Do environmental regulations constitute an involuntary conversion?

Environmental regulations may have the effect of decreasing the value of land. Can a developer claim an involuntary conversion loss when the wetlands regulations prevent development? A district court has recently ruled, in Moore, DC Va., 6/6/96, that a developer could not deduct the reduction in value caused by an involuntary conversion when his plans were obstructed by tougher wetlands regulations. Under different facts and circumstances, the decision might have been different.

On Oct. 1, 1988, the Moores purchased a 59.7 acre parcel of land in Chesapeake, Virginia, for $1,025,000. The parcel was intended for residential development. After acquiring the land, the Moores hired an environmental consultant to perform a wetlands assessment to determine the percentage of the tract protected under the 1987 Wetlands Manual. The consultant concluded that in 1988 the Moores could have reasonably expected to be able to develop the tract. In late 1989, the Army Corps of Engineers and the Environmental Protection Agency (EPA) signed a Memorandum of Agreement, which effectively reinterpreted the EPA guidelines applied when issuing development permits under Section 404 of the Clean Water Act. The 1989 Memorandum Agreement had two principal effects: it established (1) a national policy of no net loss of wetlands (in accordance with a directive from President Bush) and (2) a uniform sequence of analysis for the evaluation of Section 404 permits The 1989 Memorandum Agreement made it almost impossible for the Moores to acquire a development permit The Moores filed their first application for a Section 404 permit in 1991.

The Moores claimed a loss deduction on their 1989 tax return for the regulatory taking of the parcel, which they treated as an involuntary conversion loss under Sec. 1231(a). Under Sec. 165(a), a loss must be (1) evidenced by a closed and completed transaction, (2) fixed by an identifiable event and (3) actually sustained, with no reasonable prospect of recovery for the loss. If these criteria are met, the deduction will be classified as an involuntary conversion loss under Regs. Sec. 1.1231-1 (e). Pursuant to Regs. Sec. 1.1231-1 (e), losses on the complete or partial destruction, theft, or seizure, requisition or condemnation of property are treated as losses upon an involuntary conversion whether there is a conversion of the property into other property or money Under Sec. 1231, the Moores would be permitted to treat the conversion of property used in a trade or business as an ordinary (rather than a capital) loss.

The Moores argued that the fixed and identifiable event which created the involuntary conversion was the adoption of the new 1989 Wetlands Manual and Memorandum Agreement; the Moores believed there was a regulatory taking of their property with the publication of the 1989 Manual. Property may be regulated to a certain extent. However, if regulation goes too far it will be recognized as a taking, pursuant to Pennsylvania Coal Co. v. Mahon, 260 US 393 (1922). The issue was whether the Moores' claim was premature, since they were never formally denied a Section 404 permit. In Riverside Bayview Homes, Inc., 474 US 121 (1985), it was held that only when a permit is denied, and the effect of that denial is to prevent "economically viable" use of the land in question, can it be said that a taking has occurred.

If the Moores had filed an application for the Section 404 permit in 1989 (the year the deduction was claimed), the decision might have been different. Under Southern Pacific v. City of Los Angeles, 922 F2d 498 (9th Cir. 1990), the court has recognized a narrow "futility exception," which says that a decision maker (e.g., the Corps) must be given an opportunity to review at least one reasonable development proposal before a challenge to a land use regulation can be brought. The development proposal must be "meaningful." The rejection of "exceedingly impressive development plans" was sufficient to show that the agency did not intend to allow reasonable development. By the same token, denial of a sketchy plan does not give a fair indication of how a comprehensive development plan would be handled Futility may also exist if there is unreasonable, extraordinary, excessive or considerable delay (see, e.g., Tahoe-Sierra Preservation Council, Inc. v. Tahoe Regional Planning Agency, 911 F2d 1331 (9th Cir. 1990); Sinaloa Lake Owners Association v City of Simi Valley, 882 F2d 1398 (9th Cir. 1989)).

Once a regulatory taking has been proven, an identifiable event has occurred. However, if the permit was not denied, there can be no claim for compensation. In Lakewood Associates, TC Memo 1995-552, the involuntary conversion loss was denied pursuant to Regs. Sec. 1.165-1 (d) (2) (i). Regs. Sec. 1.165-1(d)(2)(i) provides that when an event occurs that may result in a loss, even though there exists a claim for reimbursement on the loss with respect to which there is a reasonable prospect of recovery, no loss may be reported until it can be ascertained with reasonable certainty whether such reimbursement will be received. In the Moore case, it was not reasonably certain that the Corps was going to deny the permit application Therefore, a claim for compensation could not be filed with the courts.