A History of Conservation Easements

Definition

A conservation easement is a “bundle of restrictions on the development and use of land designed to protect the land’s conservation or historic values.”  These easements have become the most popular form of land protection in the United States.^[1] It is a simple concept that originated in the 1950s that has become extraordinarily complex due to federal and state law.

Charitable Deductions

Congress thought it would be beneficial incentivize people to preserve property for conservation, and if taxpayers contribute easements on their property, then the property’s value would presumably decline due to its limited use, and the owner would be permitted a charitable deduction, or qualified charitable contribution (“QCC”). For example, if someone owns property that is estimated to have coal underground but does not want it open to mining, it can create an easement and donate it so it could never be used for mining.

The tax deductions started after the interstate highway system began in the late 1950s, where people could donate the land next to the highways to preserve scenic views. In 1964, the IRS published a Revenue Ruling authorizing a federal charitable income tax deduction for the donation of a conservation easement to the United States for the purpose of protecting land.  In 1980, following the enactment of a number of temporary provisions, Congress made the deduction provision a permanent part of the Internal Revenue Code (“IRC” or “the Code”).

Pursuant to IRC §170(h),^[2] a landowner donating a qualifying perpetual conservation easement to a government entity or charitable organization is eligible for a federal charitable income tax deduction generally equal to the value of the easement. Generally, a charitable contribution deduction is not allowed for a charitable gift of property consisting of less than the donor’s entire interest in that property.^[3] However, the law provides an exception for a QCC that meets certain criteria. Under §170(h), the conservation easement must be: 1) donated voluntarily; 2) donated to a qualified organization; 3) qualified “real property” such that the easement covers all outstanding interests in the property and the property is clear of any prior encumbrances; 4) granted for conservation purposes; and 5) protected in “perpetuity,” namely, the conservation easement must be permanent and legally binding on . all future landowners. In other words, if all of these requirements are met, someone could theoretically purchase a property for $1 million, yet take a $10 million deduction

If this criteria is met, the federal charitable income tax deduction is then determined by the value of the conservation easement. The value of the contribution under §170 is equal to the difference between the fair market value of the property it encumbers before the granting of the easement and the fair market value of the encumbered property after the granting of the easement. In order words, under this “before and after” valuation, a taxpayer takes the highest and best use associated with the property pre-donation (e.g. fully operating coal mine), and compares it with the actual post easement value (a nice park), and that is the size of the charitable deduction.^[4]

In light of the importance of a conservation easement’s valuation in considering what a taxpayer’s charitable deduction will be, appraisals have become the most important aspect of a conservation easement. Over the years, the major dispute between the IRS and taxpayers has been the value of the property and the decline in value post-donation (i.e. appraisal for “best use”), as taxpayers that wanted the largest deduction claimed sometimes overinflated appraisals. Congress originally anticipated it would lose $5 million per year in tax revenue from these easements, but deductions grew over $1 billion a year. One of the ways this happened is through syndication.

Syndication and Response

Shortly after §170 was passed, individuals realized that the charitable deductions could be syndicated. In other words, promoters of these plans create and sell multiple ownership interests in the entity that owns the property, suggesting to prospective investors that they may be entitled to a share of a charitable contribution deduction that greatly exceeds the amount of an investor’s “contribution.”

The annual deduction for QCCs is mostly limited to 50% of the taxpayer’s adjusted gross income, with some exceptions. Instead of losing any portion of the charitable deduction, however, a taxpayer may transfer the underlying real property to a syndicate such as a partnership or LLC. In other words, if someone with a large track of land is unable to use the entire deduction, he/she can sell it to an entity. The conservation easement is then made by the entity, entitling it to the charitable deduction. A typical syndication arrangement sells interests in the entity to third parties, and the operating agreement of the entity generally allocates its income entirely to the taxpayer who owned the property. But it also allocates its deductions, including any QCC deduction, to the other partners or members. Thus, the syndication is used to “sell” the taxpayer’s QCC deduction. In sum, investors could “invest” as a partial owner of an entity that owns real property or acquires qualified property and then claim a deduction.

As noted above, because the real property’s valuation determines the amount of charitable deduction allowed, overvaluing started to become a huge issue as people sought the largest possible deduction. Promoters began obtaining an inflated appraisal of the conservation easement based on unreasonable factual assumptions and conclusions about the development potential of the real property, which resulted massive deductions.

In 2003 and 2004, The Washington Post published a series of articles highlighting the abuses associated with syndicated easements. The reporters claimed abuses in the valuation of donation appraisals that formed the basis for deductions and questioned the validity of certain façade easements that replicated protections already in place under local law. Although the questions raised in the articles were not necessarily new, they quickly raised interest at the IRS. Congress responded, and the IRS fired a shot across the bow of easement abusers when it published Notice 2004-41, advising that it was aware of the abuses and that it was going to start disallowing improper easement transactions.^[5] The IRS further noted that:

“The IRS has seen abuses of this tax provision that compromise the policy Congress intended to promote. We have seen taxpayers, often encouraged by promoters and armed with questionable appraisals, take inappropriately large deductions for easements. In some cases, taxpayers claim deductions when they are not entitled to any deduction at all (for example, when taxpayers fail to comply with the law and regulations governing deductions for contributions of conservation easements). Also, taxpayers have sometimes used or developed these properties in a manner inconsistent with section 501(c)(3). In other cases, the charity has allowed property owners to modify the easement or develop the land in a manner inconsistent with the easement’s restrictions.”

As such, with the growing abuse associated with the use of syndicated conservation easements, and with the significant uproar the Washington Post articles created, the IRS dedicated its efforts to look for abuses at each component of the charitable contribution of the conservation easement, specifically the “perpetuity” requirement. Ultimately, the IRS’s efforts led to Congress to enact further protections to offset the potential for abuse, and Congress also acted.

In 2006, Congress tweaked section §170(h) with the Pension Protection Act (“PPA”)^[6], which included amendments to QCCs, and charitable gifts in general. With the same series of amendments, Congress increased the allowable tax benefit for making a conservation easement donation. Before 2006, QCCs were subject to the same rules as any charitable contribution of capital gain property. That is, the donations were deductible up to 30 percent of the donor’s adjusted gross income (AGI) and the excess deduction, if any, could carry over for application to any of the following five tax years. The 2006 amendments increased the deduction limit to 50 percent for conservation contributions and added 10 years to the carry-over period, for a total of 15 years.

Focus on 170(h) Requirements and Amendment Clauses

As noted above, under §170(h), the donation of a conservation easement is considered a tax-deductible charitable gift, provided that the easement is 1) perpetual; 2) held by a qualified governmental or non-profit organization; and, 3) serve a valid “conservation purpose”, meaning the property must have an appreciable natural, scenic, historic, scientific, recreational, or open space value. In light of both Congress’ and the IRS’s heightened scrutiny for potential abuses involving these types of transactions in the mid-2000s, individuals looking to get involved with these transactions were given a clearer understanding of §170(h)’s requirements and the purpose behind them.

Specifically, it came to be understood that the definition of a “qualified real property interest” requires, among other things, that the restriction be “granted in perpetuity.”^[7] Further, the language “exclusively for conservation purposes” also requires that the “conservation purpose is protected in perpetuity.”^[8] The requirement that “qualifying” conservation easement be donated to a “qualified” land protection organization/serving a valid “conservation purpose” made sure the easement would adhere to the conservation purposes for which the easements were originally granted. This prevented abuses such as transferring to an entity that had no intent to preserve the property and would file for bankruptcy shortly thereafter, thus defeating the purpose of §170(h).

The perpetuity requirement was also designed to prevent a sham dedication where a property owner reserves the right to void the easement at any time, for any reason, for a nominal payment to easement holder. In order to extinguish the easement, Congress required that the easement had to go through the court, and the proceeds/loss of deductions would go evenly between owners and entities to avoid shams. Treasury Regulations offered a single, narrow exception to the requirement that a conservation easement impose a perpetual use restriction, when a subsequent change to the surrounding property make it impossible or impractical for continued use for conservation purposes.^[9]

However, §170(h) was not intended to leave donated land fallow for all time, and improvement clauses on the easement could be inserted as long as they did not run afoul of §170(h). For example, conservation easements often allow a landowner to retain a “reserved right” to build, e.g., a house or other structure on the property. The tension with an improvement or amendment clause is that its presence may mean that the restrictions are not in perpetuity because they can be changed (amended) later. 

That tension regarding “perpetuity” arose in In Belk v. Commissioner.^[10] In this case, the Tax Court held that, although an easement was perpetual in its terms, the deed allowed the parties to change the property subject to the easement; as such, the Tax Court held that the easement was not a qualified real property interest because it was not granted in perpetuity. In other words, specific property was not donated that was subject to a use restriction granted in perpetuity. In Belk, the taxpayer owned 410 acres of land in North Carolina that they converted to a golf course and donated to a land trust that created an easement. The easement imposed on the 184-acre parcel a number of enforceable use restrictions, including a prohibition on further development and a requirement that the parcel be used “for outdoor recreation.” The taxpayer granted the easement in perpetuity, subject to certain “Reserved Rights,” and claimed a $10 million charitable deduction. The Reserve Rights permitted the land trust to swap equal land in and out of the trust, e.g. remove one acre on the 4^th hole, and add an acre on the 18^th hole, as long as the trust totaled 184 acres.^[11] The IRS determined it was not a QCC, the Tax Court agreed, and the Fourth Circuit affirmed.^[12] They all found that the Reserve Rights amendment clause ran afoul of the “perpetuity” requirement.

Another requirement under §170(h) is that an easement deed provide for a specific division of proceeds that result from any extinguishment (by judicial proceeding, e.g. bankruptcy) of all or part of the easement, for example if the property were condemned. If the property were later condemned, the proceeds from the condemnation sale would thus include the value of those improvements, and in turn, the value attributable to such improvements would be the property of the landowner who paid to build them. Accordingly, improvement clauses typically carve out and reserve the amount of proceeds attributable to the value of such improvements for the land owner, and the remaining proceeds are divided between the land trust and land owner in the proportion described in the regulation.

The valuation differences, requirements for perpetuity, combined with the syndication attempts meant that these easements became an entirely different beast than when created in the 1970s.

2008 Private Letter Ruling

In 2008, the IRS issued guidance that approved an improvements clause in a conservation easement deed.^[13] The IRS determined that a conservation easement was protected in perpetuity notwithstanding the fact that the easement deed allocated proceeds attributable to post-easement improvements to the owner.^[14]

PBBM-Rose Hill

However, things changed significantly for syndicated easements and amendment clauses in 2018 following the case of PBBM Rose, Ltd. v. Commissioner of Internal Revenue. In 2006, PBBM Rose, Ltd. (“PBBM”) owned an unprofitable 27-hole golf course in North Carolina. It conveyed a conservation easement to the North American Land Trust (“NALT”). The deed “voluntarily, unconditionally, and absolutely” conveyed any “easements, covenants, prohibitions, and restrictions,” in “perpetuity” for the “Conservation Purposes” set forth in the deed. For the 2007 tax year, PBBM claimed a $15 million charitable contribution deduction. In 2014, the IRS determined that PBBM was not entitled to the $15 million deduction and issued them a penalty for over-valuing the easement. PBBM appealed, and the 5th Circuit found that while the easement was exclusively for conservation purposes, it was not made in perpetuity and so affirmed the ruling against PBBM.

First, the Court determined that the easement was for conservation purposes.  PBBM argued that the language of the deed satisfied the public access requirements for a conservation easement, while the Commissioner argued that the actions taken by the owner should be used. The Commissioner argued that since a part of the easement was cordoned off for public use, it should fail the public-use requirement.  The Court held that the specific language found in the deed should be used to determine whether the easement was to include public-access and therefore be a recreational easement under the conservation purposes.

However, the Court then determined that the taxpayer’s contribution failed to be “exclusively for conservation purposes” because the extinguishment provision in the deed violated the “perpetuity” requirement of §170(h)(5)(A). The deed’s extinguishment provision allowed the NATL to receive a proportionate share of proceeds in any sale, exchange or involuntary conversion.  The Court held that this failed the perpetuity requirement as it  did not: (1) to prevent a taxpayer (or his successor) “from reaping a windfall if the property is destroyed or condemned” such that the easement cannot remain in place and (2) to assure that the donee can use its portion of any proceeds to advance the conservation purpose elsewhere.

The Treasury Department promulgated the Extinguishment Proceeds Requirement (EPR) to ensure that a tax-deductible conservation easement will continue to fulfill its purposes in perpetuity, but in the unlikely event that an easement is terminated because of condemnation of impossibility, the EPR provides that the property owner must pay the easement holder the value of the easement, defined as the “proportionate value that the perpetual conservation restriction at the time of the gift, bears to the value of the property as a whole at that time.” In PBBM, the court agreed with the IRS that the extinguishment clause must strictly copy the regulations’ precise language, and most importantly, the easement is not perpetual if it excludes any post-easement improvements built by the landowner (where permitted by improvement clause) from the calculation of the value to go to the easement holder upon extinguishment.^[15] While a technicality, the IRS has been seizing on this in pursuing other cases.

The Court also took issue with the “before” valuation of the property which would require rezoning of the property and significant work would be required to qualify for rezoning upon which the valuation relied. The Court decided the $15 million valuation incorrectly assumed the land could be developed instead of using its current value as a golf course and outdoor recreation plot. Since there were a number of barriers which could prevent development on the land including zoning issues, the Court ruled that the $15 million valuation was grossly overvalued. Finally, since PBBM’s lower tax payments were directly attributably to a gross misevaluation, the valuation-related penalty applied.

A subsequent case, Champions Retreat Golf Founders,^[16] highlighted how the IRS was really “going after” golf course easements at this time as presumably improper.

IRS and DOJ Start Cracking Down

In December 2016, the IRS decided that the penalties imposed by Congress were not enough to dissuade improper tax shelters. It thereafter issued Notice 2017-10 (the “Notice”)^[17] with respect to conservation easements, which identified syndicated conservation easements as “listed transactions.”^[18] A listed transaction is a transaction that is the same as or substantially similar to one of the types of transactions that the IRS has determined to be a tax avoidance transaction. In other words, the IRS decided that all of these would be presumed to be tax shelters and would respond accordingly (and aggressively). By identifying these conservation easement deals as a “listed transaction,” investors in syndicated conservation easements were also now required to file a tax shelter disclosure statement with their easement, with significant penalties for failing to file. 

In March 2019, the IRS added syndicated easements to its annual “Dirty Dozen”^[19] list of “the worst of the worst tax scams.”^[20] As the IRS noted, a conservation easement tax shelter “start[s] with a legitimate tax-planning tool that is improperly distorted almost always by a promoter to produce benefits that are too good to be true and ultimately seriously compromise the taxpayer.” The IRS has decided to go after these tax shelters, the investment advisor/promoters, and the lawyers and accountants that have recommended these.

In November 2019, the IRS announced that it was further stepping up enforcement actions involving syndicated conservation easements, noting that this was a priority compliance area.^[21] The commissioner stated:

“We will not stop in our pursuit of everyone involved in the creation, marketing, promotion and wrongful acquisition of artificial, highly inflated deductions based on these aggressive transactions. Every available enforcement option will be considered, including civil penalties and, where appropriate, criminal investigations that could lead to a criminal prosecution.”

Taking up the mantle of criminal prosecution, in December 2019, the Department of Justice (DOJ) sued to shut down promoters of a conservation easement syndicate scheme. The DOJ filed a complaint seeking to stop certain defendants from organizing, promoting, or selling an allegedly abusive conservation easement syndication tax scheme, which purportedly revolves around donations of conservation easements and corresponding tax benefits from those donations. The DOJ alleges that defendants were able to receive tax deductions of approximately 250% of their initial investment by relying on grossly overvalued appraisals as part of their scheme. 

A chief target of the DOJ is EcoVest Capital, which has allegedly been involved with 51 syndication deals in the last decade totaling $1.7 billion in deductions. According to a private placement memorandum dated October 24, 2019, EcoVest was planning as many as three new syndicated deals on 1,549 acres in rural Calhoun County, Texas. One, touting a deduction of $4.10 for every $1 invested, was completed in December 2019.  An appraiser, Claud Clark III, is also a major target of the DOJ, his was allegedly involved in at least 58 syndicated easement that he “continually and repeatedly” generated “grossly overvalued appraisals.”^[22]

On December 13, 2019, the Tax Court entered its first decision on a syndicated conservation easement transaction.^[23] In TOT Property Holdings LLC v. Commissioner,^[24] the Tax Court sustained in its entirety the IRS’s determination that all tax benefits from a syndicated conservation easement transaction should be denied and that the 40 percent gross valuation misstatement and negligence penalties applied.

Seemingly spurred by the publicity of the DOJ’s lawsuit, the United States Senate Committee on Finance (the “USSCF”) subpoenaed subjects of the DOJ investigation, including EcoVest.^[25] Those subjects failed to comply by the subpoena,^[26] and the USSCF set a deadline which was right before the COVID-19 shutdown, so we believe that investigation has stalled. However, we do not expect that it will go away.

Finally, Congress attempted to act and introduced a bill in the House of Representatives to limit the aggregate amount of a partner’s annual tax deductions for QCCs to 2.5 times the partner’s adjusted basis in the partnership, but the bill died in committee.

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[1] https://www.conservationeasement.us/about/

[2] https://www.law.cornell.edu/uscode/text/26/170

[3] In other words, normally one cannot claim a $10 deduction on a donation of $1.

[4] One example is an easement granted in 2015. An entity acquired 28 acres in North Myrtle Beach, South Carolina, for $9 million, then made an easement donation based on a claimed value for what the land would be worth if developed as a multifamily resort. That projection, made by an appraiser, produced a tax deduction of about $39.7 million. The tax write-off for investors was $4.12 for every $1 invested.

[5] https://www.irs.gov/pub/irs-drop/n-04-41.pdf

[6] https://www.irs.gov/charities-non-profits/pension-protection-act-of-2006-revises-eo-tax-rules

[7] IRC § 170(h)(2).

[8] IRC § 170(h)(5).

[9] Impossibility was such as if the surrounding land changed, e.g., an airport was built next to the donated property that would prevent its intended use.

[10] 140 T.C. 1 (2013).

[11] By swapping out land, the court found that it would throw off any appraisal used for the charitable deduction.

[12] https://www.ca4.uscourts.gov/Opinions/Published/132161.P.pdf

[13] I.R.S. Priv. Ltr. Rul. 2008-36-014 (Sept. 5, 2008).

[14] http://www.legalbitstream.com/scripts/isyswebext.dll?op=get&uri=/isysquery/irl9f2a/1/doc  

[15] This is confusing because if the right to build improvements was reserved, it was not conveyed to the easement holder and should not be included as the easement’s value, and any appraisal of the easement will be altered by the reserve clause.

[16] T.C. Memo. 2018-146 (Sept. 10, 2018).

[17] https://www.irs.gov/pub/irs-drop/n-17-10.pdf    

[18] https://www.irs.gov/businesses/corporations/listed-transactions  

[19] https://www.irs.gov/newsroom/irs-concludes-dirty-dozen-list-of-tax-scams-for-2019-agency-encourages-taxpayers-to-remain-vigilant-year-round

[20] https://www.irs.gov/newsroom/abusive-tax-shelters-trusts-conservation-easements-make-irs-2019-dirty-dozen-list-of-tax-scams-to-avoid 

[21] https://www.irs.gov/newsroom/irs-increases-enforcement-action-on-syndicated-conservation-easements

[22] In January 2019, the Alabama state real estate appraiser board brought a formal complaint against Clark, after a detailed review of one of his easement appraisals found an inflated valuation riddled with errors and omissions. Threatened with loss of his Alabama license, Clark voluntarily surrendered it instead. He faces a second complaint filed with state regulators in Louisiana, regarding a 2018 appraisal he did for syndicators in Jefferson Davis Parish. Clark is nonetheless still being used by promoters despite surrendering his license.

[23] Belk did not involve syndicated easements.

[24] Docket No. 005600-17.

[25] https://www.finance.senate.gov/chairmans-news/grassley-wyden-subpoena-subjects-in-investigation-of-syndicated-conservation-easements

[26] https://www.finance.senate.gov/chairmans-news/grassley-wyden-continue-pressing-syndicated-conservation-easement-promoter