The Changing Landscape of Conservation Easements: Appendix

This appendix discusses, in alphabetical order, various recent and landmark decisions affecting the law of conservation easements. It accompanies the article “The Changing Landscape of Conservation Easements,” 42 The Tax Adviser 166 (March 2011).

Bruzewicz: Use of Strict Compliance Regarding Substantiation Rules

In Bruzewicz,1 the donors executed a facade easement on their home in November 2002 and claimed a deduction on their federal income tax return, but failed to comply with the substantiation requirements of Sec. 170(f)(8)(A) (obtaining contemporaneous written acknowledgment of the contribution by the donee organization) and other substantiation requirements in the regulations. The taxpayers provided a form letter from the donee dated early the following year, which stated that a list of their contributions for 2002 was attached. The attachment listed two cash contributions and indicated only that the type of donation was “easement.”

The court determined that whereas the letter provided documentation of the two cash contributions made by the taxpayers, the word “easement” next to each did not substantiate the facade preservation easement, as the taxpayers asserted. In addition, the statute is clear about the need for a written acknowledgment, and Secs. 170(f)(8)(A)–(C) spell out in detail what must be included in the acknowledgment and when the acknowledgment must be received. Moreover, the court found that the donors’ appraisal failed to provide the appraisers’ qualifications or a description of the easement itself, as required by Regs. Sec. 1.170A-13(c)(3).

The court explained that the doctrine of substantial compliance as applied in the Seventh Circuit applies only to cases in which the taxpayer had a good excuse, though not a legal justification, for failing to comply with either an unimportant requirement or one that was unclear or confusing in the regulations or the statute. The court found that the substantiation requirements here were neither unclear nor confusing and that they could not be considered unimportant. Therefore, not only was the doctrine of substantial compliance not available here, but the taxpayer’s substantiation would not be considered to be substantial compliance in any event.

Takeaway: This court reminds us that the Tax Court’s interpretation of substantial compliance is not binding upon the district court system. Although the court does not indicate precisely where the lines are drawn for a finding of substantial compliance, it does point to the opinion in Tamulis2 as well as other cases cited in that opinion.

Glass: Protecting the Conservation Purpose

In Glass,3 the taxpayers had donated conservation easements on undeveloped lakefront and shoreline property to a nonprofit nature conservancy. The IRS challenged the easement on the basis that the encumbered property (1) was too small (the property’s dimensions were generally 460 feet in width from north to south and 1,055 feet in depth from east to west), (2) allowed the taxpayers too many retained rights, and (3) failed to restrict the building rights of neighboring property owners.

The court found that the relatively small size of the encumbered property did not prevent this conservation easement from being valid. Precluding conservation easements of relatively small size would preclude larger conservation benefits achieved by aggregate donations of relatively small conservation easements, each serving its own stated conservation purpose.

Each reserved right must be carefully limited to ensure that the identified plant and wildlife habitats (the conservation purpose) on the encumbered property remain protected. A donor may retain the right to prune, trim, or cut trees for the limited purpose of preserving a scenic view or for safety and may retain the right to erect structures on the property as long as it is done in a manner and location that minimizes interference with the identified plant or wildlife habitat, although the land trust may not allow such construction if it is found to be inconsistent with the easement’s conservation purpose. A donor may also retain the right to maintain and establish footpaths that enhance rather than diminish the ability of plant and wildlife habitats to flourish because they stop people from trampling the plants that are being protected and from jeopardizing the structural integrity of the land.

There is no statutory or regulatory provision requiring consideration of neighboring property owners’ building rights when determining whether a conservation easement is a qualified conservation contribution. Donors cannot realistically limit building on property outside their control.

Takeaway: This opinion provides excellent instruction in drafting a conservation easement in which the donor retains specific rights while maintaining the conservation purpose, and it should also encourage landowners who may believe that their holdings are too small to be deemed valid conservation easements. Moreover, the opinion indicates that the courts appreciate the effect of multiple easements in a region and the collective impact that aggregation might have on an ecosystem.

Hughes: IRS Argued That Some Easements Have No Value

In Hughes,4 the taxpayer had granted a conservation easement on two large parcels of property in a sparsely populated area of Colorado. The court sustained the original deficiency determined by the IRS on the basis that the valuation of the easement was more generous than would have been calculated by the court.

The court denied the taxpayer’s expert’s appraisal of the parcel’s highest and best use as residential development on the basis that there was not significant demand for residential property in the area and determined that the highest and best use for the property before the grant of the easement was continued agricultural and recreational use. However, it also denied the IRS’s argument that the conservation easement had no, or only nominal, impact on the fair market value (FMV) of the parcels for two reasons. First, by granting the easement, the taxpayer had prevented any future purchasers from granting a conservation easement and thus receiving the benefit of Colorado state tax credits. Second, the court considered the possibility that although there was little demand in that area for residential property at the time of granting the easement, residential development might be a realistic possibility in the future. These factors should have been reflected in the diminution in FMV.

Takeaway: This case is significant as one of the recent cases in which the IRS has failed in its assertion that the donor’s easement has zero value. The court’s rejection of this argument is rooted in the recognition that a conservation easement is a perpetual restriction on the use of the property and therefore cannot be valueless. Further, this decision is an important indication that the courts recognize that conservation easements have significant value.5

Kiva Dunes Conservation, LLC: Easement Valuation—Hiring the Best Appraiser Available

In Kiva Dunes,6 the taxpayer placed a perpetual conservation easement on Kiva Dunes Golf Course, a 140.9-acre piece of property located in Baldwin County, Alabama, and claimed a charitable contribution deduction of $30.6 million for the easement. The only real issue at trial was the valuation of the easement for purposes of determining the amount of the allowable deduction.

The taxpayer’s appraisal used the comparable sales method to determine the “after” value of the property, based on taking the actual sale prices of property similar to the subject property and then adjusting them upward or downward based on comparisons with the similar property. The appraisal made adjustments for differences in market conditions, location value, access and visibility, size, availability of utilities, topographical and wetland characteristics, and financing terms. The only adjustments made by this court to the comparable price were the cost of turning the unimproved real estate into a comparable golf course property and depreciation of the improvements.

Takeaways: Kiva Dunes is valuable for three reasons: (1) it provides a valuable explanation of IRS valuation of conservation easements, (2) it gives an illustrative lesson in the value of appraisals prepared by appraisers who are not only experienced in appraising land of the type under easement but also knowledgeable about the specific locale and market in which the property is situated, and (3) it confirms that a conservation easement may be successfully upheld on golf course property, long thought to be a risky undertaking.

In addition, because the IRS has been defeated on recent challenges such as Kiva Dunes due to being outmaneuvered by donors’ experts (appraisers), it is wise to anticipate that where larger sums are involved, the IRS is likely to invest in appraisers who are more highly qualified than in the past in appraising not only land of the type under easement but the specific locale in which the easement is situated.

Richey: Appraisal Workfile Protected by Attorney-Client Privilege

In Richey,7 The court denied the IRS’s motion to enforce summons of the appraiser’s workfile containing analysis of a conservation easement claimed by the donors. Instead of responding to the IRS demand, the appraiser turned over his workfile to the donors’ attorney and did not respond to the demand. The law firm had not prepared the donors’ returns; however, the appraisal had been prepared at the law firm’s direction to aid the attorney in providing legal advice to the taxpayers, bringing any notes in the workfile under attorney-client privilege. Since the workfile itself was prepared in anticipation of future litigation, it received work-product protection.

Takeaway: As a result of Richey, donors may be able to strengthen their position in case of audit by requesting that their attorney retain the appraiser to value the easement.

Satullo: Recording the Subordination of the Mortgagee

In Satullo,8 a facade easement did not qualify as a conservation contribution. Although the deed of gift was intended to be effective in December 1985, it was not recorded until January 1988, two years after the mortgagee had recorded its security interest in the property. State law provided that until an easement is recorded, its intended property restrictions are legally unenforceable. In this case, the deed of gift was not recorded under state law until after the mortgagee had recorded its security interests in the property, which gave the mortgagee priority interest over the easement.

The court considered Regs. Sec. 1.170A-14(g)(3), providing that a deduction for an easement will not be disallowed if on the date of the easement donation the possibility that the easement may be defeated by the performance of some act or occurrence of some event is “so remote as to be negligible.” However, based upon the fact that the donee organization had historically lost between 38% and 45% of its accepted easements to foreclosure proceedings, the court considered the possibility that the donee organization might lose the easement in a foreclosure proceeding to be far from remote, and the taxpayers had not proven otherwise.

Takeaway: This opinion is a reminder of the importance of strictly adhering to the qualified conservation contribution requirements. Although there is a possibility of some reprieve if the taxpayer has not strictly followed the requirements, there is considerable risk associated with such a strategy.

Simmons: Use of Substantial Compliance Regarding Substantiation Rules

In Simmons,9 the taxpayer donated facade easements on urban row houses that were designated historic properties. The IRS attacked the easements primarily on the basis that substantiation requirements were not met and that they were duplicative of local preservation laws.

Substantiation requirements were not met: The court found that although the taxpayer had not strictly complied with substantiation requirements of Sec. 170 and the appraisals did not meet the requirement of a qualified appraisal as defined in Regs. Sec. 1.170A-13(c)(3), there was sufficient language to express intent to subordinate the rights of the mortgage holders and sufficient detail in the appraisals to consider that the taxpayer had substantially complied with the Sec. 170 substantiation requirements.

Easements were duplicative of local preservation laws: The court determined that although the easements were duplicative in some respects, they would be subject to a higher level of scrutiny and enforcement in the hands of the donee than from local government officials. This additional level of oversight would affect the subsequent sale price. As a result, the value of the easements (the reduction in FMV) for these properties was determined to be 5% of its FMV before the easement.

Takeaway: The Simmons opinion seems inconsistent with other recent cases such as Bruzewicz10 and Gomez,11 in which courts have declined to apply the substantial compliance doctrine and have disallowed the donor’s charitable contribution deduction where the donor failed to meet the applicable substantiation requirements to the letter. Because courts are not always consistent in their application of the substantial compliance doctrine, and the IRS’s auditing position has been to insist on strict compliance, it is imperative that donors and donee organizations strictly comply with the recordkeeping and substantiation requirements for donations of conservation easements. Failure to do so could cost the taxpayer his or her tax deduction.12

Symington: Valuation Using the Before-and-After Method

In Symington,13 an early and frequently cited case, the only real issue to be determined was the valuation of the open-space easement. The opinion provides an excellent explanation of the before-and-after method of valuation, noting that in determining the FMV of property, the realistic, objective potential uses for property control the valuation. Thus, in determining the reasonable and probable use that supports the highest present value, the court will focus on the highest and most profitable use for which the property is adaptable and needed or likely to be needed in the reasonably near future. The property’s FMV is not affected by whether the owners actually have put the property to its highest and best use or whether they ever intend to do so, as long as the highest and best use is not prohibited by law.

Easements on adjacent property: Interestingly, in determining the property’s FMV, the court considered the location of the property subject to the easement in proximity to important landmarks in the area, including the existence of mountains in two directions. Contributing to the property’s FMV was the consideration that adjacent property had building restrictions similar to those on the donor’s deed of easement, which assured an unobstructed view of the Blue Ridge mountains in perpetuity and assuring that no major subdivision would occur on that adjacent property.

Takeaway: This case raises the interesting prospect that the valuations of later easements may be affected by earlier easements placed on adjacent or nearby property.

Turner: Deed Must Limit Some Right Not Already Limited by Local Law

In Turner,14 a real estate developer had acquired unimproved land in an historical overlay district in Fairfax County, VA, near the home of George Washington. Of the entire parcel, approximately half was located in a 100-year flood plain and was not available for residential development; of the remaining property, a small portion was rezoned for use as a commercial building site. Property development of the parcel was subject to county regulations that were more stringent for property within an historical overlay district. Thirty lots were permissible under zoning in effect at that time; county approval would have been required for denser zoning usage. Nevertheless, the taxpayer claimed a contribution deduction for a contribution of a conservation easement restricting the development on the property to 30 building lots on the erroneous assumption that he was entitled to develop up to 62 residences on smaller lots. Ultimately, the taxpayer sold the land without applying for a change in the zoning.

No conservation purpose found: In what is seen as a just result by most commentators, the Tax Court disqualified the grant because it did not satisfy the conservation purposes required under Sec. 170(h)(4)(A); the deed did not preserve open space or an historically important land area15 or a certified historic structure. The easement only limited the taxpayer’s development of the property to its maximum capacity within the property’s existing zoning classification.

Takeaway: A taxpayer may not claim a qualified conservation contribution deduction unless the easement granted reflects a limitation on some use of the property that is not already limited by local zoning or land use laws. Existing limitations on the use of the land, based on the specific facts and circumstances of the particular parcel of land, must be considered in valuing the property and any easement placed thereon.

Footnotes

¹ Bruzewicz, 604 F. Supp. 2d 1197 (D.C. Ill. 2009).

² Tamulis, 509 F.3d 343 (7th Cir. 2007).

³ Glass, 124 T.C. 258 (2005), aff’d, 471 F.3d 698 (6th Cir. 2006).

⁴ Hughes, T.C. Memo. 2009-94.

⁵ Note that because one of the parcels had been held by the taxpayer for less than a year at the time of easement, the opinion also provides an explanation of the rules applicable to property held for less than one year.

⁶ Kiva Dunes Conservation, LLC, T.C. Memo. 2009-145.

⁷ Richey, No. 09-35462 (9th Cir. 2011).

⁸ Satullo, T.C. Memo. 1993-614.

⁹ Simmons, T.C. Memo. 2009-208.

¹⁰ Bruzewicz, 604 F. Supp. 2d 1197 (D.C. Ill. 2009).

¹¹ Gomez, T.C. Summ. 2008-93.

¹² For more information, see the Miller Chevalier fact sheet on substantiation requirements, available at http://tinyurl.com/landtrustalliance

¹³ Symington, 87 T.C. 892 (1986).

¹⁴ Turner, 126 T.C. 299 (2006).

¹⁵ In Turner, the Tax Court reasoned that the historic preservation requirement might be met by showing the preservation of land, which is important in its own right (“historically important land area”) or in relation to historic structures (“certified historic structure”). Whereas land surrounding an historic structure makes that land historically significant, proximity alone does not provide a basis to support a claim of protection of an historic structure. Unless the land itself is historically significant (e.g., a Civil War battlefield), the taxpayer cannot claim that the property is independently (historically) significant.