Valuing conservation easements for charitable contributions

Editor: Mark G. Cook, CPA, CGMA

On May 30, 2024, the Tax Court issued an opinion on a charitable contribution deduction linked to the valuation and donation of certain conservation easements. The case, Excelsior Aggregates, LLC, T.C. Memo. 2024-60, centered on three of 13 subdivided parcels of land that the taxpayer, Excelsior Aggregates LLC and its affiliates (EAG), valued as a conservation easement totaling 4,608 acres, and on which EAG claimed $187 million as a charitable contribution in 2014. The IRS argued that the valuation methods used in determining the charitable contribution deductions for the tax year in question were improper.

The land under consideration had been purchased by the taxpayer in February 2014 for $9.5 million. After the purchase, the land was subdivided into 13 subplots and donated as a conservation easement along with a full fee simple interest at the end of 2014. In the year of the donation, EAG claimed a charitable deduction of $187 million, based on valuations conducted by third-party appraisers employing various valuation methods, including the highest-and-best-use (HBU) methodology, discounted-cash-flow (DCF) analysis, and comparable-sales method, in determining the donated property’s fair market value (FMV).

The IRS determined that the 1,872% increase in appraised value from the purchase price of $9.5 million under the taxpayers’ valuation reports was improper and excessive. The IRS proposed to disallow most of the charitable contribution deductions taken in excess of $30 million on the three parcels for the tax year ended Dec. 31, 2014. The IRS provided Final Partnership Administrative Adjustment (FPAA) notices to EAG summarizing this position. EAG did not agree with the proposed adjustments in the FPAAs and petitioned the Tax Court for a review of the FPAAs. The Tax Court ultimately issued a decision upholding the valuation method used by the taxpayer for one parcel of land and upholding the IRS’s determination of a severely reduced valuation for the other two parcels.

This item examines in greater detail the various tax concepts and considerations relevant to the Tax Court’s decision and aims to provide greater clarity as to the outcomes in favor of EAG and the IRS on the various real property valuations.

As part of this case, only three specific parcels were evaluated within the scope of the trial proceedings. However, the parties agreed to a stipulation to have the remaining 10 parcels be bound to the resolution and ruling on the three selected parcels and have any valuation methods apply across all subdivided plots. The material nature of the IRS’s proposed adjustment highlights a need to understand acceptable valuation methods for charitable deductions for conservation easements and their impact on landowners engaged in or seeking to engage in conservation easements and tax professionals.

What is a conservation easement?

A conservation easement is a voluntary tool used by a landowner that permanently restricts certain uses and activities to protect the conservation values associated with a property’s natural resources and wildlife habitat. The property owner usually retains many private property rights as part of the designation, referred to as a fee simple interest.

Conservation easements are used in various instances to preserve and protect land, providing targeted benefits to landowners, communities, and the environment. Common scenarios in which conservation easements are typically employed include:

• Environmental protection;
• Agricultural preservation;
• Scenic preservation;
• Historic preservation;
• Public recreational use;
• Urban planning and smart growth; and
• Climate change mitigation.

While conservation easements have certain sociocultural and environmental benefits, a strong draw to these arrangements also lies in the potential tax benefit for the landowner. For tax purposes, landowners may be eligible for significant federal income tax deductions for the charitable contribution of a conservation easement. Charitable donations normally require donation of the full interest in the property to be eligible for a tax deduction (Sec. 170); however, the requirements differ for a conservation easement contribution to be claimed as a deduction. One primary difference is the requirement for a conservation restriction in perpetuity, which provides that the donated real property interest be reserved for specific conservation uses indefinitely (see Regs. Sec. 1.170A-14 for a complete list).

The value of the charitable deduction for a conservation easement is generally based on the difference between the property’s FMV before and after the easement is granted, commonly referred to as the “before and after” approach (Regs. Sec. 1.170A- 14(h)(3)(i)). Apart from the income tax deduction, tax benefits also extend to potentially lowering property taxes if the value of the land is reduced due to the restrictions placed on its use. In certain scenarios, conservation easements can also reduce the value of an estate, lowering the tax liability for its heirs.

Understanding fee simple interest

While landowners generally relinquish control over decision-making power on the use of the property after its designation as a conservation easement, they do retain certain rights to specific aspects of the donated property. The landowners still legally own the land on paper and retain the right to sell, transfer, or mortgage the land so long as these actions fall within the agreed-upon stipulations for the land’s use under the conservation easement agreement. Examples of other retained rights may be an entitlement of license, profit, and leasehold decisions of the land. In Excelsior Aggregates, the court held that the donation of the fee simple interest in addition to the conservation easement resulted in the complete donation of the property with no retained rights, supporting an elevated valuation of the charitable contributions deduction taken on the 2014 tax return for one of the parcels of land.

This case highlights the importance of finding a valuation of the fee simple interest when considering a charitable deduction using a conservation easement. The Tax Court emphasized, though, that the value of the conservation easement and the fee simple interest combined should not exceed the FMV of the donated property.

Deductions for charitable contributions

Sec. 170 is the primary governing provision allowing the federal tax deduction for charitable contributions in the United States. In general, a charitable deduction includes any charitable contribution made during the tax year of a full interest in the property contributed, subject to certain limitations. Charitable giving, donations, and contributions come in many forms. Deductions for a charitable contribution of a conservation easement are addressed in Regs. Sec. 1. 170A-14. The regulation provides more clarity around conservation easement contributions and charitable contribution deductions for them, stating: “A qualified conservation contribution is the contribution of a qualified real property interest to a qualified organization exclusively for conservation purposes. To be eligible for a deduction under section 170(h) and this section, the conservation purpose must be protected in perpetuity.”

With a growing number of taxpayers seeking to participate in conservation easements — and given that conservations easements vary widely in their use, purpose, and value — the IRS has attempted to label certain arrangements as “syndicated conservation easements,” stamping them as prohibited listed transactions (also known as tax-avoidance transactions). Syndicated conservation easements, as far as the IRS has argued, generally fail to meet certain tests under Sec. 170. In Excelsior Aggregates, the IRS contended that the land parcels represented a syndicated conservation easement because the charitable contributions “significantly exceed[ed] the amount invested” (see Notice 2017-10). Thus, the elevated appraisal values as compared to the original cost were considered an abusive tactic with the aim of circumventing the U. S. tax system by a promoter of abusive transactions.

Generally, for any contribution of property to be eligible as a charitable deduction, the taxpayer must obtain a “qualified appraisal” and retain other documentation related to the contribution (see Sec. 170(f)(11)(E)(i)). One key point at the heart of Excelsior Aggregates was whether the property valuations conducted by the taxpayer’s third-party appraiser were qualified appraisals, using appropriate valuation methods to derive an impartial and dependable FMV of the conservation easements. The core of the IRS’s argument was that EAG and its associates engaged in a syndicated conservation easement transaction and that the appraisal methods used were not appropriate for the various parcels of subdivided land, an argument that was sustained for two of the three parcels under examination by the Tax Court.

Valuation methods

With the nature of the tax considerations revolving around the marketable value of the charitable contributions, the Tax Court sought to verify what FMV methodologies were relied upon for valuing the real property and whether such methods rose to the level of a qualified appraisal. For conservation easements, a taxpayer must look to Regs. Sec. 1.170A-1(c) (2) , which defines FMV as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.” Because the definition of FMV is somewhat opaque, without any further guidance, finding the true value of real property can be considered a subjective exercise.

The Tax Court over the years has provided various guideposts to help taxpayers and practitioners in evaluating reasonable values of real property when engaging in business transactions. While the taxpayer in Excelsior Aggregates attempted to employ a number of valuations methods, such as sales comparisons and the DCF analysis, the court narrowed in on one method that has been relied upon by the courts for years.

The cornerstone method of determining a valid FMV of property is tied to the property’s HBU on the valuation date. The HBU method is a key principle in real estate valuation and represents the most probable and legally permissible use of a valued property. Other factors to consider in determining HBU extend to potential ongoing profitability, financial feasibility, and maximum use and utility of the property (Mitchell, 267 U. S. 341, 344–45 (1925)).

The IRS argued that, in line with other similar cases, the best valuation for real property is the most recent sales price when sold reasonably close to a valuation date (Ambassador Apartments, 50 T.C. 236, 243–44 (1968)). Where possible, in the case of conservation easements, this valuation method should serve as the best “before” value of the land.

Before-and-after approach

The before-and-after approach is a widely accepted method used to determine the FMV of a conservation easement for the purpose of calculating the allowable charitable contribution deduction. This approach requires an appraisal of the property immediately before the granting of the easement (“before” value) and an appraisal immediately after the easement is granted (“after” value). The difference between these two values represents the value of the conservation easement and the basis for the tax deduction. Regs. Sec. 1.170A-14(h)(3)(i) explains that, in the absence of a direct comparable-sales method for determining value, the next best method that should be employed is the before-and-after approach.

A restriction is placed if the owner of the land receives or can reasonably expect to receive a financial or economic benefit greater than the value of the easement. If so, then no charitable contribution deduction will be allowed. For example, if the value of the land increases due to the conservation easement, no deduction would be allowed. In Browning, 109 T.C. 303 (1997), the Tax Court applied the before-and-after method to determine the value of a conservation easement, emphasizing the importance of credible appraisals and market-based evidence in valuing conservation easements. In its opinion in Excelsior Aggregates, the Tax Court cited Browning and other authority from Hughes, T.C. Memo. 2009-94.

Court finding and adjustments

The before-and-after approach played a crucial role in determining the FMV of EAG’s donated parcels. In reviewing the various valuation methodologies, the court held firm on the following:

• Highest and best use: The court scrutinized the HBU assumptions, especially the feasibility of commercial sand and gravel mining. Testimonies and historical data indicated that prior mining operations had left the parcels with limited economically viable sand and gravel resources.
• Sales-comparison method: This method, comparing the subject properties with comparable properties sold in the market, was pivotal. The court found the IRS’s comparisons more credible than those presented by the taxpayer’s appraiser.
• DCF analysis: In some cases, the taxpayer’s appraiser attempted to use DCF to justify higher valuations. However, the court found these analyses speculative and unsupported by market realities.

By critically evaluating the HBU assumptions and the methodologies used by the taxpayer’s appraiser, the court largely sided with the IRS’s lower valuations for Parcels 1 and 2, while accepting the taxpayer’s valuation for Parcel 3 as summarized below:

Parcel 1:

• Taxpayer’s claimed “before” value: $16,700,000
• IRS’s determined value: $693,000
• The Tax Court upheld the IRS’s significantly lower valuation, agreeing that the taxpayer’s high valuation based on sand and gravel mining was unrealistic, given the conditions and historical data of the property.

Parcel 2:

• Taxpayer’s claimed “before” value: $14,950,000
• IRS’s determined value: $810,000
• The court agreed with the IRS’s valuation, significantly reducing the allowable deduction.

Parcel 3:

• Taxpayer’s claimed “before” value: $2,070,000
• IRS’s determined value: $1,975,000
• The court largely accepted the taxpayer’s valuation, resulting in a deduction close to the claimed amount.

The Tax Court’s opinion in Excelsior Aggregates highlights the necessity of realistic and market-supported valuation methods in claiming tax deductions for donations of conservation easements.

Editor Notes

Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Cook at mcook@singerlewak.com.

Contributors are members of or associated with SingerLewak LLP.