Conservation easements and real estate investments are two popular tools for offsetting ordinary income tax. How do you know which one is right for you? This article explains what these strategies are and when they make sense.

Key Highlights and Takeaways

• Two Ordinary Income Tax Strategies: Both strategies can offset ordinary income tax to a significant extent.
• Conservation Easements are Risky but Can Yield Large Tax Savings: A conservation easement is a legal arrangement in which a landowner agrees to restrict the use of a piece of land. Conservation easements are a type of charitable gift and yield similar deductions. Donors often claim very aggressive valuations for the land over which the easement is being granted. The resulting tax savings can be quite large, but it is a very aggressive tax strategy that involves significant legal risk to the donor.
• Investing in Real Estate Yields Tax Savings but Requires More Hours: Real estate investments can yield large deductions. But in order to offset non-real estate income with real estate depreciation, the investor must be a “real estate professional,” which requires the investor to devote several hundred hours each year to real estate.

What are Conservation Easements?

A conservation easement is a legal agreement between a landowner and a qualified organization, such as a land trust or a government agency, that restricts the development of the land in perpetuity, protecting wildlife habitats or preserving historic sites even if the property is later sold or passed down to future generations. Conservation easements, in short, are a way for landowners to protect property from future development, no matter who ends up in control of the land in the future.

Conservation easements are also a tax tool. When you agree to restrict the use of your land for conservation reasons, the government considers that a type of charitable donation, and you get a charitable deduction based on the lost value of the land. In practice, taxpayers often claim a value that is a multiple of the value at which the land was purchased. This deduction can be used to offset ordinary income up to 30% of the donor’s adjusted gross income (AGI), with any excess carried forward for up to five years.

Because a number of players in the space are unscrupulous, the IRS has become concerned in recent years that the tax code’s conservation easement rules are being exploited. Certain types of conservation easements are now considered “listed transactions” that must be flagged for the IRS. Sen. Ron Wyden, chair of the Senate Finance Committee, has been consistently critical of conservation easements, which he describes as “a tax shelter gold mine.”

Benefits of Conservation Easements:

1. Tax Benefits: A donor can receive a charitable deduction for the value of the easement, which can significantly reduce the donor’s taxes. The resulting deduction may exceed the initial cost of the land.
2. Preservation of Land: The easement permanently protects the land from development, preserving its historical or environmental value.

Drawbacks of Conservation Easements:

1. Permanent Restrictions: Once granted, the easement permanently restricts development of the land.
2. Complex Valuation Process: Determining the value of a conservation easement can be complex and may require an expensive appraisal.
3. Legal Risk: The IRS has been scrutinizing conservation easements very closely, so there is substantial risk that an aggressive deduction will be disallowed.
   

What is an Ideal Use Case?

Gabriel, a single New Jersey resident, earns $1,200,000 per year. His annual tax bill is $550,000. Gabriel happens to be an avid conservationist with an appetite for risk. Tired of paying so much tax on his salary, Gabriel purchased a $100,000 property fours years ago and this year he put a conservation easement on the land to protect it from future development. The easement is valued at $350,000 and he is allowed to deduct this entire amount from his income, reducing his taxable income by $350,000 this year. If his marginal tax rate is 50%, that will save him close to $175,000, effectively reducing his taxes this year from $550,000 to under $375,000.

What are Real Estate Investments?

This article uses “real estate investment” broadly to mean any investment involving the purchase, sale, management, or leasing of property for profit. Real estate investors can benefit from several tax-saving strategies, but depreciation (specifically accelerated depreciation) is the most important for people looking to reduce their ordinary income taxes. Critically, to offset ordinary income with real estate depreciation, you need to be a real estate professional, which means spending more than 500 or 750 hours in a year on your real estate business. For practical purposes, that means you can’t have another job. But if your spouse doesn’t have a full-time job (and wants to spend 750 hours per year on real estate), or you don’t have a full-time job (and want to spend 750 hours per year on real estate), it can work.

Benefits of Real Estate Investments:

1. Tax Deductions: Investors can deduct a range of expenses, including depreciation, which reduces taxable income.
2. Appreciation Potential: Real estate can appreciate over time, providing both rental income and capital gains.
3. Leverage: Real estate allows investors to use debt to finance purchases, amplifying potential returns and tax savings from depreciation.

Drawbacks of Real Estate Investments:

1. Illiquidity: Real estate investments can be difficult and time-consuming to sell.
2. Management Burden: Owning and managing real estate requires significant time, effort, and expertise.
3. Market Risk: Real estate markets can be volatile, and values may decrease due to economic downturns or other factors.
4. Material Participation Requirements: To use the depreciation to offset ordinary income, real estate has to be your (or your spouse’s) full-time job.

What is an Ideal Use Case?

Kevin, a married New Jersey resident who is a real estate developer, is earning $1,000,000 with a $420,000 annual tax bill. In the past, he has only invested in stock indexes. Tired of paying so much tax on his salary, Kevin buys a $500,000 duplex and rents it out. He deducts 60% of this amount as depreciation in the first year, reducing his taxable income by $300,000 that year. If his marginal tax rate is 50%, that will save him $150,000, effectively reducing his taxes in that year from $420,000 to about $270,000 (not including the income tax generated by the rental). Due to leverage, he may have only had to invest $100,000 in the property upfront, with the rest covered by loans. The loan interest will also be deductible, reducing his taxable income by another $20,000 or so. In future years, he’ll be able to deduct additional depreciation as well as interest on the loan. That said, taking on leverage is risky and means that Kevin will have to cover the interest and principal payments as they come due. Kevin or his spouse will also have to qualify as a real estate professional in order to use the depreciation to offset his ordinary income.

Why Choose One Strategy or the Other?

Creating conservation easements and investing in real estate are both potentially attractive tax strategies. Both generate upfront deductions, though only real estate generates ongoing cashflow. Conservation easements require no work on the taxpayer’s part, but they also subject the taxpayer to potential legal risks. Real estate investments are more conservative legally but require significant time commitments if a taxpayer is looking to offset non-real estate income. The right strategy for any given person will depend on a person’s risk tolerance as well as how they assess the pro’s and con’s of each approach.

Conclusion

Conservation easements and real estate investments are popular strategies for reducing ordinary income tax exposure. Hopefully this article has given you a better idea of what each strategy entails, and whether one or the other might be a better fit.

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