Pine Mountain Preserve v. Commissioner: Charitable Deductions for Easements Don’t Pass Muster
The donation of a conservation easement is a long-standing way for property owners to help satisfy their philanthropic urges while securing a valuable tax deduction. Those deductions, though, may be under threat after a recent ruling from the U.S. Tax Court.
Conservation easements often reserve to the property donors future rights to construct structures and additions to those structures, such as single-family homes with sheds, garages or pools. Such easements usually don’t specify the precise location of that construction. Under the new ruling, however, this common practice disqualified the donor from claiming a charitable contribution deduction for the easement.
IRS rejects easement deductions
The case involved a limited partnership that owned 10 adjoining parcels, comprising more than 6,200 acres. Between 2005 and 2007, the partnership granted three easements on undeveloped land — one each tax year — to a charitable land trust.
The 2005 and 2006 easements both reserved for the partnership the right to small parcels of development in the conservation areas. The 2005 easement allowed for residential development and structures, such as scenic overlooks, stables and piers, in 16 building areas. In addition, the building areas could be relocated from the area indicated on the plat, by a man-made lake, to other, potentially more desirable areas. The 2006 easement allowed residential development in six building areas, without defining the locations of those building areas.
Like the first two easements, the 2007 easement recited charitable purposes, generally prohibited development and reserved certain rights. It didn’t, however, designate any building areas where development was permitted or allow any construction.
On the respective federal income tax returns, the partnership claimed charitable deductions for the easements of $16.55 million, $12.73 million and $4.1 million, based on appraisals. The IRS disallowed the deductions. It contended that the easements didn’t convey “qualified real property interests,” as required under the relevant tax regulation, because the restrictions on land use weren’t granted in perpetuity.
Tax Court agrees — in part
On appeal, the Tax Court explained that the central question in such circumstances is whether the easement includes a perpetual use restriction at the time the easement is granted. If building areas can be placed anywhere within the conservation area, the court determined that the perpetual restriction doesn’t attach at the outset to a defined parcel of land, because the developer could later build on land that was intended to be protected forever from any type of development.
Applying this reasoning, the court found that the 2005 and 2006 easements didn’t convey qualified real property interests. The 2005 easement essentially gave the partnership the right to construct a 16-unit residential development that was exempt, for practical purposes, from the easement restrictions. With the 2006 easement, it was impossible to define at the time of the grant which “real property” was restricted from development because the building areas could be anywhere in the conservation area.
The Tax Court upheld the 2007 easement, though. Unlike the other easements, it didn’t allow the partnership to later choose areas for development within the conservation area.
Not surprisingly, an appeal of the case is widely expected. Until then, property owners hoping to reap the tax benefits of conservation easement contributions should take care to specify which, if any, parts of the easements they want to reserve for future development. And, as always, they should retain qualified experts to value those easements for purposes of their charitable conservation easement deductions. (See “Court splits the difference on easement valuation.”)
Court splits the difference on easement valuation
Before taxpayers can claim a deduction for a charitable conservation easement, they must value the property. While the taxpayer in Pine Mountain Preserve lost out on two easement deductions, it fared well on the value of the third. The U.S. Tax Court issued a separate opinion valuing the surviving charitable conservation easement.
The IRS expert had used a comparable sales method to reach a value of $449,000, while the taxpayer’s expert applied a before-and-after approach to produce a value of $9.1 million. The court found the former undervalued the easement by ignoring the property’s development potential. But the taxpayer’s expert overstated the value by overestimating that potential.
Finding that neither expert employed a method that satisfied the relevant tax regulation, the court opted to give equal weight to both values. Even though each rested on errors, the court ruled that both had helpful aspects. Thus, it found that the taxpayer was entitled to a deduction of approximately $4.8 million (the average of the experts’ conclusions).
For additional information contact Nick Sarinelli, CPA, CFE or Doug Collins, CPA on (973) 298-8500 or visit our real estate services page.