Monday, June 11, 2018

Conservation Easements - Tax Court Lets Owner Sell Them Or Give Them But Not Both

This post was originally published on Forbes Jun 1, 2015

There have been a lot of cases on conservation easements of late.  My impression is that planners may well have gotten just a little carried away with the concept.  You get a tax deduction for giving away a "might have been", a fable in a way and the more fantastic the fable the greater the tax deduction.  The way it works is that you have a piece of property that, hypothetically, could be developed, but there is a bunch of do-gooders or city or regional planners who would like to see it stay the way it is because it looks nice to drive by or is a refuge for birds or, in the big city, preserves the historic character of the neighborhood.  So you give up the right to change the property, which is worth something, probably.  For that you get a charitable deduction.

About Easement Valuation

To determine the amount of your charitable deduction you need to get an expert appraiser.  Generally there is not an active market for conservation easements, so the value is determined by valuing the property at its "highest and best use" (i.e. what brings the most money) and subtracting the value of the property in the current use to which it is now to be restricted.  It's the "highest and best use" that is the fantasy number.  It is something that nobody is ever going to do so why not make it as grand as conceivable.  Since practical obstacles don't have to actually be overcome, they can be safely ignored.

The latest easement case is that of David C. Costello and I have to say, this is a case where the charitable deduction for an easement would not have been icing on the cake.  It would have been a whole extra cake, with icing and a cherry on top.  Here is the story.

The Story

Mr. Costello and his spouse, Barbara, acquired Rose Hill Farm in Cooksville, MD for $1,682,556 in April 2000.  There were 73.6 acres - a working farm, a residence and a three-car garage.  Over the years they made many improvements which brought their basis to just shy of $2,000,000.  There were also 17 development rights associated with the property, meaning they could have put up 17 houses.  The Costellos might have been able to buy some additional development rights and been able to put as many as 24 units on the property, assuming that the lots could pass percolation tests.

They decided on another course which was to participate in the Agricultural Land Preservation Program (ALPP)
Petitioners thereafter investigated selling their development rights to private parties. On October 12, 2005, petitioners executed a contract to sell 15 of their 17 development rights to Kennard Warfield, a developer, for $2.4 million. This contract was later amended to extend the closing date and require Mr. Warfield to make a $1.2 million downpayment toward the purchase price. Petitioners subsequently agreed to sell another development right to Mr. Warfield, which increased the total purchase price to $2.56 million.
There were some formalities
On October 17, 2006, Howard County gave final approval to the density sending and receiving plats. On October 20, 2006, the deed of easement and the [*8] plats transferring the development rights were recorded in Howard County land records. These documents state that they were being filed simultaneously to describe the conservation easement, convey it in perpetuity to Howard County, and sever the development rights from Rose Hill. Petitioners in due course received from Mr. Warfield the $1.36 million balance of the purchase price. Upon recordation of the deed of easement, all future development was prohibited for Rose Hill with the exception of farming.
That was a pretty sweet deal.  Buy a property for $2.0 million and six years or so later somebody pays $2.56 million so that they build some houses someplace else and you still have the property.  It gets even better.  The IRS agreed that Revenue Ruling 77-414 applied:
when it is impractical or impossible to determine the cost orother  basis of the portion of the property sold, the amount realized on such sale should be applied to reduce the basis of the entire property and only the excess over the basis of the entire property is recognized as gain.
It seems like it can't get any better than that.  And it probably cannot, but the Costellos and their advisers tried anyway.

Trying To Make A Great Deal Greater

Appraiser Bruce Dumler determined that the highest and best use of Rose Hill would be a 25 home development which by his reckoning made the pre-easement value of the property $7.69 million.  There were some minor issues that he had not been filled in about.  Like one of the lots not passing the percolation test and that whole thing about the $2.56 million for giving up the development rights.  After all his appraisal was a "valuation scenario representing a hypothetical condition".

On the initial 2006 return the taxpayers claimed a charitable contribution of $5,543,309.  Howard County had refused to issue them a Form 8283.  They managed to get one after an addendum was done to the appraisal that took into account the $2,56 million they had received which had reduced the charitable deduction to $3.03 million.  Because of the percentage limitation it took them three years (2006. 2007 and 2008) to burn through that.
The IRS had three arguments to knock out the charitable contribution
Respondent contends that petitioners' claimed charitable contribution deductions were properly disallowed for three distinct and independent reasons: (1) Mr. Dumler's appraisal issued July 1, 2007, was not a “qualified appraisal”; (2) the Form 8283 accompanying petitioners' original return was not a valid “appraisal summary”; and (3) petitioners lacked donative intent because the easement they granted Howard County was part of a quid pro quo exchange.
In this game it only takes one strike for the IRS to put you out but the Tax Court called all three strikes.

The Appraisal
 These omissions were not trivial, formal, or mechanical. Because of them, the appraisal failed to inform the IRS of the essence of the transaction in which petitioners engaged. Because the July 1, 2007, appraisal did not provide an accurate description of the property contributed, did not specify the date of the contribu tion, and did not inform the IRS of the salient terms of the agreements among petitioners, Howard County, and Mr. Warfield, we find that it was not a “qualified appraisal” within the meaning of ection 1.170A-13(c)(3)(i), Income Tax Regs.
Form 8283
Petitioners received “consideration” from Howard County in return for the easement, namely, the county's permission to sell 16 development rights to Mr. [*22] Warfield, which petitioners otherwise could not have done. The Form 8283 accompanying their original return disclosed neither the quid pro quo they received from the county nor the $2.56 million they received from Mr. Warfield. Because the Form 8283 failed to include the donee's signature and failed to disclose the consideration petitioners received from the donee, their appraisal summary did not comply with the regulations.
Quid Pro Quo
The external features of the transaction show that petitioners granted an easement to Howard County in exchange for the county's granting them permission to sell their development rights. Under the ALPP, petitioners could not transfer their development rights to Mr. Warfield until the density sending and receiving plats were approved by Howard County and an easement was placed on Rose Hill to restrict future development. Petitioners would not have conveyed the easement unless they received permission to sell their development rights; and they could not legally sell their development rights unless they executed the deed of easement. Petitioners' transaction thus bears the classic features of a quid pro quo exchange as defined in Hernandez and its progeny.

The Tax Court dithered a bit on the accuracy penalty when it came to 2007 and 2008, since the revised 8283 was a sign of due diligence, but there still was not a qualified appraisal, so the 20% stuck for all three years.  In the footnotes it is mentioned that the IRS could have gone for the 40% valuation overstatement penalty, but they let it go.

My interest in conservation easements traces back to a post I did in 2011 titled Conservation Easements A New Field For Villainy.  Apparently the field is still thriving.  I received a call a few months ago from somebody pitching a plan that had people investing in land with the notion that conservation easements would be donated after a year or so.  In order for that to work, they have to either be buying the land from idiots or, you know, fibbing on the valuation.  Maybe it is a little of both

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