute.

When one acquires a fee interest, one acquires the entire bundle of twigs that make up a given parcel of real property. However, typically, when one speaks of owning a fee interest in a nontechnical sense, one is merely referring to owning the right to possess and use the surface of a parcel of real property, regardless of whether rights such as mineral rights, water rights, or an access easement, for example, have been previously conveyed to others, all of which "off-conveyances" reduce the fee simple to something less than the complete bundle of twigs.

Traditional land conservation involved acquiring fee interests (in this case the term fee is used in its nontechnical sense). The federal government acquired land through conquest, purchase, and the power of eminent domain for national parks, forests, seashores, and so forth. Early private land conservation efforts also involved acquisition of fee interests.

Land conservation today still involves fee acquisition, although less extensively than in the past due to the inflated costs of real property and the additional costs of holding fee interests, including insurance, taxes, and maintenance. Some substantial conservation organizations such as The Nature Conservancy still depend extensively upon acquiring fee interests. Such efforts often involve the acquisition of the fee and then resale of the fee subject to a conservation easement reserved by the conservation organization to ensure that future use by the purchaser will be consistent with that organization's conservation goals. Such transactions are known as "conservation buyer transactions." Conservation buyer transactions are discussed in more detail in section VII of this chapter and in section II, B, 3 of chapter 4.

When a governmental agency or public charity (e.g., a land trust recognized as a public charity under section 501(c)(3) of the Internal Revenue Code) acquires a fee interest as a contribution, or for less than the fair market value of the fee, the grantor of the fee is entitled to a federal tax deduction.

II. Conservation Easements

Conservation easements are the primary tool of private land conservation today. According to the Land Trust Alliance's 2005 National Land Trust Census, in the past five years over 6.2 million acres of land have been protected by local and state land trusts through the use of conservation easements, compared to just over 2.5 million acres in 2000. Those 6.2 million acres of conservation easements contrast sharply with the increase in acquisition of fee interests by land trusts over the same period, which has been just over 480,000 acres.

Conservation easements, from a legal standpoint, are a mixture of different legal concepts. They have some of the attributes of contracts, some of the attributes of real property easements, and some of the attributes of charitable trusts. Much has been written about their origin and nature. Today, conservation easements are almost entirely creatures of state statutory law, typically based on, or copied from, the Uniform Conservation Easement Act first proposed in the 1980s by the National Conference of Commissioners of Uniform State Laws.

Because conservation easements were generally not enforceable under the common law, any conservation easement conveyed today must comply exactly with the state statutory law that authorizes conservation easements. Anything less than exact compliance may render the easement unenforceable and, therefore, under federal tax law nondeductible. Thus, any conservation easement must be written to conform to the requirements of the law of the state in which it is conveyed.

Conservation easements have the advantage of allowing the private ownership, use, and management of land to continue, subject to the restrictions on use imposed by the easement. Conservation easements leave land on local tax rolls for real property taxation, although typically at a reduced rate. Because a land trust that owns a conservation easement does not have responsibility for management of the land, or payment of taxes or insurance on the land, the financial burden of conserving land with an easement is less than preserving land by acquiring a fee interest. Finally, because the value of a conservation easement, which leaves ownership in private hands, is less than the value of the fee, purchasing conservation easements can be considerably less expensive than purchasing the fee.

Conservation easements are not without potential problems, however. First, as already mentioned, creating an enforceable conservation easement requires attention to statutory detail. Second, because ownership remains in private hands, land trusts face expenses for monitoring the use of land subject to easement and enforcing easements in case of violation. These are expenses that land trusts would not have if they owned the land in fee. Third, there are growing concerns that conservation easements, which are in most cases intended to be permanent, may be easily and improperly modified or terminated, thus eroding or eliminating the conservation benefits afforded by the easement and wasting the public's investment in the tax incentives that may have inspired the easement in the first place.

Again, the contribution or sale of a conservation easement for less than its fair market value to a public agency or land trust can generate federal tax benefits for the grantor of the easement. Where a conservation easement is contributed in compliance with the rules provided in section 170(h) of the Internal Revenue Code, the U.S. Treasury subsidizes the gift by granting both income and estate tax benefits to the donor of the easement.

III. Bargain Sales

A bargain sale is the sale of property (including a conservation easement) to a governmental agency or public charity, such as a land trust, for less than its fair market value. Sections 1011(b) and 170 of the Internal Revenue Code recognize that such a sale may, in part, constitute a charitable contribution and allow the seller to deduct from his income the difference between the sales price and the actual value of the property as determined by an independent appraisal.

In a bargain sale, the U.S. Treasury, in effect, subsidizes the purchase by providing tax benefits to the seller to help make up for the shortfall between what a land trust, for example, can afford to pay and what the property sold is really worth.

IV. Purchase of Development Rights

The purchase of development rights (sometimes referred to as PDRs) is really the purchase of a conservation easement on land. Because conservation easements typically reduce or eliminate the development potential of land by prohibiting future development, buying a conservation easement has come to be referred to as the purchase of development rights.

PDR programs are typically managed or subsidized by local or state governments and are often tied to the land-use planning of such entities. In some cases conservation easements are purchased that impose permanent restraints on future development. In other cases conservation easements may be purchased that only temporarily constrain development or allow the governmental entity that holds the PDRs to sell those rights to developers after infrastructure necessary to support development has been put in place. The use of PDRs for temporary land conservation is sometimes referred to as "land banking" or "development rights banking."

The purchase of a conservation easement in a PDR program for full value does not generate an income tax deduction, although there may be some estate tax savings from the restraint on future appreciation in land value resulting from the restrictions on development imposed by the conservation easement. However, if a PDR is bought for less than fair market value, the transaction may constitute a bargain sale, for which the seller may claim a charitable deduction.

A word of caution about PDRs: PDRs are typically structured by governmental agencies who may, or may not, have any concern about whether the grantor of the PDR receives a tax deduction for the transfer. One should not assume that because the PDR is bargain-sold to a governmental entity, the transaction automatically meets the strict requirements of the federal tax code for deductibility. Unless the conservation easement involved meets all of the requirements of section 170(h) of the Internal Revenue Code, it will not be deductible.

V. Transfer of Development Rights

The transfer of development rights (TDR) is a complex land-use tool that allows landowners in an area designated by a locality as a "transfer zone" to sell development rights from their land to landowners in another area designated as a "receiving zone." Typically, transfer-zone land has been restricted to low density (often by "down-zoning," i.e., rezoning to reduce development potential), and the landowners there are "compensated" for the effect of these restrictions by being allowed to sell development potential they are no longer permitted to use to landowners in the receiving zones, where additional development is allowed. Receiving-zone landowners are allowed higher densities, but only if they acquire development rights to use those higher densities from landowners in transfer zones.

There is no rigid format for TDRs. However, in some cases localities require landowners in a transfer zone who sell TDRs to put conservation easements on their land to ensure that the elimination of development potential by the sale is permanent. In theory, conservation easements thus imposed supersede zoning. Thus, if some future local governing body decided to increase density on land from which development rights had been sold by rezoning that land, the rezoning would be ineffective. Of course, the success of such a scheme would depend on whether the holder of conservation easements on transfer-zone land would enforce those easements in the long run, and on whether there was any market demand for the TDRs.

Some extremely complex transactions grow out of the combination of TDRs, PDRs, and conservation easement contributions in states where all of these tools can be used together. Some states further complicate such transactions by allowing easement donors a tax credit against state income tax for the contribution of conservation easements, including the bargain sale of PDRs.

TDRs are typically sold to other private individuals and are not donated to governmental agencies or public charities, so charitable deductions are not involved.

VI. Cluster Development

Cluster development schemes are another planning tool used by localities. These schemes typically allow a landowner to concentrate all of the zoning potential of his property in one portion of that property by giving up the right to develop the balance of the property. This can be visualized by thinking of a checkerboard on which a player shoves all of his pieces into one corner, leaving the rest of the board empty. Depending on local zoning rules, the "open space" (the empty part of the checkerboard) resulting from moving development to one portion of a property may be preserved through the imposition of a conservation easement. Alternatives may include conveying the open space to a homeowners' association, or imposing restrictive covenants enforceable by adjoining residential development.

Where conveyance of a conservation easement to preserve the open space in a cluster development is mandated in exchange for increased density elsewhere, a charitable deduction is very unlikely (see chapter 4, section II, B, 1).

VII. Conservation Buyer Transactions

Conservation buyer transactions have been an increasingly important part of voluntary land conservation. They come in different forms and are described more fully in chapter 4, section II, B, 3. Briefly, these transactions depend on a conservation-minded buyer capable of using the federal income tax benefits associated with contributing a conservation easement (a "conservation buyer"). Land trusts try to match conservation-worthy land with conservation buyers. Once the conservation land has been conveyed to the conservation buyer, the buyer is expected to contribute a conservation easement to protect the land. Such a contribution can generate tax benefits that effectively reduce the buyer's cost of acquiring the property (the "acquisition cost"). The trick in conservation buyer transactions is figuring out how to ensure that the buyer conveys the easement, while, at the same time, preserving the buyer's tax deduction for the contribution.

Conservation buyer transactions work best if the buyer is bound to protect the land once he acquires it. For a number of years these types of programs worked quite successfully. Typically, when a land trust showed a prospective conservation buyer a property, it required the buyer to sign an agreement, or pledge, that if he acquired the property, a conservation easement would follow. However, in July of 2004, the IRS issued Notice 2004-41 critical of transactions in which a taxpayer claimed a tax deduction for the contribution of a conservation easement granted in connection with the purchase of property. The notice is vague, and IRS representatives have said (unofficially) that it was not directed at the kind of conservation buyer deal described here. Nevertheless, because the IRS has refused to clarify the notice, most attorneys have since been unwilling to advise their clients that binding conservation buyer agreements will result in deductible easement contributions.

An alternative to a conservation buyer transaction in which the prospective buyer pledges an easement if and when he acquires property is a transaction in which a land trust acquires a fee interest and resells the property but retains a conservation easement. Such deals work, although there is no deduction for the purchaser and the land trust loses the economic value of the easement in the transaction.

Another approach is for the buyer to "overpay" for property subject to an easement. For example, a buyer pays $2 million for land that, subject to easement, is worth $1 million. The land trust selling such land acknowledges that the buyer has overpaid by $1 million and acknowledges the overpayment as a charitable contribution. This structure is similar to other situations in which the IRS has allowed charitable deductions and has been (again, unofficially) acknowledged by the IRS as providing the basis for a deduction.

Basic Tax Law Principles

I. The Importance of Tax Compliance

At a Senate Finance Committee hearing in 2005, an IRS official acknowledged that it had been ten years since the IRS had paid much attention to conservation easement contributions. In fact, of all of the approximately 115 reported court cases involving challenges to conservation easement deductions at that time, at most 5 related to compliance of the terms of the easement with the requirements of federal tax law. The rest were decided exclusively on appraisal and valuation issues. In the face of this history, it is not surprising that strict compliance with tax law requirements has not been taken seriously by many donors and land trusts.