Navigating IRS Challenges to Conservation Easements
The Internal Revenue Service is certainly in attack mode when it comes to deductions of contributions of conservation easements. Since 2010, courts have published at least 60 opinions addressing issues related to conservation easements. Practitioners with clients considering conservation easements or who are defending conservation easement cases must keep current with the influx of rulings and have a good understanding of how these rulings fit within the framework of §170(h).1 This article provides an overview of some of the more recent developments.
Background
In an effort to encourage preservation of the country’s natural resources, Congress, in 1976, enacted legislation permitting a deduction for the contribution of a conservation easement.2 With the enactment of §170(h), Congress created an exception to the general rule that taxpayers cannot deduct contributions of partial interests in property.3
In a typical case, a landowner grants an easement over real property to a charitable donee (generally a land trust) and is thereafter subject to restrictions on the use and development of the property. At the same time, the charitable donee is granted the right to enforce these restrictions in furtherance of the conservation purposes set forth in the easement. So long as the contribution of the easement is made for prescribed conservation purposes, the donor can take a charitable deduction equal to the value of the easement (often 25 to 50 percent of the value of the unencumbered land). The conservation easement runs with the land and the conservation purposes and restricted uses must be protected and enforced in perpetuity. Under the right circumstances, the contribution of a conservation easement can result in substantial tax savings without meaningfully affecting a taxpayer’s ownership or use of the property.4
In recent years, however, the IRS has increased its scrutiny of conservation easements, generally focusing on whether the easement furthers specific conservation purposes, whether the easement would in fact be enforced in perpetuity, and whether the parties have overvalued the easement. In an examination, a taxpayer can expect the IRS to address at least three areas: 1) statutory/regulatory sufficiency; 2) proper substantiation;5 and 3) valuation. This article examines the first area and addresses recent interpretation of the statutory (and regulatory) elements of a “qualified conservation contribution.”
Definition of “Qualified Conservation Contribution”
Taxpayers may deduct the value of a charitable contribution of a partial interest in property only if the contribution constitutes a “qualified conservation contribution.”6 A “qualified conservation contribution” is a contribution that is: 1) a qualified real property interest; 2) made to a qualified organization;7 and 3) exclusively for conservation purposes. While the requirement that the contribution be made to a qualified organization is rarely an issue, the “exclusively for conservation purposes requirement” has been the subject of substantial litigation. After a few key wins, the IRS seems to have expanded its challenges to include whether the “qualified real property interest requirement” is satisfied.
Exclusively for Conservation Purposes Requirement
A contribution of a conservation easement is deductible only if it 1) achieves a conservation purpose; and 2) that conservation purpose is protected in perpetuity.8
The conservation purpose may be any one of the following: 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 for the scenic enjoyment of the general public or pursuant to a governmental conservation policy; or 4) the preservation of an historically important land area or a certified historic structure.9
Section 170(h)(5)(A) provides that a contribution shall not be treated as exclusively for conservation purposes unless the conservation purpose is protected in perpetuity. The Code does not define “protected in perpetuity” or otherwise describe how a taxpayer can satisfy this requirement. The Treasury, however, has promulgated regulations to fill in this statutory gap. Additionally, much of the recent litigation involves the interpretation of this requirement. What follows is a summary of recent, important judicial interpretations.
• Size of Eased Land Does Not Matter. So long as the easement protects a natural habitat (or otherwise satisfies a listed conservation purpose), the size of the eased land does not affect deductibility.
In Glass v. Comm’r, 471 F.3d 698 (6th Cir. 2006), aff’g 124 T.C. 258 (2005), the taxpayer contributed an easement over a 10-acre parcel of land along the shoreline of Lake Michigan. The IRS argued that the easement was not exclusively for conservation purposes because it neither protected a relatively natural habitat of wildlife or plants nor preserved open space (as described in the easement). The taxpayer introduced credible testimony that the property was a famous roosting spot for bald eagles and was suitable to foster growth of Lake Huron tansy and pitcher’s thistle (both threatened plant species). After concluding that the shoreline of Lake Michigan constituted a “relatively natural habitat” for these species, the Tax Court held that the easement was contributed for a conservation purpose.
On appeal to the Sixth Circuit the IRS argued that the easement could not be for conservation purposes due to its small size. The court disagreed and pointed out that there is no statutory or regulatory provision that requires a minimum size for a qualifying conservation contribution.10 The court explained that it is not the size of the conservation easement that matters; instead, it is whether any retained use undermines the conservation purposes stated in the easement.
• Mortgage Subordination is an Absolute Requirement. A mortgage must be subordinated to the rights of the charitable donee at the time of the contribution regardless of whether the risk of default on the loan is negligible.
If the eased land is subject to a mortgage, the mortgagee must subordinate its rights to the donee organization’s ability to enforce the conservation purposes in perpetuity.11 In Mitchell v. Comm’r, 775 F.3d 1243 (10th Cir. 2015), the taxpayer subordinated the mortgage on the eased property two years after the contribution of the conservation easement. The court confirmed that a mortgage must be subordinated to the rights of the donee organization at the time of the contribution irrespective of the risk of foreclosure (and even if the risk of default by the debtor is remote). The court found the mortgage subordination requirement to be a bright line rule and not subject to the doctrine of substantial compliance.12
• Easement Must be Recorded in Year of Contribution. A deduction for the contribution of a conservation easement may be taken in the year the easement is recorded pursuant to local law, and not when the easement is delivered to the charitable donee.
In Mecox Partners, LP v. U.S., 2016 WL 398216 (S.D.N.Y. 2016), a partnership made a charitable contribution of a façade easement over a New York City building and reported a deduction of $2.21 million in 2004, the year the partnership delivered the easement to the charitable donee. The easement, however, was not recorded until November 2005. The New York district court determined that, as a matter of law, the contribution of the easement was not exclusively for conservation purposes in 2004 because it was not protected in perpetuity at the time of contribution. As provided under New York law, an easement is not effective until recorded. Thus, the delivery of the deed to the charitable donee in 2004 was insufficient to satisfy the perpetuity requirement; the easement could protect conservation purposes in perpetuity only after it was recorded.13
• Charity Must be Entitled to Extinguishment Proceeds Without Diversion of Proceeds to the Taxpayer. In the event of extinguishment of the easement (e.g., condemnation), the proceeds cannot be diverted to, or for the benefit of, the taxpayer; instead, the charitable donee must be entitled to its proportionate share of any extinguishment proceeds.
If unforeseen circumstances make it impossible or impractical to continue using the eased land for conservation purposes, the conservation can nonetheless be treated as protected in perpetuity if the restrictions are extinguished by judicial proceedings and all of the donee’s proceeds from a subsequent sale of the property are used by the donee in a manner consistent with conservation purposes of the original contribution.14 This extinguishment provision is designed both to 1) prevent taxpayers from reaping a windfall if the property is destroyed or condemned and they get the proceeds from insurance or condemnation; and 2) to ensure that the charity can use its proportionate share of the proceeds to advance the cause of preservation elsewhere.15
In Kaufman v. Shulman, 687 F.3d 21 (1st Cir. 2012), the taxpayer contributed a façade easement over a mortgaged Boston row house. While the easement itself provided that the charitable donee was entitled to a proportionate share of post-extinguishment proceeds, the mortgage subordination agreement provided that the lender had a superior claim to all insurance or condemnation proceeds so long as the mortgage was outstanding. The IRS proposed to disallow the deduction because the mortgagee, although subordinated to the easement, could receive extinguishment proceeds before the charitable donee. The First Circuit sided with the taxpayer and explained that the extinguishment provision does not require that the charitable donee get the “first bite” as against the rest of the world or have an absolute right to the proceeds.16 The court noted that a donor cannot require a mortgagee to give up its own protection against, for example, fire or condemnation proceeds, and pointed out that the regulations do not require such.
In Irby v. Comm’r, 139 T.C. 371 (2012), the charitable donee purchased conservation easements over farmland in Colorado through a bargain sale with funds provided by various federal, state, and local entities. As a condition to receiving the funds, the charitable donee agreed to repay the governmental entities if the easements were extinguished. The IRS proposed to disallow the deduction on the grounds that the charitable donee’s obligation to repay the governmental entities violated the requirement that the charitable donee receive extinguishment proceeds. The Tax Court disagreed and allowed the deduction based primarily on the fact that none of the extinguishment proceeds could be diverted to the taxpayer. In other words, the charitable donee had an absolute right to any extinguishment proceeds vis-à-vis the taxpayer. The court further explained that the funding governmental entities were tax-exempt entities that would be required to use any extinguishment proceeds in a manner consistent with the original conservation purposes.
• Savings Clauses do not Save Deductions. A savings clause in an easement prohibiting any action that would defeat the qualification of the deduction is disregarded.
In Belk v. Comm’r, 774 F.3d 221 (4th Cir. 2014), the easement included a savings clause that provided that the parties could not agree to any amendments that would result in the conservation easement failing to qualify for a deduction under §170. The Fourth Circuit confirmed that such a savings clause is a “condition subsequent” savings clause that cannot be enforced and should be disregarded for federal tax purposes. The court rejected the taxpayers’ argument that the savings clause was an interpretive clause meant to ensure the overriding intentions of the parties that the conservation easement qualify as a charitable deduction. The court explained that “[i]f every taxpayer could rely on a savings clause to void, after the fact, a disqualifying deduction (or credit), enforcement of the Internal Revenue Code would grind to a halt.”17
• Amendment Provisions Should Not Defeat Exclusively for Conservation Purposes Requirement. An amendment provision in an easement should not defeat the exclusively for conservation purposes requirement (although it may defeat the qualified real property interest requirement, as discussed below).
In Comm’r v. Simmons, 646 F.3d 6 (D.C. Cir. 2011), the taxpayer contributed façade easements on properties located in the Logan Circle historic neighborhood of Washington, D.C., and claimed a charitable deduction of $255,000. The easements provided that the charitable donee could consent to changes and could abandon the easements altogether. Because of this amendment provision, the IRS proposed to disallow the deduction for failing to satisfy the exclusively for conservation purposes requirement.
On appeal, the circuit court held in favor of the taxpayer reasoning that the easements protected conservation purposes in perpetuity because the easements 1) imposed an affirmative obligation on the taxpayer “in perpetuity” to maintain the property in a manner consistent with its historic character; 2) granted the charitable donee the authority to inspect the properties and enforce the easements; and 3) would survive the termination of the charitable donee. The court explained that the easements did all the IRS could reasonably demand to prevent uses of the properties inconsistent with conservation purposes.
The court specifically noted that any charitable donee could fail to enforce an easement, but would do so at the risk of losing its tax-exempt status. Further, the court found it important that a charitable donee have some flexibility to accommodate any changes that may become necessary to make the property livable for future generations while still ensuring the change is consistent with the original conservation purposes. Finally, the court pointed out that the particular charitable donee had a long history of holding and monitoring easements and that the IRS could not point to a single instance when the organization had abandoned its right to enforce an easement.
In response to a similar amendment provision in Kaufman v. Shulman, 687 F.3d 21 (1st Cir. 2012), the IRS proposed to disallow a deduction, asserting that such an amendment provision gave the charitable donee a “blank check” to consent to any type of change irrespective of its compatibility with the conservation purposes of the contribution.18 The First Circuit held that the deduction cannot be disallowed based on the remote possibility that the charitable donee will abandon the easements. Specifically, the court explained that
the IRS’s reading of its regulation would appear to doom practically all donations of easements, which is surely contrary to the purpose of Congress. We normally defer to a agency’s reasonable reading of its own regulations,…but cannot find reasonable an impromptu reading that is not compelled and would defeat the purpose of the statute….19
Qualified Real Property Interest
In addition to being contributed exclusively for conservation purposes, the property must constitute a “qualified real property interest.” Section 170(h)(2) defines “qualified real property interest” to include “a restriction (granted in perpetuity) on the use which may be made of the real property.” The regulations clarify that the restriction on use must be legally enforceable to limit any use of the land that is inconsistent with the conservation purpose of the contribution.20 This requirement can be satisfied by recording the restriction (the easement) in the records of the jurisdiction where the land is located.21 As summarized below, a few courts recently have opined on the interpretation of the qualified real property interest requirement.
• Taxpayer Cannot Substitute or Modify Eased Land. An easement cannot permit the parties to substitute eased land for noneased land or modify the boundaries of the easement.
In Belk, the taxpayers contributed a conservation easement over a 184-acre golf course and claimed a charitable deduction of $10,524,000. One of the taxpayers’ reserved rights was the right to swap land in and out of the easement provided that the donee organization agreed that 1) the substitute land was of the same or better ecological stability; 2) the substitution would have no adverse effect on the conservation purposes; and 3) the fair market value of the substitute land was at least equal to that of the eased land. The IRS proposed disallowance of the deduction asserting that, because the taxpayers could change what property was subject to the conservation easement, the use restriction was not granted in perpetuity and, thus, the taxpayers did not contribute a qualified real property interest.
The court agreed with the IRS concluding that the use restriction must attach to the same property subject to the original easement rather than any or some other, interchangeable parcel. In other words, the court imposed a strict requirement that the property boundaries be fixed at the time of the contribution of the conservation easement.22
The Tax Court in Bosque Canyon Ranch v. Comm’r, T.C. Memo. 2015-130, also held that a contribution of a conservation easement did not constitute a qualified real property interest when the taxpayer reserved the right to modify the boundary lines of the easement. Similarly, in Balsam Mountain Investments, LLC v. Comm’r, T.C. Memo. 2015-43, the Tax Court concluded that a conservation easement was not a qualified real property interest when, for five years after contributing the easement, the taxpayer reserved the right to change the boundaries subject to two limitations: 1) the total acreage restricted remained the same; and 2) at least 95 percent of the original eased land had to remain within the boundaries of the easement. The court confirmed that an easement is a qualified real property interest only if it is an interest in an identifiable, specific piece of real property at the time of contribution.
• Right to Amend May Defeat Qualified Real Property Interest Requirement. The IRS recently asserted that the mere existence of an amendment provision in the easement prevents satisfaction of the requirement that an easement constitute a qualified real property interest, no matter the restrictions and limitations surrounding the amendment.23
Easements typically include an amendment clause that permits the parties to amend certain provisions of the easement if necessary to protect conservation values in the face of changing circumstances. Often, these amendment clauses build in strict limitations and restrictions on the parties’ ability to amend. For example, an amendment may be prohibited if it would adversely affect qualification for a deduction under §170(h), would create private inurement or private benefit, would adversely affect the conservation purposes of the easement, or would be in conflict with the charitable donee’s conservation policy. In addition, amendments generally must be approved by state or local agencies and recorded in public records. Even without amendment clauses in an easement, most states have enacted legislation that specifically allows for the amendment of easements in certain situations.24
The IRS’s position appears to be that, if an easement includes an amendment provision, the parties could agree to move the boundary lines of the easement or substitute noneased land for eased land, either of which violates the qualified real property interest requirement. Practitioners should watch for a decision on this issue. An IRS victory on this issue could sound the death knell for conservation easement programs.
Conclusion
It is clear that the IRS is skeptical of conservation easements and undoubtedly will continue to challenge contributions. A taxpayer considering the contribution of a conservation easement must be familiar with the ever-changing legal landscape or else risk a battle with the IRS and loss of the deduction.
1 Unless otherwise noted, “§” or “section” references are to the Internal Revenue Code of 1986, as amended.
2 Tax Reform Act of 1976, Pub. L. No. 94-455, §2124(e)(1)(C), 90 Stat. 1520, 1919 (1976); S. Rept. 96-1007, 1980-2 C.B. at 603.
3 I.R.C. §170(f)(3).
4 Noneconomic benefits include keeping land in its current use, keeping land within a family by discouraging development or sale, and preserving the environment and wildlife. Economic benefits include deductions for income, gift, and estate tax purposes, the potential for an estate tax exclusion, a reduction in value of a gross estate, and the receipt of state and local benefits and incentives. See, e.g., C.T. Lindstrom, A Guide to the Tax Aspects of Conservation Easement Contributions, 7 Wyo. L. Rev. 441 (2007); §2522; §2055; §2031(c).
5 To claim a deduction, the taxpayer must obtain a contemporaneous written acknowledgment from the charitable donee, attach a Form 8283 (noncash charitable contributions) to the return, obtain a qualified appraisal (attached to the return if the value of the easement is more than $500,000), and obtain a baseline study of the eased property. See Treas. Reg. §1.170A-13.
6 I.R.C. §170(f)(3)(B)(iii).
7 A qualified organization generally includes governmental units and publicly supported charitable organizations. I.R.C. §170(h)(3).
8 I.R.C. §170(h)(5)(A).
9 I.R.C. §170(h)(4)(A).
10 The Sixth Circuit noted that, in PLR 8546112, the IRS allowed a deduction for a conservation easement over a three-quarter-acre parcel of land. Glass, 471 F.3d at 711.
11 Treas. Reg. §1.170A-14(g)(2).
12 See also Minnick v. Comm’r, 796 F.3d 1156 (9th Cir. 2015) (mortgage must be subordinated at the time of the contribution for the contribution to be deductible).
13 See also Zarlengo v. Comm’r, 108 T.C.M. (CCH) 155 (2014); Rothman v. Comm’r, 103 T.C.M. (CCH) 1864 (2012).
14 Treas. Reg. §1.170A-14(g)(6)(i).
15 Kaufman v. Shulman, 687 F.3d 21 (1st Cir. 2012).
16 Id. at 27.
17 Belk, 774 F.3d at 230.
18 Kaufman, 687 F.3d at 28.
19 Id. at 27.
20 Treas. Reg. §1.170A-14(g)(1).
21 Id.
22 The court further noted that the ability to substitute land would bypass several other requirements for charitable contribution deductions, including: 1) having a qualified appraisal (changing boundaries of the eased land would make the original appraisal meaningless); and 2) having a baseline report (establishing the condition of property at the time of contribution). Id. at 226.
23 See, e.g., Pine Mount Preserve, LLLP et al. v. Comm’r, Docket No. 8956-13 (Tax Court filed April 24, 2013).
24 Section 2(a) of the Uniform Conservation Easement Act, adopted by 22 states, specifically provides that a conservation easement may be modified, terminated, or otherwise altered or affected in the same manner as other easements.
Micah G. Fogarty is a partner with Barnett Bolt Kirkwood Long & Koche in Tampa where she focuses on federal tax planning and controversy matters.
This column is submitted on behalf of the Tax Law Section, William Roy Lane, Jr., chair, and Michael D. Miller, Benjamin Jablow, and Christine Concepcion, editors.
