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Conservation easements as qualified conservation contributions.

Preservation of aesthetic, environmental, historic, and recreational values on private lands is difficult to accomplish. Government entities often do not have the funding to purchase and preserve these lands in an undeveloped state. As a result, income tax incentives in return for the donation of conservation easements by private landowners often provide the most useful tool for accomplishing these preservation goals.

The Internal Revenue Code allows for income tax deductions for charitable contributions under [section] 170. One type of such charitable contribution is a conveyance of a partial property interest that qualifies under the Code as a "conservation contribution." (1)

The most common form of these contributions is a conservation easement. Generally speaking, a conservation easement is a type of negative easement that is generally unenforceable under common law due to its intangible nature, but which many state legislatures have specifically authorized by statute. (2) Due to its inherent characteristics, a conservation easement (i.e., restriction on use) is best suited to a landowner who wants to retain some limited use of the property, while ensuring the property will not be further developed in the future.

In turn, a conservation easement must meet specific requirements outlined in the Code and Treasury Regulations in order to qualify for the income tax deduction. (3) A qualified conservation contribution is defined as "a contribution of a qualified real property interest, to a qualified organization, exclusively for conservation purposes." (4) This definition presents the following four primary queries: 1) What constitutes a qualified real property interest? 2) What is a qualified organization? 3) What constitutes exclusivity? and 4) What are conservation purposes?

Qualified Real Property Interest

The Code identifies three categories of "qualified real property interests." These interests include: "(A) the entire interest of the donor other than a qualified mineral interest, (B) a remainder interest, [and] (C) a restriction (granted in perpetuity) on the use which may be made of the real property." (5)

Qualified Organization

This requirement identifies who may receive the qualified real property interest and what restrictions on alienability must be imposed on the donee. Generally, the organization must "have a commitment to protect the conservation purposes of the donation, and have the resources to enforce the restrictions." (6) Treasury Regulations identify four classes of organizations which qualify under this definition:

1) A governmental unit described as a State, a possession of the United States, or any political subdivision of any of the foregoing, or the United States or the District of Columbia, but only if the contribution or gift is made exclusively for public purposes; (7)

2) An organization described as one which normally receives a substantial part of its support ... from a governmental unit ... or from direct or indirect contributions from the general public; (8)

3) A charitable organization described in I.R.C. [section] 501(c)(3) [i.e., tax-exempt] that meets the public support test of [section] 509(a)(2); (9) or

4) A charitable organization described in I.R.C. [section] 501(c)(3) that meets the requirements of I.R.C. [section] 509(a)(3) and is controlled by an organization [qualifying under one of the three foregoing categories]. (10)

In addition to the requirement that the grant be made to a qualified organization, it must also include certain restrictions on the transfer of the interest. Specifically, subsequent transfers can only be made to other qualified organizations and the original conservation purposes must be carried out by the grantee organization. (11) However, if surrounding conditions have changed to such an extent that it is impossible to continue the original conservation purposes, the proceeds from the transfer must be used in a manner consistent with the conservation purposes. (12)

Exclusivity

The Code states that, "[a] contribution shall not be treated as exclusively for conservation purposes unless the conservation purpose is protected in perpetuity." (13) The Treasury Regulations further interpret this statutory provision to require that a mortgagee of the conservation property must subordinate its rights to those of the qualified organization and to limit surface mining of reserved mineral interests. (14) However, the regulations include de minimis provisions for the exclusivity requirement regarding remote future events and minor mining impacts. (15) The taxpayer must substantiate the condition of the property at the time of the gift by providing the donee organization with appropriate baseline documentation in situations where the continuing permitted uses of the property may potentially adversely impact the conservation purpose protected by the easement. (16) In Glass v. C.I.R., 124 T.C. No. 16 (2005), the Tax Court recently interpreted exclusivity to require that the purpose or function of the qualified organization's tax exemption be related to holding the conservation easement and that it be able to enforce its rights as such holder.

Conservation Purpose

While the preceding three requirements are relatively straightforward, the determination of whether a particular contribution satisfies the conservation purpose requirement can be difficult to ascertain. This is because every tract of land possesses a unique mix of conservation values. The Code identifies four general classes of 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;

3) the preservation of open space (including farmland and forest land) where such preservation is--for the scenic enjoyment of the general public, or--pursuant to a clearly delineated Federal, State, or local government conservation policy and will yield a significant public benefit; or

4) the preservation of a historically important land area or a certified historic structure. (17)

The Treasury Regulations attempt to further define these broad categories and provide some specific examples, (18) but are not exhaustive because it is impossible to identify the infinite circumstances that qualify as conservation purposes. The regulations do identify that public access is required where the conservation purpose is for the preservation of land areas for outdoor recreation by, or the education of, the general public. Public access is not required to accomplish the other general categories of conservation purposes except where the lack of public access would frustrate the proposed conservation purpose. (19)

Given the wide variety of individual circumstances that would qualify as conservation purposes, the determination inherently necessitates a case-by-case analysis. In turn, such uncertainty may cause taxpayers to shy away from making conservation contributions for the fear that they would invite an Internal Revenue Service audit. The only certain way to determine whether a particular taxpayer's contribution will qualify for a conservation deduction is to request a private letter ruling from the IRS prior to making the gift. A request in writing must be submitted outlining the facts of the particular conservation contribution, setting forth the controlling law (e.g., "under [section] 170(h) of the IRC a deduction is allowed for"), and asking the IRS to rule on whether the contribution constitutes a qualified conservation contribution.

The problem with requesting private letter rulings is that they are quite expensive (the present application fee is $7,000 (20)) and time consuming (possibly taking over a year). Additionally, the IRS will not rule on whether the valuation of the deduction (discussed below) is correct. (21)

While requesting a private letter ruling often is not a viable option for determining how to create a conservation contribution that will qualify for an income tax deduction, an analysis of past private letter rulings provides useful insight into how to structure the transaction. It should be noted, however, that a private letter ruling applies solely to the taxpayer who requested it and it cannot be used or cited as precedent. (22)

The IRS issued 45 private letter rulings during the period between 1982 and 2004 directly addressing whether a particular contribution constituted a qualified conservation contribution that qualified as an income tax deduction. The rulings involved a wide variety of conservation purposes, and were all determined to be valid conservation contributions pursuant to IRC [section] 170(h). This high approval rate could be attributable to the fact that a taxpayer would not undertake the effort and expense to obtain a private letter ruling without presenting a strong case. Further, it may reflect that the qualified organization receiving the easement helps ensure the contribution meets the conservation purpose requirement. On the other hand, it may simply indicate a somewhat tolerant approach by the IRS in the interpretation of "conservation purposes" under IRC [section] 170(h)(4) given that the volume of litigation with the IRS is regarding the valuation of the contribution as discussed in the next section. (23)

Additionally, the conservation easements often involved contributions that were claimed to fulfill several of the broad categories of conservation purposes identified in the Code. Furthermore, many of the easements involved agricultural/ livestock farms or ranches, by which the taxpayers proposed restricting the land from commercial and residential development while continuing to engage in farming/ranching activities. Easements preserving structures or areas with historic significance were another common category. Other easements involved retained uses such as forest management and harvesting; mineral rights; outdoor recreation; water use; limited residential development; commercial campgrounds; summer camps; and guest ranches. Most of the rulings, however, involve a combination of the above listed uses. Moreover, the subject property often is located in close proximity to a public recreation area and/or ecologically sensitive area such as a park, national forest, wildlife refuge, or public waterbody. Other properties were located in areas experiencing rapid growth and development and in which areas express governmental policies and goals for preserving and maintaining undeveloped lands were in place. (24)

Conservation Contribution Deduction Valuation

The value of the conservation contribution is the fair market value of the restriction at the time of the contribution. (25) Such fair market value can be determined through a comparable sales appraisal approach using sales of similar easements in the area. However, such information is often limited. Therefore, the fair market value of the contribution often will be determined as the fair market value of the property prior to donation of the easement (its highest and best use), less the fair market value of the property after donation of the easement. (26) Such before and after valuation,

must take into account not only the current use of the property but also an objective assessment of how immediate or remote the likelihood is that the property, absent the restriction, would in fact be developed, as well as any effect from zoning, conservation, or historic preservation laws that already restrict the property's potential highest and best use. (27)

A deduction in excess of $5,000 for a donation of a conservation easement must be substantiated by the submission of a qualified appraisal by a qualified appraiser. (28) However, the intangible nature of conservation easements can lead to widely varying opinions as to value of the easement by equally competent appraisers. Indeed, the Congressional Joint Committee on Taxation recently referred to such valuation difficulties in justifying its recommendations for significant revised limits on the allowable charitable deductions for donations of qualified conservation contributions. (29) Thus, large deductions for conservation contributions provide potential fertile ground for IRS audits. (30)

Indeed, as mentioned above, much of the litigation in this area has been regarding the valuation of the donation. In some cases, the IRS has taken the position that the easement donation was worth nothing because there had been no change in the highest and best use of the property. For example, Schwab v. C.I.R., T.C. Memo 1994-232, involved the preservation of a waterfowl preserve on a 1,500-acre farm where the taxpayer claimed $900,000 as the value of the easement and the IRS asserted $0 value for the easement on the basis that there was no change in the highest and best use. The Tax Court ruled the easement value to be $544,000. Fannon v. C.I.R., T.C. Memo 1986-572, modified and remanded, 842 F.2d 1290 (4th Cir. 1988), involved a donation of a scenic easement over a farm through restricting development where the taxpayer claimed a value of $236,752 for the easement and the IRS asserted a $0 value on the basis that there had been no change in the highest and best use. The Tax Court ruled the easement value to be $90,956. On further appeal, the Fourth Circuit increased the easement value to $121,781.

A review of cases in the box on page 20 regarding valuation indicates a general trend of both the U.S. Tax and U.S. district courts to recognize some value for the conservation contribution, usually (but not always) somewhere between the valuations presented by the taxpayer and IRS experts, and, more recently, leaning toward the taxpayer's valuation. (31)

The review of the cases clearly demonstrated that the valuation of a conservation contribution is a highly fact specific inquiry and largely dependent on expert opinions. (32)

Conclusion

Conservation easements are useful tools for preserving aesthetic, environmental, and historic values on privately owned lands. Furthermore, they can provide significant income tax deductions for the donor landowner. Ambiguities in the Code and Treasury Regulations as to what constitutes a qualified conservation contribution, however, may tend to cause taxpayers to shy away from donating conservation easements and claiming an income tax deduction. Moreover, application for private letter rulings on the validity of a given contribution can be obtained, but are expensive and time consuming. Additionally, analysis of past private letter rulings, while not available as precedent for future determinations, provides valuable insight into how to structure a qualified conservation easement. In turn, past rulings indicate that the IRS typically approves proposed conservation easements as qualified conservation contributions under IRC [section] 170(h). Significantly, while the intangible nature of conservation easements can lead to disputes with the IRS over the value of the deduction, the courts have recognized the value of such deductions over IRS objection. Proof of the change, due to the easement, in the highest and best potential use of the property has been shown to be instrumental in supporting valuations of the easement and thus the deduction taken by the taxpayer.

(1) I.R.C. [section] 170(f)(3)(B)(iii).

(2) FLA. STAT. Ch. 704.06.

(3) I.R.C. [section] 170(h); 26 C.F.R. '1.170A-14.

(4) I.R.C. [section] 170(h)(1).

(5) I.R.C. [section] 170(h)(2).

(6) 26 C.F.R. [section] 1.170A-14(c)(1).

(7) 26 C.F.R. [section] 1.170A-14(c)(1)(i); I.R.C. [section] 170(c)(1).

(8) 26 C.F.R. [section] 1.170A-14(c)(1)(ii); I.R.C. [section] 170(b)(1)(A)(vi).

(9) 26 C.F.R. [section] 1.170A-14(c)(1)(iii).

(10) 26 C.F.R. [section] 1.170A-14(c)(1)(iv).

(11) 26 C.F.R. [section] 1.170A-14(c)(2).

(12) Id.

(13) I.R.C. [section] 170(h)(5)(A).

(14) 26 C.F.R. [section] 1.170A-14(g)(2).

(15) Id.

(16) 26 C.F.R. [section] 1.170A-14(g)(5)(i).

(17) I.R.C. [section] 170(h)(4)(A).

(18) 26 C.F.R. [section] 1.170A-14(d)-(f)

(19) 26 C.F.R. [section] 1.170A-14(d).

(20) Rev. Proc. 2005-1 Appendix A(3)(c) (fee reduction to $625 is available for letter rulings where gross income is less than $250,000).

(21) Rev. Proc. 2005-3 [section] 4.02(1).

(22) I.R.C. [section] 6110(j)(3).

(23) I.R.S. PLR 200403044; I.R.S. PLR 200208019; I.R.S. PLR 199952037; I.R.S. PLR 199933029; I.R.S. PLR 199927014; I.R.S. PLR 9736016; I.R.S. PLR 9632003; I.R.S. PLR 9603018; I.R.S. PLR 9537018; I.R.S. PLR 9420008; I.R.S. PLR 9318027; I.R.S. PLR 9318017; I.R.S. PLR 9218071; I.R.S. PLR 9052028; I.R.S. PLR 8810009; I.R.S. PLR 8753015; I.R.S. PLR 8729061; I.R.S. PLR 8722047; I.R.S. PLR 8721017; I.R.S. PLR 8713018; I.R.S. PLR 8713016; I.R.S. PLR 8711054; I.R.S. PLR 8652013; I.R.S. PLR 8638012; I.R.S. PLR 8630056; I.R.S. PLR 8626075; I.R.S. PLR 8623037; I.R.S. PLR 8605008; I.R.S. PLR 8546112; I.R.S. PLR 8544036; I.R.S. PLR 8518024; I.R.S. PLR 8450065; I.R.S. PLR 8449025; I.R.S. PLR 8428037; I.R.S. PLR 8428034; I.R.S. PLR 8422064; I.R.S. PLR 8420016; I.R.S. PLR 8418032; I.R.S. PLR 8410034; I.R.S. PLR 8313123; I.R.S. PLR 8302085; I.R.S. PLR 8248069; I.R.S. PLR 8247024; I.R.S. PLR 8243125; I.R.S. PLR 8233025.

(24) Id.

(25) 26 C.F.R. 1.170A-14(h)(3)(i).

(26) Id.; see also Schapiro v. C.I.R., T.C. Memo. 1991-128, (Tax Court held that "before value" is highest and best potential use, accepting the approach in the taxpayer's appraisal, which gave the "before value" of multiple lots in subdivided condition and that the approach in IRS appraisal that "before value" was single residence on vacant acreage was inapplicable).

(27) 26 C.F.R. [section] 1.170A-14(h)(3)(ii).

(28) 26 C.F.R. [section] 1.170A-13(c).

(29) Options to Improve Tax Compliance and Reform Tax Expenditures, January 27, 2005, Congressional Joint Committee on Taxation.

(30) Written Statement of Mark W. Everson, commissioner of Internal Revenue, before the Committee on Finance United States Senate Hearing on Exempt Organizations: Enforcement Problems, Accomplishments, and Future Direction, April 5, 2005, pp. 9-10. (The IRS identifying increased enforcement activities involving conservation easement donations. The IRS is targeting abusive practices with conservation easement donations such as over-valuation of the contributions and failures of charities to enforce easement restrictions. The IRS is modifying its tax forms filed by both the donor taxpayer and the receiving charity to assist with identifying abuses. Approximately 400 open space easements and 700 historic facade easements have been targeted for audit.)

(31) Browning v. C.I.R., 109 T.C. 303 (1997); Schwab v. C.I.R., T.C. Memo 1994-232; Dennis v. U.S., 1992 WL 330398 (E.D. Va. 1992); Clemens v. C.I.R., T.C. Memo 1992-436; Schapiro v. C.I.R., T.C. Memo 1991-128; Dorsey v. C.I.R., T.C. Memo 1990-242; Higgins v. C.I.R., T.C. Memo 1990-103; Griffin v. C.I.R., T.C. Memo 1989-130; Richmond v. U.S., 699 F. Supp. 578 (E.D.La 1988); Losch v. C.I.R., T.C. Memo 1988-230; Fannon v. C.I.R., 842 F.2d 1290 (4th Cir. 1988); Symington v. C.I.R., 87 T.C. 892 (1986); Todd v. C.I.R., 617 F. Supp. 253 (W.D. Penn. 1985).

(32) Id.

Harwell E. Coale III is an associate with the Mobile, Alabama, firm of Coale, Dukes, Kirkpatrick & Crowley, P.C. He received his undergraduate degree from the University of the South and his J.D. from the University of Alabama School of Law. He also holds masters degrees in forest resources from the University of Georgia and environmental law from Vermont Law School and recently completed his L.L.M. in taxation with honors from the University of Alabama.
Case Taxpayer IRS Court

Browning v. CIR(1997) $254,000 $0 $209,000
Schwab v. CIR(1994) $900,000 $0 $544,000
Dennis v. U.S.(1992) $50,610 $7,700 $50,610
Clemens v. CIR(1992) $910,000 $110,000 $703,000
Schapiro v. CIR(1991) $595,031 $388,000 $595,031
Dorsey v. CIR(1990) $245,000 $46,000 $153,422
Higgins v. CIR(1990) $110,000 $50,150 $103,000
Griffin v. CIR(1989) $195,000 $35,000 $70,000
Richmond v. US.(1988) $150,000 $59,000 $59,000
Losch v. CIR(1988) $235,000 $70,000 $130,000
Fannon v. CIR(1986) $236,752 $0 $90,956
Symington v. CIR(1986) $150,000 $0 $92,370
Todd v. CIR(1985) $353,000 $31,000 $31,000
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Author:Coale, Harwell E., III
Publication:Florida Bar Journal
Date:Oct 1, 2005
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