Conservation easement deductions denied

In Carter v. Commissioner, T.C. Memo. 2020-21 (Carter), the easement deed restricted use of the property but retained a right to build single-family dwellings in certain areas.

In Railroad Holdings, LLC v. Commissioner, T.C. Memo. 2020-22 (Railroad Holdings), the easement deed provided that if the easement were extinguished, sale proceeds would be allocated to the charitable organization based on the fair market value of the conservation easement as of the date granted, rather than a future proportionate share of the proceeds.

Background – Carter

The petitioners in Carter were joint owners of Dover Hall Plantation, LLC (DHP), which owned a large tract of land in Georgia. In 2011, DHP conveyed a 500-acre easement to the North American Land Trust (NALT). The easement deed restricted use of the property and generally prohibited construction or occupancy of any dwellings. However, DHP retained the right to build single-family dwellings on 11 “building areas,” each no more than two acres with locations subject to NALT approval. Petitioner’s valuation expert described the building areas as being for family use and not for development and sale, but nothing in the easement deed limited the building area residences to those of petitioners or their family members.

DHP claimed a deduction for the conservation easement contribution on its 2011 tax return, and petitioners claimed a related deduction on their individual income tax returns based on their shares of DHP. The IRS issued revenue agent reports (RARs) proposing to disallow the charitable contribution deductions and also proposing a gross valuation misstatement penalty under Code § 6662. The petitioners did not administratively appeal, and the IRS then issued notices of deficiency with assessments based on the adjustments set forth in the RARs.

Code § 170 generally allows a deduction for a qualified conservation contribution of a qualified real property interest to a charitable organization. Conservation requires a purpose of preserving land for recreational or educational uses by the general public, protection of a relatively natural habitat of fish, wildlife plants or similar ecosystem, preservation of open space for significant public benefit, or preservation of a historically important land area or a certified historic structure. For the contribution to be treated as exclusively for conservation purposes and therefore be deductible, the conservation purpose must be protected in perpetuity.

The court noted that prior cases, Belk v. Commissioner, 140 T.C. 1 (2013) (Belk) and Pine Mountain Pres. LLP v. Commissioner, 151 T.C. 274 (2018) (Pine Mountain), impose two distinct perpetuity requirements: (1) use of the property must be restricted in perpetuity, and (2) the conservation purposes must be protected in perpetuity. Based on Belk, Pine Mountain, and other cases, the court found that easements allowing donors to change what property is subject to a conservation easement do not grant a use restriction in perpetuity.

Tax Court Decision – Carter

The court was not persuaded by petitioner’s arguments that prior cases involved commercial use as distinguished by petitioners’ residential use, finding that Pine Mountain stands for the proposition that building homes is antithetical to preservation of natural habitat and open spaces. The petitioners further argued that exercise of their rights with respect to the limited building areas would not impair the overall conservation purposes in perpetuity. However, the court rejected this argument because it overlooks the “framing issue” imposed by prior opinions: regardless of whether building houses on 11 two-acre lots would impair the conservation purposes in the entire easement, it would impede achievement of the conservation purposes within each building area. The court notes that petitioners’ argument might support perpetual protection, but it does not establish the perpetual restriction requirement as interpreted by the Pine Mountain case.

The court determined that the restrictions in the easement that would apply to selected building areas would not prevent development of single-family homes, and that use would not preserve open spaces, natural habitats, or similar ecosystems. The court concluded that this would be antithetical to the easement’s conservation purposes. Based on this analysis and following the Pine Mountain decision, the court held that the easement granted by DHP to NALT did not meet the perpetual restriction requirement of § 170 and was not a qualified real property interest, and that as a result the conveyance was not a qualified conservation contribution. Therefore, the court denied the deduction claimed by the petitioners for the conveyance.

As noted, the IRS also assessed gross valuation misstatement penalties in Carter. The court rejected assessment of these penalties because the IRS failed to establish timely supervisory approval prior to imposition of the penalties.

Background – Railroad Holdings

In Railroad Holdings, the petitioner executed a conservation easement of a 452-acre parcel of property in favor of the Southeast Regional Land Conservancy, Inc. (SERLC). For purposes of the opinion, the court assumed that SERLC was a qualified organization and also assumed that the easement qualified as a charitable contribution deduction, apart from the issue addressed in the case.

The easement deed in Railroad Holdings set terms for possible future extinguishment of the easement and sale of the property. In this event, the deed provided that the value of SERLC’s right and interest would be the fair market value as of the date the conservation easement was granted. The deed further provided that upon a future sale, SERLC would be entitled to at least this initial fair market value, which was to remain constant.

The petitioner claimed a deduction for the conservation easement contribution on its 2012 tax return. On audit, the IRS determined that the donation was not a qualified conservation contribution under Code § 170 and disallowed the deduction. The petitioner petitioned the Tax Court, and the IRS moved for summary judgment on this conservation easement issue.

Tax Court Decision – Railroad Holdings

The IRS argued that the allocation of sale proceeds in the event the easement is extinguished and the property is sold failed to protect the conservation purpose in perpetuity, as required under Code § 170. The court noted that Treasury regulations interpreting § 170 acknowledge that an easement may be extinguished, and thus not last in perpetuity. However, the regulations provide that if extinguishment does occur, the donation may be deemed to be in perpetuity if the proceeds are paid to the donee organization and used for conservation purposes. For a deduction to be allowed under these circumstances, the donation must, at the time of the gift, vest the donee organization in an immediate property right with a fair market value that is at least 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. This proportionate value of the donee’s property rights is required to remain constant under the regulations.

The petitioner in Railroad Holdings argued that its deed used the phrase “at least” so that SERLC would receive a minimum portion of future proceeds but was not capped by the formula, and further argued that a declaration by SERLC and construction of the language supported this position. Thus, the petitioner argued that SERLC would receive proportionate proceeds upon a sale, and the deed simply set a minimum floor below that proportionate amount. The court found no language in the deed to support petitioner’s arguments, and the court determined that a donee must obtain a property right to a proportionate share of proceeds. The court held that where a donee’s only right under a deed is to receive a less-than-proportionate share with only a hope of more proceeds, the deed does not comply with the regulations.

The court also relied on another recent case, Coal Property Holdings, LLC v. Commissioner (October 28, 2019) (Coal Property) for the proposition that a future allocation of proceeds in a conservation easement deed could not reduce a donee organization’s proportionate share of the proceeds. In Coal Property, the deed contained a formula that reduced the donee’s share based on value increases after the donation attributable to improvements, and the court held this was not permitted. Similarly, in Railroad Holdings the court found that SERLC’s proportion of potential extinguishment proceeds would shrink over the years if the underlying property appreciated, and concluded that a shrinking contribution cannot be “perpetual” as required by the regulations.

Based on these fact findings, the regulations, and prior cases, the court determined that the conservation purpose of the easement in Railroad Holdings granted to SERLC was not protected in perpetuity under Code § 170. As a result, the court held that the IRS properly denied the deduction and granted the IRS motion for summary judgment.

Conclusion

The Carter and Railroad Holdings cases demonstrate the need to carefully draft conservation easement deed language to protect the donee organization’s interest and conservation purposes in perpetuity, particularly if the deed reserves rights for the donor. These cases, and the other cases referenced by the court, are also a good reminder that conservation easements are an active audit and litigation issue for the IRS.