The purpose of estate tax planning is to maximize the assets you pass on to future generations by minimizing gift and estate taxes. Estate-tax strategies revolve around the use of irrevocable trusts. This article discusses the most common types of irrevocable trusts that are used to minimize gift and estate […]
“The first rule of Fight Club Conservation Easements is: You do not talk about Conservation Easements.” Yes, a tax planning article is an odd place for a reference to a cult classic film from more than two decades ago, but stay with us: Fight club’s famous rule illustrates the mysterious aura that surrounds conservation easements, because the IRS has created an environment in which this strategy is not openly discussed.
We’re here to demystify this strategy. Why the secrecy? What even are conservation easements, and what makes them so intriguing? This article will unfold the world of conservation easements, exploring their structure, benefits, and potential growth, the IRS’s approach, and the risks involved.
Let’s start with the basics. 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 for conservation purposes — say, protecting wildlife habitats or preserving historic sites — even if the property is sold or passed down to future generations. Conservation easements, in short, are a way for landowners to protect their property from future development, no matter who ends up in control of the property.
Critically for our purposes, conservation easements are also a tax tool. When you agree to restrict the use of your land to the conservation cause, the government considers that a charitable donation, and you’ll get certain associated deductions. More on this in a bit, but first, let’s start with understanding the risks of Conservation Easements and why people don’t talk about them.
The IRS has become increasingly interested in conservation easements in recent years as a result of unscrupulous players in the space exploiting the tax advantages of Conservation Easements. Oregon Sen. Ron Wyden, chair of the Senate Finance Committee, speaking on Conservation Easements said “there is a tax shelter gold mine here, and they’re fighting very hard to protect it. There are enormous sums of money to be made as long as the number of transactions keeps increasing.” To fight back against these transactions, the IRS has been cracking down on technical errors, many of which may appear minor — incomplete forms, inadequate appraisal records, inaccurate deeds — as well as less rigorous claims like the lack of apparent charitable intent in the transaction and the absence of significant public benefit, all with the goal of discouraging people from taking advantage of these structures.
Moreover, the IRS has proposed new regulations to dramatically curtail syndicated conservation easements. Under proposed rules, conservation easement transactions would be considered abusive, or a “listed transaction,” and give the agency powers to disallow the deduction, if they have the following four hallmarks:
The last three factors describe most conservation easements; indeed, the last two are required for the easement to serve its tax-planning purpose. Accordingly, the first factor is the whole ballgame: If an easement yields a 2.5x or greater charitable deduction, the transaction will be a listed transaction and presumptively suspect.
If the transaction is considered a listed transaction, that means that any time an individual claims a deduction as a result of the transaction, they have to let the IRS know they are doing so, which makes it easy for the agency to audit or disallow the deduction. Historically, the IRS doesn’t have a great record in Tax Court when challenging conservation easement tax deductions hence the push for the legal changes that allow them to avoid tax court and directly disallow the deductions. As a result, much of the industry has moved from utilizing conservation easements to similar structures (with similar returns) that aren’t governed by the new laws such as fee simple land donations, historical easements or the donation of appreciated assets (you can learn more here).
When a landowner donates land or other property to a conservation easement, they give up some of the rights to their property, such as the right to develop the land for whatever purpose they want. For example, the landowner might agree to preserve the land for natural use — a nature conservancy, for example — meaning they will not be able to build on the land in the future, even if they want to. The donated conservation easement becomes a permanent part of the property’s title, binding on all current and future owners.
In exchange for giving up the right to develop the land how they want in the future, the landowner will be eligible for a tax deduction equal to the value of the thing they’re giving up — the easement. But what is the value of the land? You might think it’s just what you paid for it, but there’s another layer: the concept of “highest and best use.”
There isn’t usually a large, liquid market for perpetual land easements and, as a consequence, there aren’t many comparable sales to serve as the basis for a valuation. Instead, the valuation of any such easement is generally made using a “before and after” approach.
When appraising a property for the purposes of donating or selling a conservation easement, the appraiser will typically assess the property’s value in two scenarios:
The difference between these two values represents the value of the conservation easement itself. This difference can be significant, especially in areas with high development pressures. Now critically, there are two charitable deduction approaches with conservation easements:
To make this more digestible, let’s walk through an example. Let’s say you bought land for $1 million, the highest and best use of the land is valued at $5 million and the encumbered value with the conservation easement is $2 million. As a result you would receive a different charitable deduction based on which approach you used.
There are two common approaches for individuals to participate in a conservation easement:
A landowner who donates their land with an easement may be eligible for a federal income tax deduction of up to 50% of their adjusted gross income (AGI) in the year of the donation, equal to the before value of the donation, with the ability to carry forward any unused deduction for up to 15 years.
Put more simply, you can earn a deduction against your income for the highest and best use of the land after putting an easement on the land and donating the land. And if the highest and best use value of the land is 5 times your purchase price, your tax savings are 2.5X your purchase price (assuming a 50% tax rate). In recent years, typical highest and best use valuations on easement land have been 4-6x the purchase price. It won’t surprise you, then, that the popularity of conservation easements has been growing rapidly.
Conservation easements have grown rapidly in popularity in recent years, with a total of 1.6 million acres of land newly protected by conservation easements in 2018 alone. Between 2010 and 2017, taxpayers took an estimated $26.8 billion of charitable deductions from conservation easements. This growth has been driven by a number of factors, including an increasing awareness of environmental issues and the collective desire to preserve natural resources for future generations, but the biggest impact has probably been the tax benefits.
In fact, these benefits have been so powerful that the IRS has chosen to focus on reducing abuse of conservation easements.
Now let’s dive more into the risks of conservation easements to help you understand why much of the conservation industry has moved on to different opportunities.
Investing in conservation easements carries risks, including the potential for the IRS to disallow the tax deduction — and potential interest, penalties, and fees as a result. To mitigate those risks, interested individuals should typically choose a fund with General Partners who have a long history in the space, as the details are critical but lets walk through those risks.
Let’s start with the basic of what is audit risk. It refers to the likelihood that a taxpayer’s return will be examined by the Internal Revenue Service (IRS). If you are investing in any listed transaction such as a conservation/historical easement or fee simple deal you should assume there will be an audit as the IRS has made them a focus (to point out a critical point – you should assume a listed transaction will receive a valuation audit while unlisted transactions likely won’t). Critically if an IRS looks at your taxes and disagrees with the charitable deduction from the fund they have to go audit the investment fund partnership to adjust the valuation i.e. valuation risk. This is important as is means the cost of the audit isn’t paid by you and why most easement funds have a legal defense reserve, so they can fight these valuation audits, and why its important to work with partners who have experience in defending against audits.
So assuming the partnership gets audited you are probably wondering what are the risks your deduction is lowered. The answer is its hard to tell because of the recent legal changes. Historically the IRS has struggled to win most of its cases unless the partnership fund made a mistake but the recent legal changes will likely substantially change these results with syndicated conservation easements. The risk is lower with fee simple deals and in particular historical easements because those are governed by different IRS rules than conservation easements.
In addition, you will want to ensure that the valuation of the assets are done by experienced partners to ensure they understand how to correctly handle every detail of the valuation process and have experience defending their valuations in legal proceedings.
For those who are willing to take on these risks, investing in conservation easements may provide a unique opportunity to make a positive impact on the environment while also potentially receiving significant tax benefits.
Conservation easements provide a unique investment opportunity for individuals interested in both environmental conservation and potential tax benefits. While there are some risks associated with investing in conservation easements, the potential environmental and tax benefits make it a worthwhile investment for many.
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