Long before the buzz in Washington was about creating a stimulus package to help the struggling economy, in 2008 tax incentives were approved by Congress that promotes voluntary land conservation. The new law raised the deduction a landowner can take for the donation of a conservation easement from 30% to 50% of adjusted gross income and to 100% for qualifying ranchers and farmers. The law extended the carry-forward period for deductions from 5 years to 15 years.
Many small volunteer-run land trusts operate statewide, protecting and preserving our unique character. These Trusts are frequently asked to accept a donation of a conservation easement in exchange for cash. Since the cash must come from donations, this process is lengthy and often ranked on a priority basis. It can take years to raise the cash needed to protect a single project. One solution is to have the easement donated as a combination bargain sale and tax incentive. With a fifteen-year carry-forward for the tax benefits of up to 50% of the donor’s adjusted gross income, dramatic benefits can be realized under the new law.
It has always been important for rural families to protect their land heritage. Landowners have a unique opportunity to consider the donation of a conservation easement for 1) cash, 2) tax credits, and/or 3) “like-kind” property. If the land can be preserved and cash can be spun off, future generations will live to enjoy the family farm. It’s all well and good to receive a tax break but some donors don’t have a tax burden to mitigate so a combination of strategies can be employed to achieve the desired outcomes.
One strategy is to have the conservation easement sold with the net cash proceeds used in an IRC Section 1031 Tax Deferred Exchange for new property. Any investment property or any property held for productive use, regardless of grade or quality will qualify; i.e.; commercial/investment, land, improved or unimproved, single family, multi-family, and under certain circumstances, vacation homes can be structured as a Section 1031 Exchange. Property owners with low tax basis have the most to benefit since their tax obligation will be the greatest. This means that a landowner can use the provisions of Section 1031 to diversify or consolidate their real estate investment portfolio without incurring any Federal or state capital gains tax, both are deferred, and this deferred tax can be almost completely eliminated with careful planning.
Specific rules apply to successfully use the provisions of 1031. In order to have the sale of property qualify for deferred tax treatment, it is necessary to first employ the services of a Qualified Intermediary (QI) to handle the transaction. If the sale takes place before an Exchange Agreement is signed and the landowner receives the proceeds of the sale, it’s too late; the tax is triggered! The task of the QI is to create an Exchange Agreement between itself and the landowner/taxpayer, have the contract of sale assigned to the QI, and instruct the settlement agent of the sold property to direct the net proceeds at closing to the QI to be held in escrow. The next step is for the landowner to identify its Replacement Property choices and negotiate agreements of purchase. Once purchase agreements are in hand, they are assigned to the QI, instructions are provided to the settlement agent and funding is arranged for the purchase of the new property using the escrowed exchange funds.
All of this must be done within strict time periods. Commonly referred to as the 45 and 180-day rules, they require that the exchangor identify Replacement Property within 45 days of the day of the sale of the old or Relinquished Property. Likewise, the entire transaction must be complete within 180 days of the sale of the first Relinquished Property. If the exchangor fails to identify within the 45 days, the exchange fails and the sale is then subject to taxation (Federal and State). When possible, the exchangor should designate one or more back-up properties in case the transfer of the first replacement property cannot be accomplished. While this technique will not lengthen the 45 day identification period for the primary or alternative properties or cause the completion of the transaction within the replacement period deadline, it will permit the exchangor to complete the exchange with one of several properties, provided completion can occur within 180 days.
To defer all capital gains, the purchase price of the new or Replacement Property must be of an equal or greater value of the price of the old or Relinquished Property. The goal is avoid receiving “boot”. “Boot” is a tax term describing any property of an unlike kind; boot can result from the receipt of cash from going down in value in an exchange or from debt relief.
The following examples illustrate a combination of strategies:
Scenario 1: A landowner has approached a local land trust to donate a conservation easement on his 250-acre farm. The land is open and adjacent to other conserved property and has a market value of one million dollars. The landowner wants to preserve the property but is approaching retirement age and would like to have some cash and be in a position to acquire an investment property in Arizona to be rented to others and eventually used personally for part of the year. The landowner has indicated that he is unable to make a large donation but he expects to continue working for the next five years and some tax credits will be helpful.
The trust offers $500,000 for the easement; $250,000 will be designated as a bargain sale and deducted over time using up to 50% of the clients adjusted gross income (AGI). The balance of $250,000 will be raised in cash by the land trust and targeted donors. The landowner employs a QI to handle the transaction as a partial Section 1031 Exchange. At closing, the landowner designates that he wishes to receive $50,000 in cash and $200,000 is directed to the QI and then used to acquire property in Arizona, identified in 45 days and acquired in 180 days. The landowner earns $80,000 AGI annually, allowing for a 50% deduction of the AGI, he will pay income tax on only one-half of that amount for the next 15 years. If he retires in five years as anticipated, he will have used all of the charitable donation carry forward.
Outcomes: The land trust adds 250 acres to it’s preserved property holdings for $250,000.
The client keeps his property, receives $50,000 in cash that is taxed immediately, acquires investment real estate in Arizona and gets a tax credit of 50% of his AGI annually for the next 15 years.
Scenario 2: A landowner is anxious to acquire new investment property that can generate steady dependable cash flow but is reluctant to sell the “homestead” and resettle elsewhere. His land holdings include forestland that has been determined to be of high importance to national conservation efforts since it borders national forest lands. He expresses his desire to place a permanent conservation easement on the property in exchange for cash. The transaction is facilitated by a QI as a Section 1031 Exchange. The potential easement holder arranges for the funds to acquire an easement and a price of $750,000 is agreed upon. The landowner continues to hold title to the forestland and will remain in the adjacent homestead without interruption. The proceeds of the sale of the easement will be held by the QI while the landowner identifies a list of possible properties in 45 days and acquire within 180 days. He locates three properties with an income stream to support him well into the future.
Outcomes: The landowner continues to reside in his home and the land is permanently protected against development with a conservation easement. The landowner is able to acquire three new properties to create a dependable income stream.
The combination of conserving the land and utilizing a Section 1031 Exchange simultaneously provides the ability to acquire new property without disturbing the existing farm or forest. In the end, protecting the land that has provided a rich heritage can also bring a monetary reward without disturbing the land itself, a win-win for the landowner and future generations.