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Sale of development easement.

In Estate of Gibbs, 12/1/98, the Third Circuit ruled that the sale of a development (conservation) easement was a prohibited"disposition of any interest" under Sec. 2032A, thereby triggering the recapture of estate tax. This case is important not only in applying Sec. 2032A, but also for the recently enacted Sec. 2057 family-owned business deduction, which contains similar language.

Generally, real property must be included in the gross estate at its fair market value on the date of the decedent's death. Sec. 2032A, enacted in 1976, provides an exception for certain family farms and other closely held businesses. If the estate makes a Sec. 2032A election, such property is valued based on its actual use, rather than on its highest and best use. Under Sec. 2032A(a)(2) and (3), the maximum reduction in value is $750,000, adjusted for inflation for decedents dying after 1998. The purpose of Sec. 2032A is to provide relief to heirs who might otherwise need to sell family businesses to pay estate taxes.

Although an estate must satisfy many conditions to elect Sec. 2032A, only the recapture tax provisions were at issue in Estate of Gibbs. Additional estate tax is imposed if, within 10 years after the decedent's death and before the death of the qualified heir, the latter either "disposes of any interest" in the qualified real property or ceases to use the property for the qualified use that allowed the reduction in valuation (Sec. 2032A(c)(1)). However, dispositions to a member of the qualified heir's family are allowed, as are charitable contributions of a qualified conservation easement restricting the property's use (Sec. 2032A(c)(1) and (8)).

In Estate of Gibbs, James Gibbs, Sr. owned and operated a dairy farm at his death in 1984. At that time, the property had a value of $988,000 based on its highest and best use. However, if it were used only for farming, its value would be $349,770. James Gibbs, Jr. (Gibbs) was the executor of his father's estate and its sole heir. He made a Sec. 2032A election and valued the farm at $349,770 on the estate tax return.

In December 1993, nine years after his father's death and while the property was still being used as a farm, Gibbs deeded a development easement in the farmland to the state of New Jersey under a state statute enacted to preserve farmland. New Jersey paid Gibbs $1,433,494 for the easement. The Deed of Easement specified that any development of the property for nonagricultural uses was expressly prohibited. This restriction was binding on all present and future owners.

The IRS claimed that the sale of a development easement was a disposition of an interest in property, and assessed the estate $159,823 in additional tax. The estate paid the tax and sued for a refund. The district court ruled that the sale was not a disposition of an interest in property because, under New Jersey law, a development easement creates contract rights, not property rights; the Service appealed.

The Third Circuit reversed, ruling that New Jersey's classification of the easement as creating contract rights was irrelevant in determining whether the estate recapture tax should apply. Instead, New Jersey law is relevant only in determining if the sale of the easement transferred rights to the state. If any rights were transferred, Federal tax law determines how they are taxed. The court found that the Deed of Easement explicitly transferred "all of the nonagricultural development rights" to New Jersey.

The court then ruled that Gibbs had disposed of an interest in real property in violation of Sec. 2032A(c)(1) and therefore was liable for additional estate tax. The court reasoned that the property Gibbs inherited from his father comprised two distinct portions--the rights related to the agricultural use and the rights related to the nonagricultural (development) uses. Without Sec. 2032A, Gibbs would have paid estate tax on both portions. Instead, he made the Sec. 2032A election and paid the tax only on the agricultural use, thereby avoiding estate tax on the nonagricultural uses. In making the Sec. 2032A election, Gibbs understood that he could not realize the value of the nonagricultural uses for at least 10 years. Nonetheless, he sold these rights for $1.4 million before the 10-year period expired. The court noted that the legislative history supports this result; Congress intended to prevent an heir from avoiding estate taxes on property and shortly thereafter (within 10 years) reaping the monetary benefits of the nonagricultural uses.

Clearly, qualifying estates can reduce estate taxes by electing the Sec. 2032A special-use provisions or the Sec. 2057 family-owned business deduction. However, Estate of Gibbs clarifies that the sole circuit that has addressed this issue will broadly interpret the recapture tax provisions.

FROM PETER C. BARTON, MBA, CPA, J.D., PROFESSOR OF ACCOUNTING, UNIVERSITY OF WISCONSIN-WHITEWATER, WHITEWATER, WI
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Title Annotation:taxation
Author:Barton, Peter C.
Publication:The Tax Adviser
Geographic Code:1USA
Date:May 1, 1999
Words:816
Previous Article:Gift tax SOL prop. regs.
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