Certain Deductions of Conservation Easements Now Require IRS Notification
If you contribute a conservation easement to a qualified organization, then you’re not just protecting the natural value of that land for future generations. You may also be able to claim that contribution as a charitable deduction on your tax return.
If you have invested in or plan to invest in a pass-through entity so you can benefit from a deduction for a charitable contribution of a conservation easement, a recent notice from the Internal Revenue Service (“IRS”) could affect you. And, if you are considering whether to donate a conservation easement to charity with respect to property you already own, the notice may provide some guidance about how the IRS views such a donation.
It’s well known that the value of charitable contributions you make can be deducted from your personal income tax return, subject to certain limitations. You can also reduce your tax bill based on your share of contributions that are made by a pass-through entity of which you are an owner. Special benefits apply in the case of contributions of qualified conservation easements.
What Is a Conservation Easement?
The purpose of a conservation easement is to conserve property and protect its resources and natural value in perpetuity. A conservation easement is a voluntary legal agreement that limits or prevents certain types of uses and/or development from taking place on the land for as long as the land remains in private hands. The easement stays in place, even if the property is sold or passed to heirs. The landowner usually enters into the agreement with a private environmental organization or a public agency, which then enforces the landowner’s promise not to engage in certain types of activities on the land. These agreements can often be tailored to fit a landowner’s current use of the property. The landowner gets to retain private ownership and use of the property while protecting the land permanently.
Internal Revenue Code Section 170(h)(1) defines “a qualified conservation contribution” as “a contribution – (A) of a qualified real property interest, (B) to a qualified organization, (C) exclusively for conservation purposes.” Conservation purposes include outdoor recreation; saving the natural habitat of wildlife, plants or fish; preservation of open spaces; and historical preservation. These kinds of restrictions are commonly referred to as conservation easements. Permissible donees include most public charities, land trusts and governmental agencies within the U.S.
Normally, you cannot claim a deduction if you retain an interest in donated property. However, conservation easements are an exception. A charitable deduction is allowed for the contribution of a conservation easement despite the fact that the donor can still use the property that is subject to the restriction.
For example, a rancher can legally restrict construction on a portion of his land, donate the easement to a charity focused on protecting the environment, and claim a charitable deduction on his tax return in the year he made the contribution. He can continue to graze cattle on the property until the property is eventually sold. The sale would subject the purchaser to the same restriction(s), but the seller would retain all proceeds of the sale.
The limitation on this kind of deduction is normally 50% of adjusted gross income for individuals. This is in contrast to the normal limit on the deduction for contributions of capital assets, which is 30% of adjusted gross income. In the case of certain farmers and ranchers, the limitation is raised even more. They can use a contribution of a conservation easement to offset 100% of adjusted gross income. For corporations, the normal limit of 10% of modified taxable income does not apply.
A third benefit of contributing a conservation easement to charity is that the carryover period that applies to charitable contributions in excess of the annual limitation on deductions is 15 years. In contrast, most unused charitable contributions can only be carried forward for five years.
Certain conservation easements can also be created and donated at death to charity or a governmental agency, providing estate tax savings.
The IRS has continually challenged both the valuation of contributions of charitable easements and whether taxpayers have satisfied the technical requirements for either the creation of the easement or the transfer of the easement to the donees.
These challenges have occurred because the IRS believes many taxpayers took improper deductions for contributions. These improper deductions have taken several forms, including inflated appraisals that did not consider any practical or legal impediments to development of the property or that may have been performed by appraisers unfamiliar with the area where the land was located.
In addition, the IRS was aware of promoters who sold interests in partnerships that promised the investors contribution deductions far in excess of their partners’ investments in the partnerships. These partnerships offered little opportunity for profit other than the tax savings from the charitable deduction.
In Notice 2004-41, the IRS said that it would aggressively pursue tax and penalties from taxpayers who claim improper deductions with respect to contributions of easements. The same notice said that the IRS would consider challenging the tax exemption of certain organizations that participate in transactions leading to improper deductions.
What Is New?
In its latest challenge to the contribution of conservation easements, the IRS has designated the donation of a syndicated conservation easement as a listed transaction. Notice 2017-10 describes the listed transaction like this:
An investor receives promotional materials that oﬀer prospective investors in a pass-through entity the possibility of a charitable contribution deduction that equals or exceeds an amount that is two and one-half times the amount of the investor’s investment [emphasis added] […] The investor purchases an interest, directly or indirectly (through one or more tiers of pass-through entities), in the pass-through entity that holds real property. The pass-through entity that holds the real property contributes a conservation easement encumbering the property to a tax-exempt entity and allocates, directly or through one or more tiers of pass-through entities, a charitable contribution deduction to the investor. Following that contribution, the investor reports on his or her federal income tax return a charitable contribution deduction with respect to the conservation easement. (p. 3-4)
By designating certain syndicated conservation easement transactions as listed transactions, the IRS has effectively made it easy to identify taxpayers who made these investments. If you are a participant in a listed transaction for any year, or your tax return reflects tax consequences resulting from the transaction, you must disclose your participation. Any intervening entities are also considered participants and are required to disclose the transaction. No disclosure is required if the transaction was entered into on or before December 31, 2009.
Form 8886, Reportable Transaction Disclosure Statement, must be filed with your tax return for each year you are required to report your participation in any listed transaction, including the deduction for the donation of a conservation easement described in the notice. The form must include a summary of the facts related to the transaction and the amount of the deduction you claimed. You must also file a disclosure statement with IRS Office of Tax Shelter Analysis (“OTSA”) for the first year of your participation.
Form 8886 must be filed for 2016 and for any prior year that is still open under the statute of limitations. If you filed your prior year’s tax returns when they were due, this generally would apply to deductions claimed by individuals during 2013, 2014 and 2015. The due date of Form 8886 will generally be May 1, 2017, for transactions that would have normally required disclosure after December 24, 2016, and prior to May 1, 2017. Older transactions that now require disclosure must be reported by June 21, 2017.
Your failure to make a timely disclosure of a listed transaction will result in a penalty equal to the lesser of 75% of the decrease in tax or $100,000. The maximum penalty is $200,000 for taxpayers other than individuals. The IRS can also impose a special tax shelter penalty equal to 20% of any understatement of tax related to a listed transaction. The penalty rate is increased to 30% if the transaction was not properly disclosed. The IRS will also retain the ability to adjust your return until a year after it receives notification of the transaction.
The penalties that apply to listed transactions may be imposed in addition to any other penalties that may apply to your tax return, including late payment and accuracy-related penalties.
Can a Conservation Easement Still Benefit You?
If you have a genuine desire to prevent development on a portion of your property, you can still claim a charitable deduction for the donation of a conservation easement. Notice 2017-10 is an attack by the IRS on a particular type of transaction that they believe to be abusive. It does not apply to any conservation easements you choose to make or donate with respect to property you already own. It also doesn’t apply if the contribution is made by a pass-through entity that was not promoted as a way to benefit from the contribution of an easement.
Because the IRS has a history of challenging deductions for the contributions of conservation easements, taxpayers need to:
- Make sure all formalities are followed – taxpayers have lost the ability to deduct contributions, because formalities required by their state and local laws weren’t followed.
- Ensure the recipient of the conservation easement is a qualified charity, land trust or state or local government.
- Correctly substantiate the amount – the valuation should be done by a qualified appraiser who is familiar with the location and type of property that you have; preferably, the appraiser will also have specific experience with valuing conservation easements.
This latest notice signals that the IRS is paying particular attention to transactions when the original amount invested is 40% or less than the value claimed as a deduction. However, this is not an authoritative statement that deductions in excess of this ratio will be automatically disallowed. Particularly if you have held your property for a long period of time, the value of an easement could exceed the amount you paid for the property. You should not be dissuaded from claiming a deduction for a legitimate contribution just because a potentially abusive transaction has been identified by the IRS as a listed transaction.
What’s Your Next Move?
Whether you have participated in this type of listed transaction, have made a contribution of a conservation easement, or are planning to make this kind of contribution in the future, consider reaching out to Tim Cherry, CGMA, CPA, Industry Leader in Cherry Bekaert’s Real Estate and Construction Group, for some expert advice. Or you can also discuss your situation with your local Cherry Bekaert advisor.
Do you want to make sure future contributions provide you with the maximum justifiable deduction? Or, do you need some assistance or advice complying with new filing requirements, if you’ve invested in a syndicated investment that is now a listed transaction? Let us be your guide forward, through the process of claiming deductions for conservation easements and the new filing requirements.