Small opened the discussion by pointing out that the problems Texas and many other states in the nation face with respect to fragmentation is only going to get more challenging, particularly since today the majority of landowners in the U.S. are 65 years of age or older. Small pointed out that over the next several years, millions of acres are going to change hands and potentially change use. That’s not good news, given the challenges facing landowners with regard to estate taxes.
“The federal estate tax does not distinguish between a $5 million stock portfolio and a $5 million piece of land,” Small reminded listeners.
“The really bad news is if that family farm or ranch is sold and paved over, it is gone forever. It is not only an irrevocable loss to the family, but also to the community,” he opined. “A friend of mine in Virginia said asphalt is the last crop. There are landowners all over the country who don’t like to be told what to do with their real estate. I can assure them, if they don’t do the planning for their real estate, Uncle Sam may tell their heirs what to do with that real estate, and they aren’t going to like what they hear.”
There are many rules that landowners need to fully understand. Getting it done right was the focus of Small’s half-day seminar.
“For many, many years the IRS didn’t care much about conservation easements, and there were very few audits of conservation easements,” he told listeners. “That has changed dramatically over the last seven or eight years. In recent years the IRS has won a lot of cases on technical issues — something as simple as whether or not the forms were filled out correctly. That’s why it’s all the more important if you’re going to do it to get it done right.”
He started off with a discussion on the tax code, Section 170, which provides the basis for the deductions for conservation easements and also basically explains what a conservation easement is. To qualify, the party must donate a qualified real property interest, the easement has to be held by an eligible charitable organization, and the conservation purposes test must be met. “The regulations also say to be able to hold a conservation easement, not only does the entity have to be a public charity or a unit of government, it also has to have the commitment and the resources to enforce the easement terms,” Small noted.
Almost all land trusts in the U.S., such as TALT, are in good standing and have the commitment and the resources to enforce the terms, but he added that there are some “fringe or rogue organizations” out there that don’t enforce the terms. These are among the groups that the IRS has been going after.
The heart of the statute dealing with a qualified conservation contribution deals with the conservation purposes. To qualify for a deduction there are several clearly defined conservation purposes, though the party involved only has to meet one such purpose. The first is preservation of land areas for outdoor recreation by, or the education of, the general public.
“Some landowners think that if they put a conservation easement on their property that they have to allow public access. That’s absolutely not correct, unless this is the conservation purpose you choose to meet,” Small stressed.
The second conservation purpose is the protection of a relatively natural habitat of fish, wildlife, plants, or similar ecosystem. The third is the preservation of open space, and the final conservation purpose is the preservation of a historically important land area or certified historic structure.
The statute also clearly states that a contribution shall not be treated exclusively for conservation purposes unless a conservation purpose is protected in perpetuity. “The easement has to be perpetual and the conservation purpose must be protected in perpetuity,” Small reiterated.
He clarified that statement with an example. “Say Aunt Sally has a 500-acre property and the property qualifies for a conservation easement. She reserves the right to put 25 20-acre house lots on the property. In this case Aunt Sally has reserved too much building,” Small told listeners. “She can’t put that many buildings on the property without destroying the conservation values that existed in the first place.” He qualified that example by further stressing that landowners wishing to do a conservation easement can allow for additional residential development. “It’s very property-specific, but a conservation easement does not have to eliminate all future development,” he reiterated.
“One of the tips I give landowners at the beginning of a conservation easement process is to write a wish list of all things that they might want to do with that property going forward, and I also encourage them to make a list of the things they don’t want to see happen to the property.” Small also stressed that a conservation easement and economic activity are compatible. “If you put a conservation easement on your property, you can continue to farm or ranch, or in the case of forest land, timber can continue to be harvested.”
Qualifying for an easement can be a bit more complicated if the property in consideration is subject to a mortgage. “In this case the holder of the mortgage has to subordinate his rights to the holder of the conservation easement. That means if there is ever a foreclosure, the lender has to agree that the property will be resold subject to the conservation easement,” Small explained. Another highly technical point on the mortgage matter is that those entering into a conservation easement must make sure they get the correct kind of mortgage subordination. He encouraged landowners to have their attorney read the Kaufman Tax Court case.
Though oil and gas development may be allowed on a property that has a conservation easement, the rules clearly state that no surface mining is permitted. “The rule says if the landowner doesn’t own all the mineral interests on the property, then to qualify for a conservation easement deduction, the landowner must be able to establish that the likelihood of surface mineral extraction is so remote as to be negligible.” A geologist, he added, is needed to make such a determination.
A property with an established caliche or gravel operation, however, may qualify for a conservation easement. “The way we’ve solved that is we put a non-deductible conservation easement on the gravel pit and caliche pit to make sure they can never be turned into anything else, and then we put a deductible conservation easement on the balance of the property,” Small explained.
After he moved through some of the basics, the presenter turned his attention back to the requirements for getting it right, and specifically what needs to go into the package that is filed with the IRS. The first requirement is Form 8283, known as the Noncash Charitable Contribution. “It’s an IRS form, so by definition it isn’t simple and clear and easy to fill out,” Small admitted, “but there are instructions, and you can get it right, and your tax return preparer can get it right.” If it is a donated conservation easement, there is also a required supplemental statement that must be attached to the form 8283. The third piece of the required paperwork is the qualified appraisal report. If the value of the gift is greater than $500,000, a copy of the appraisal must be filed with the tax return.
The rules for a qualified appraisal are specific and clear. However, Small also noted that in a number of the cases that the IRS has won over the last several years there has been one fundamental mistake made repeatedly. The appraisal, he said, was lousy. “If you read the appraisal and you understand it and you understand how the appraiser reached his or her conclusion, then it’s a pretty good bet that someone at the IRS will also be able to understand it.”
The fourth part of the tax package, a relatively new addition, is the baseline documentation report. It is not required that this be filed, but Small recommended this. Included in the report is a description of the condition of the property prior to the conservation easement. The report can and should include such things as photographs, maps and a narrative by a wildlife biologist, perhaps.
The fifth and final requirement of the tax package is a gift letter. “Any time someone makes a donation to a charity with a value greater than $250, written acknowledgment is required,” Small says. “If that gift letter is not included in your tax package for the conservation easement, the tax deductions can be denied.”
Small shifted his attention then to the evaluation of an easement and the four critically important rules that must be adhered to during such an evaluation. The tax code, he noted, calls for a deduction for the fair market value of the gift, and the fair market value is generally defined as what a willing buyer would pay a willing seller.
“If you donate 100 shares of stock to your college, the value of that stock on any given day is the fair market value. The hitch with conservation easements is that they’re not bought and sold in the marketplace,” Small noted. “Sometimes state agencies and charitable organizations have funds to buy conservation easements, but 90-plus percent of the easements are donated as charitable gifts.”
The regulations lay out four rules for valuing a conservation easement. This is the part, Small reiterated, that many appraisers don’t get right. The four rules are as follows:
•If substantial records of comparable marketplace sales of easements exist, the value of the gift is based on those marketplace sales.
•The value of the easement is equal to the fair market value of the property before the easement minus the fair market value of the property after the easement.
•If the easement covers a portion of the contiguous property owned by the donor and the donor’s family, then the value of the easement is equal to the value of the entire contiguous portion before the easement minus the value of that entire contiguous portion after the easement.
•If a conservation easement is placed on a piece of property and as a result of that conservation easement the value of any other property anywhere goes up, whether it is contiguous or not — if that other property is owned by a family member or a related party — the related party is defined in the tax codes as partners and partnerships, trusts and beneficiaries, shareholders, LLCs, — then that increase in value is offset and reduces the deduction.
These rules, Small admitted, can be complicated. He outlined a few specifics on each. The first rule, he reiterated, is not important at this time because not a lot of easements are bought and sold, so no such record exists. The second rule, Small says, probably applies to 90 percent of easement donations, but he noted that the so-called “before and after test” really involves two different appraisals — an appraisal before the easement and an appraisal after the easement. The spread is the deduction.
The most common mistake appraisers make, Small told listeners, is failing to follow the third rule. He also noted that in the case of the third rule, family includes grandparents, parents, siblings, children, and grandchildren. It does not include nieces and nephews and aunts and uncles.
He also offered an example that further explained the fourth rule. Say Aunt Sally owns a ranch in the valley and then Aunt Sally and a partner have a ranch further up the mountain. Aunt Sally decides to put a conservation easement on the ranch in the valley. Because of that easement the view from the house on the hillside is never going to be impaired by a subdivision, so the value of the home on the mountainside goes up some. “It’s not usually a lot — historically, we find that enhancement situation is somewhere between two to 10 percent,” Small says. “So it isn’t a number that’s going to destroy a deduction, but it is an important rule to understand.” The appraisal can be done no sooner than 60 days prior to the date of the gift. However, he recommended retaining an appraiser early in the process. “Get an oral report of the expected estimated value early on, because if there are any unpleasant surprises, it’s better to find out early.”
In addition to the estate tax relief, the donor of a conservation easement may also qualify for an income tax deduction, and in 13 or so states there is now also a state income tax credit. Additionally, donors may potentially get a lower property tax bill, but Small pointed out that the tax assessor makes these calls. It has nothing to do with the tax code.
He discussed in more detail the income tax deduction. From the time conservation easements were first put in the tax code in 1976 up to 2006 the rule was such that if someone donated a conservation easement, the donor could deduct up to 30 percent of their adjusted gross income for the year with a five-year carry-forward.
In 2006 Congress changed the rules. Currently, the donor of a conservation easement can deduct up to 50 percent of their adjusted gross income with a 15-year carry-forward. “It gets even better,” Small pointed out. “A qualified farmer or rancher who donates an easement can deduct up to 100 percent of their adjusted gross income with a 15-year carry-forward.” The definition of “qualified farmer or rancher” in this case means that greater than 50 percent of their total gross income must come from farming or ranching.
“The key lobbying effort for this came from the West,” Small told listeners. “There are a lot of ranchers and farmers whose income isn’t very high whose value from a conservation easement is very high, and with the old 30 percent rule it wasn’t worth it to them to donate a conservation easement.” He reiterated that the donor doesn’t have to use all the deduction in the first year, but rather, it can be banked for up to 15 years to use against future income.
Small also noted that this incentive is set to expire at the end of 2011 and conservation groups around the country are pushing hard for an extension and/or to make it permanent. “There is bipartisan support for this provision in Congress. There are more than 250 cosponsors in the House — both parties — and a lot of co-sponsors in the Senate, but as you know, Congress is not in a giving mood this year. So, I’m assuming that this incentive will not be extended, which means next year the rule will go back to the 30 percent with a five-year carry-forward.”
Small encouraged those who are considering a conservation easement to step up the process to take advantage of these tax incentives. “Nobody knows what the tax code is going to be like next year or the year after that, and this is an opportunity that we have now.”
He offered still two more caveats that need to be considered during the preparation process. Who holds the title is clearly important. “We have found many times the title isn’t held the way the landowner thinks it’s held,” Small told listeners. “If the owner is not an individual, if the owner is a family partner, an LLC, a trust, etc., that’s important to know early on, because the parties involved in the transaction need to be absolutely certain that that owner entity has the authority to make such a donation.”
One of the most common queries that he gets, Small said, has to do with whether or not a trust can in fact donate a conservation easement. He told listeners that it all depends on the kind of trust. There are basically two kinds of trusts — a grantor trust and an irrevocable trust. The grantor trust does not pose a problem. However, chances are good that if it’s an irrevocable trust, a conservation easement cannot be used. “Also it isn’t just about whether the trust is revocable or irrevocable. I’ve seen some irrevocable trusts that say they’re irrevocable that aren’t,” he told listeners. “So in some cases it’s good to get a good trusts and estates lawyer involved.”
Finally, Small discussed two other estate and gift tax issues related to conservation easements. The first is the 2031(c) exclusion, which says that if someone dies owning land subject to a conservation easement, then in addition to the reduction in value because of the easement, the donor, or in this case the heirs, can take another 40 percent of that remaining land value out of the taxable estate.
The other really big benefit is what is known as a post-mortem conservation easement. It provides the same tax benefits as a regular conservation easement. In this case the heirs have 15 months after the death to record the easement.
Throughout the presentation, those attending had opportunities to ask specific questions of the speaker. One participant wanted to know if a landowner had already begun to give partial interest of their land to their children, if or how that giving might affect the ability to protect the land with a conservation easement.
“If Aunt Sally owns the ranch and decides to put a conservation easement on the property, her signature is the only signature needed to do so,” he reiterated. “However, if Aunt Sally has given partial interests of that property to her children or grandchildren or a trust, or if the property is put into a partnership and partnership interests have been bestowed, then it isn’t just Aunt Sally’s signature that’s needed. If it’s partial interests, then everybody’s signature is needed.
“I recommend that if you’re thinking about doing a conservation easement, do it first and then start giving interests away so that you’re the one doing the voting and the controlling.”
Someone else wanted to know if the next generation of heirs could sue to remove a conservation easement. “Sure,” Small said, “but whether they win is something else entirely.”
There was a question about the impact on privacy of the landowner who decides to grant a conservation easement. Specifically, the participant wanted to know if a conservation easement granted government officials more access to their property.
“The general public absolutely does not have the right to cross your property, and government officials don’t have any more rights than they already have,” Small responded. “If you give an easement to TALT, for example, they will have the right to come onto your property once a year, possibly twice a year, to inspect the property to make sure you’re running it consistent with the terms of the easement.”
That led to other questions pertaining to the rights of the holder of the easement. “Technically, the holder of an easement has only an enforcement right,” Small told listeners. “Some organizations like Ducks Unlimited will build into their easements habitat management enhancement rules; the Nature Conservancy sometimes does that as well,” he added.
Another asked if the holder of an easement could sell the conservation easement. “I suppose they could sell it to another charitable organization. It can’t be sold to anyone who won’t enforce it,” he said.
That led someone else to ask what happens if an organization holding an easement goes out of business. “In every state, the attorney general of each state has oversight of charitable organizations. If the charitable organization goes out of business, then the AG gathers all the assets of that charitable organization and distributes them to other similar charitable organizations, so the easement would stay in effect.”
Another question pertained to the tax benefits. Specifically, the participant wanted to know what happens to the property if the IRS disallows the conservation easement. Can the grantors get it back? “No,” Small said. “A conservation easement is forever, and if the IRS disallows the deduction, that shouldn’t have any effect on the enforcement of the easement. Second, the charitable organization that holds the easement doesn’t really have the right to convey value back to a private citizen.”
Someone else wanted to know if a conservation easement could restrict construction of utility corridors such as electric transmission lines acquired by condemnation. “Short answer is no,” he told listeners. “The longer answer is that historically, if the county was going to put a road through Aunt Sally’s farm, the county usually wins. However, if Aunt Sally’s farm is under a conservation easement to a statewide organization and if that organization is part of a regional coalition and/or a national group of conversation groups, the county might decide they don’t want to take on that political fight,” Small said. “We have found that not just to be anecdotal. The people who are in the land trust business who are out there on this issue — utility corridors, transmission lines — they have said it boils down to politics; the utilities have the right to do it, and the only way to stop them is to educate them but also to educate them about the political fight they’ll be in for.”
Finally, someone commented that no one had really stated why a landowner should do an easement. “There are many, many reasons why you might want to do an easement,” Small responded. “If you don’t care if your land gets paved over, that’s okay; that’s your choice, but if you don’t want to see it paved over and you want to see it kept intact, if you have an estate tax issue that’s created in part by owning a valuable piece of land or if you like the idea of protecting your property against development and you’re also fortunate enough to have other sources of income and you like the idea of income tax deduction to shelter that source of income, then a conservation easement is a good choice.”
He added that every single easement needs to be tailored to the needs of a particular family. “A conservation easement means a lot of different things to a lot of different people. Each individual has to decide if it’s a good tool for them,” Small stressed. “It’s much more complicated than just protecting open space; that’s part of it, but it’s a significant legal planning tool that can be used in a number of ways, and it is optional,” he concluded.