Over 40 years ago, Congress modified §170 to permit deductions for donations of partial interests in land when such donations advanced an important public purpose such as protecting environmentally or historically important land from development. Starting in the early 2000’s, however, developers and tax shelter promoters began exploiting conservation easements to provide huge tax deductions for donations that provided little or no conservation benefit. The problem reached the point that the IRS issued Notice 2017-10 which described certain syndicated conservation easement arrangements and listed them as tax shelter transactions. This informative Senate Finance Committee Report from August 2020 details the abuses.
But not all conservation easements are tax shelters. Kumar Rajagopalan and Susamma Kumar v. Commissioner, T.C. Memo. 2020-159 (Nov. 19, 2020) (Judge Holmes) shows how taxpayers can properly deduct the donation of a conservation easement if they have good planning, good representation, and good luck. Details below the fold.
Law: Conservation Easement Basics
Section 170(a) allows taxpayers a deduction for a “charitable contribution.” Generally, a contribution “of an interest in property which consists of less than the taxpayer’s entire interest in such property” cannot qualify as a contribution. §170(f)(3)(B). However, §170(f)(3)(B) carves out three exceptions to the general rule, the third one of which is for “a qualified conservation contribution.”
Section §170(h)(1) says a contribution of less than an entire interest in property will be a qualified conservation contribution if it meets three requirements: (A) it is a “qualified real property interest”; (B) it is to a “qualified organization”; and (C) it is “exclusively for conservation purposes.” Each of those quoted terms are terms defined by statute, regulation, and case law. Incorporated into the first and third requirements is the idea of perpetuity. You see that in two places. First, §170(h)(2) says a restriction on the use which may be made of real property---known at common law as an easement---can be a “qualified real property interest” for (h)(1)(A) purposes but only if the restriction is granted in perpetuity. Second, §170(h)(5) says that “exclusively for conservation purposes” requires that “the conservation purpose is protected in perpetuity.” These, dear readers, are the perpetuity requirements.
Most of the syndicated conservation easement donation arrangements fail the perpetuity requirements. See, for example, Lesson From The Tax Court: No Stopping The Perpetual Debate About Conservation Easements, TaxProfBlog (Sept. 10, 2018). For a list of all conservation easement cases from 2012 through April 2020, see IRS Chief Counsel Generic Advice 2020-20002 (Released May 15, 2020).
A deed that fails the perpetuity requirements cannot be rescued by a savings provision that purports to automatically reform the deed if a court later finds the deed does not meet all the requirements. Courts have generally laughed at these blatant attempts circumvent the law. As Judge Gustafson wrote in Railroad Holdings v. Commissioner, T.C. Memo. 2020-22, “A donor cannot reserve in an easement deed a right that section 170(h) does not permit...but then save his charitable contribution by mentioning the rule he has violated and calling for that rule to kick in and save the day if his violation subsequently comes to light.” Op. at 18.
In contrast to savings provisions, however, courts have found that provisions permitting later amendment of a deed’s restrictions do not, by themselves, violate the perpetuity requirements, at least so long as the amendment powers are consistent with the conservation purpose of the donation. See Pine Mountain v. Commissioner, 151 T.C. 247 (2018), aff'd --- F.3d --- (11th Cir. Oct 22, 2020).
Taxpayers whose donation meets all three requirements have one last hurdle: figuring out the amount they can deduct for the conservation easement. Treas. Reg. 1.170A-14(h) gives the valuation rules whereby taxpayers must, sensibly enough, rely upon sales of property with easements comparable to the donated easement, if there is a “substantial record” of such sales. See (h)(3)(i). If comparable sales are scarce, the regulation then provides that “the fair market value of a perpetual conservation restriction is equal to the difference between the fair market value of the property it encumbers before the granting of the restriction and the fair market value of the encumbered property after the granting of the restriction.” Judge Holmes calls this the before-and-after test.
This case is actually a consolidation of two cases, one involving the Kumars and the other involving Warren and Jamiko Sapp. Both Dr. Kumar and Mr. Sapp were members of SS Mountain LLC, a North Carolina company formed in September 2004 to develop some 120 acres of scenic land in western North Carolina. All but 10 acres of the land was contributed to the LLC by members who had previously purchased various parcels between August and December 2004. The LLC purchased the remaining 10 acres in July 2005. The opinion is not clear on whether Dr. Kumar or Mr. Sapp contributed previously purchased parcels or not.
The LLC considered subdivided the entire acreage into 37 residential lots. It eventually decided to subdivide about 31 acres into 12 lots to develop into luxury homes, and to contribute the remaining 89 acres to the North American Land Trust (NALT). It made the contribution in late 2006 and reported a noncash charitable contribution amount of $4.9 million, of which 60% flowed through to Mr. Sapp and 4% flowed through to Dr. Kumar.
Alert readers will notice the timeline here. It’s just before the Great-Recession. Thus, before the Great Recession hit, the LLC managed to put 5 lots under contract. One was to Dr. Kumar for $750,000, one was to Mr. Sapp for $1.1 million, and the other three were to parties who were not members of the LLC. Each sale price was for $750,000. All five buyers obtained third-party lending from various banks and put between $5,000 to $100,000 into escrow to secure the closing.
Then came the Great Recession which the opinion says “caused at least some of the contracts...to not close.” Still, the taxpayers took a charitable contribution deduction for the conservation easement. The IRS audited. It disallowed the deduction, apparently taking the view that all conservation easements are impermissible tax shelters. The taxpayers timely sought Tax Court review of the resulting NOD.
After considering the case, including the valuation testimony of two expert witnesses, Judge Holmes found that there was no deficiency, teaching us that conservation easements will work with good planning, good representation, and good luck. Let’s look at each lesson.
Lesson 1: Good Planning
The taxpayers here received their planning advice from local professionals in the Asheville community, including CPA Carol King, Cynthia Eller, then a partner at The Van Winkle Law Firm. These advisors gave various and well documented options to the LLC for how to best develop the land. The decision to develop part into vacation homes while ensure the remainder was conserved thus does not appear to result from the syndicated forms of abusive donations, the kind described in this 2018 criminal complaint. The criminal complaint describes a scheme whereby promoters created LLC’s for customers to “invest” in a conservation easement syndicate by paying money and getting back a big charitable deduction pass-through. Here, these taxpayers could show they were actually planning to invest and make money on the purchase and development of the land. It was just a question of how best to develop the land.
Second, as part of their good planning the taxpayers here dotted all their i’s and crossed all their t’s. They engaged in arms-length transactions at fair market value. The LLC obtained a $5 million loan from an unrelated bank, secured by a portion of the property to be developed. The bank did its own appraisal of the property. They properly reported their deduction by attaching qualified appraisals to their returns justifying the amount of the deduction. Thus, they did not play the disingenuous games that the taxpayers played in Oakhill Woods. See Lesson From the Tax Court: Taxpayer Cannot Cure Reporting Error During Audit, TaxProfBlog (March 2, 2020).
Third, the taxpayers here were not greedy. The LLC in this case claimed a $4.879 million deduction for the conservation easement donation of 89 acres, which works out to about $55,000 per acre. That was considerably more than the $3 million that the LLC members had paid for all the undivided land contributed to the LLC.
However, the 31 acres reserved for development (subdivided into 12 lots of between 1.5 to 5.6 acres) were valued by the local tax appraisal district in 2006 at a total just over $10 million. That works out to about $322,000 per acre. The tax appraisals are for each of the divided lots, each valued at about $1 million except for two outliers, one valued at $2 million and one valued at $67,000. Those values are consistent with the contracted sales price for each of the 5 lots put under contract. For example, a Mr. Danielson bought Lot 9, about 1.8 acres, for $750,000. That’s $416,000 per acre. Dr. Kumar also paid $750,000 but for a lot size of 3.6, or $208,000 per acre. Either way, the claimed donation amount was relatively modest. As Judge Holmes notes:
“The Kumars and Sapps aren’t asking us to value the property higher than what they claimed on their tax returns. They just want us to find that there were no deficiencies, so we need not even determine the actual value of the conservation easement. We just need to determine whether they valued the conservation easement so high as to create deficiencies. And we do not. *** we find it more likely than not that the conservation easement was worth at least what [they] claimed on their tax returns.”
Lesson 2: Good Representation
The taxpayers here were well represented during the Tax Court litigation. The biggest victory for the taxpayers here was in obtaining an IRS stipulation that their donation was “exclusively for a conservation purpose.” That stipulation meant that the only IRS argument left---aside from valuation---was the argument that the amendment provision violated the perpetuity requirements. By the time Judge Holmes considered this argument, however, the Tax Court’s Pine Mountain decision (rejecting the proposition that all amendment provisions created a per se violation of the perpetuity requirement) had been affirmed by the Eleventh Circuit.
So all that was left here was valuation. The NOD found that the LLC’s conservation easement was worth only $720,000, not the claimed $4.1 million.
The valuation issue looked bad for the taxpayers. Both they and the IRS introduced expert testimony on valuation. The IRS expert supported a value of $720,000. Unfortunately, the taxpayers’ own expert valued the donation at only $1,250,000. That is still way below the $4.1 million claimed by the LLC.
Here’s where the taxpayers got lucky. They drew Judge Holmes.
Lesson 3: Good Luck
Valuation is messy. Quite often the Tax Court will split the baby when confronted by two equally credible expert witness valuations. In fact, the Eleventh Circuit in Pine Mountain criticized that practice in its opinion remanding that case back for a more thorough valuation determination.
Judge Holmes, however, is nothing if not an independent thinker. One sees that in many of his opinions where he takes a fresh, creative look at a situation to find an angle that others may not have considered. Perhaps the best example of that is his prescient concurrence in Graev v. Commissioner, 149 T.C. 485 (2017).
Here, Judge Holmes not only rejected both experts’ bottom lines but he actually found that “the FMV of the conservation easement as at least the amount claimed by SS Mountain.” Op. at 26 (emphasis in original). The basis for that finding was that the taxpayers got lucky in their timing. Let's look.
Judge Holmes carefully relied on the Treasury Regulations guidance. He first noted that here, as is usual, there were no comparable sales. He then proceeded to analyze valuation using the before-and-after test.
First, Judge Holmes was able to find a solid “before” value with respect to the 12 lots slated for development. He found that that value was $8 million dollars. He relied on three facts: (1) the contract price of 5 lots, including three contracts with buyers who were not members of the LLC, established a fair market value of $750,000 per lot, regardless of acreage; (2) an unrelated bank lent the LLC $5 million dollars to develop the property, secured by the un-sold lots and requiring that each of those lots be sold for at least $750,000; and (3) the 2006 county tax appraisals of 11 of the 12 lots showing a value close to the actual contract prices for the unimproved land.
Second, Judge Holmes concluded that the “after” value of the 12 lots remained the same $8 million. He found that while there were some reasons to think the conservation easement increased their value, there were equal reasons why the conservation easement would decreased their value.
Third, Judge Holmes accepted the IRS expert’s opinion that the proper fair market value of the donated land, after donation, was $560,000.
Fourth, there still remained the problem of determining the “before” value of the donated land. Judge Holmes solved that problem with this logic: Since the LLC claimed a total contribution amount of $4.879 million for the conservation easement donation and since the value of the donated land after the contribution was $560,000, that means “for the deduction to be sustained, the 'before value' of the conserved land would have to be at least $5,439,000.”
Judge Holmes then gave two reasons why the donated property’s “before” value was more than $5,439,000. First, he found that the land donated was comparable to the land retained for development. Therefore, using the price per lot, he divided $5,439,000 by the 25 donated lots. The resulting $217k per lot was far lower than the $750k price for the lots actually sold. Judge Holmes concluded “neither of the experts and none of the witnesses suggest any difference in their value that leads us to find it reasonable to think they were worth less” than the $217k per lot that would need to be the before value in order to sustain the taxpayers' deduction.
Second, Judge Holmes uses a price-per-acre analysis similar to the one I give above. Both reasons support his ultimate conclusion that the “before” value of the donate property was at least the amount necessary to support the donation valuation of $4.879 million.
The real key to the case is that all of these fair market values are to be determined as of the date of the donation, at the height of a real estate bubble. This is where the taxpayers got lucky a second time. They did all of these transactions at the top of what Judge Holmes calls “an amazingly frothy local real-estate market in 2006.” Sure, the Great Recession came and wiped out the best-laid plans. So the valuation of this donation would be very, very different if all of these transactions had taken place in 2008 and not 2006.
It’s good to plan carefully. It’s good to have good representation. But it’s even better to be lucky in your timing.
Coda: If you don’t know much about conservation easements, you should really visit Professor Nancy McLaughlin’s SSRN page. Professor McLaughlin, the Reporter for the Uniform Law Commission's Uniform Conservation Easement Act Study Committee, is probably the leading academic expert on this subject and on her SSRN page you can download any one of a number of highly informative and well written articles. Each year she updates this comprehensive outline on the current state of case law and other developments in the conservation easement arena.
Bryan Camp is not the leading academic expert on much of anything, but he is still the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return each Monday for a new Lesson From The Tax Court.