This Is Why We Cannot Have Nice Things

I am looking at a case involving a conservation easement.

We have talked about easements before. There is nothing innately sinister about them, but unfortunately they have caught the eye of people who have … stretched them beyond recognition.

I’ll give you an example of an easement:

·      You own land in a bucolic setting.

·      It is your intention to never part with the land.

·      It is liturgy to the beauty and awe of nature. You will never develop it or allow it to be developed.

If you feel that strongly, you might donate an easement to a charitable organization who can see to it that the land is never developed. It can protect and defend long after you are gone.

Question: have you made a donation?

I think you have. You kept the land, but you have donated one of your land-related legal rights – the right to develop the land.

What is this right worth?

That is the issue driving this area of tax controversy.

What if the land is on the flight path for eventual population growth and development? There was a time when Houston’s Galleria district, for example, was undeveloped land. Say you had owned the land back when. What would that easement have been worth?

You donated a potential fortune.

Let’s look at a recent case.

Plateau Holdings LLC (Plateau) owned two parcels of land in Tennessee. In fact, those parcels were the only things it owned. The land had been sold and resold, mined, and it took a while to reunite the surface and mineral rights to obtain full title to the land. It had lakes, overlooks, waterfalls and sounded postcard-worthy; it was also a whole lot out-of-the-way between Nashville and Chattanooga. Just to get utilities to the property would probably require the utility company to issue bonds to cover the cost.

Enter the investor.

He bought the two parcels (actually 98.99%, which is close enough) for approximately $5.8 million.

He worked out an arrangement with a tax-exempt organization named Foothills Land Conservancy. The easement would restrict much of the land, with the remainder available for development, commercial timber, hunting, fishing and other recreational use.

Routine stuff, methinks.

The investor donated the easement to Foothills eight days after purchasing the land.

Next is valuing the easement

Bring in the valuation specialist. Well, not actually him, as he had died before the trial started, but others who would explain his work. He had valued the easement at slightly over $25 million.

Needless to say, the IRS jumped all over this.

The case goes on for 40 pages.

The taxpayer argument was relatively straightforward. The value of the easement is equal to the reduction in the best and highest use value of the land before and after the granting of the easement.

And how do you value an undeveloped “low density mountain resort residential development”? The specialist was looking at properties in North Carolina, Georgia, and elsewhere in Tennessee. He had to assume government zoning, that financing would be available, that utilities and roads would be built, that consumer demand would exist.

There is a flight of fancy to this “best and highest” line of reasoning.

For example, I would have considered my best and highest professional “use” to be a long and successful career in the NFL. I probably would have been a strong safety, a moniker no longer used in today’s NFL (think tackling). Rather than playing on Sundays, I have instead been a tax practitioner for more than three decades.

According to this before-and-after reasoning, I should be able to deduct the difference between my earning power as a successful NFL Hall of Famer and my actual career as a tax CPA. I intend to donate that difference to the CTG Foundation for Impoverished Accountants.

Yeah, that is snark.

What do I see here?

·      Someone donated less than 100% of something.

·      That something cost about $6 million.

·      Someone waited a week and gave some of that something away.

·      That some of something was valued at more than four times the cost of the entire something. 

Nah, not buying it.

Neither did the Court.

Here is one of the biggest slams I have read in tax case in a while:

           We give no weight to the opinion of petitioner’s experts.”

The taxpayer pushed it too far.

Our case this time for the home gamers was Plateau Holdings LLC v Commissioner.

Getting A Tax Deduction From A Golf Course

Have you heard about Louis Bacon? He is the manager for the hedge fund Moore Capital Management. No, I am not mentioning his name because I am a client of his firm (I wish), but because I was reading that he donated a conservation easement, meaning that he got a (sizeable, I’m certain) tax deduction. The easement is on his Colorado ranch, Trinchera Blanca, which extends over 90,000 acres.

COMMENT: I wonder how long it takes to reach your house upon turning from the roadway when your property is 90,000 acres.      

This gives us an opportunity to talk about conservation easements. Let’s be upfront, however: this is a high-end tax strategy. This has as much to do with your or my daily life as piloting a fighter jet.  

There are three requirements if you want this deduction: 

• Qualifying real property
• Donated to a qualified organization
•  For conservation purposes

The third requirement includes:

• The preservation of land for substantial and regular use by the public for outdoor recreation or education
• The protection of natural habitat of fish, wildlife or plants
• The preservation of open space, where the preservation is for public enjoyment or pursuant to government conservation policy
• The preservation of historically important land or a certified historic structure

An easement makes sense if you think of real estate as more than just … well, real estate. Let’s say, for example, that you own the last remaining farm in a now heavily-developed suburban area. That farm is more than just soil. It is also a bucolic view, a possible watershed, the remaining redoubt for an endangered amphibian, and the source of great wealth from a potential sale to developers. It has layers, like a good lasagna.

We are going to donate one or more of those layers to a charity. We might be able to fit under the “preservation of open space” category above, for example. You could donate a restriction that the property will never be commercially developed. You still own the farm, mind you, but you have donated one of the rights which as a bundle of rights comprise your full ownership of the property.

We next have to put a value on this layer. This is where the horsepower to the conservation easement kicks in.

Let’s say that our farm has been in the family since before there were telephones. Chances are that its cost is relatively negligible.

COMMENT: Before someone comments, I know that the property’s basis would have been reset to its fair market value when it transferred at an ancestor’s death. Let’s compromise and say that the family is extremely long-lived.

Meet a few qualifications and that pennies-on-the-dollar cost has nothing to do with calculating the deduction. We instead are going to get an appraiser to value the property, and he/she is likely to value the easement as follows:

• The value of the property intact and before any donation, less
• The value of the property after the donation of the easement

The numbers can get impressive.

There is a famous case, for example, about an easement in Alabama.

The story begins with Mr. E.A. Drummond, who bought 228 acres on the Fort Morgan peninsula in 1992 for $1,050,000. Two years later he started a planned resort community featuring a 140.9 acre golf course. He started selling lots in 1995, and in 2002 he transferred the golf course to an entity known as Kiva Dunes.

He then donated a perpetual conservation easement on Kiva Dunes.

Kiva Dunes

He valued the easement at over $30 million.

Kiva Dunes also wrote a check to the charity for $35,000.

The IRS got wind of this and they were unamused. They disallowed the $30 million. They also disallowed the $35,000 cash donation, which seems odd. They must have been having a very cranky week.

The case went to Tax Court. The IRS immediately backed off on the fact of a donation, perhaps because by then they were having a better week. They argued instead on the amount of the easement donation. Mr. Drummond brought in an expert who had lived and worked in the area for decades and performed more appraisal work there than anyone else. The IRS brought an expert from Atlanta who had visited the peninsula only twice, and that was to appraise Kiva Dunes.

You can guess which appraiser was more persuasive. The Court reduced the donation to a little over $28 million, which means they effectively agreed with Mr. Drummond. It was a landmark taxpayer win.

The Administration did not like this result at all. They were quite determined to shut down golf course conservation easements, although little has occurred since. They had a point. After all, we are talking about a golf course.

The benefit of a conservation easement on a private golf course, especially in a luxury development, is likely to accrue to a limited number of people and not to the general public. You or I may not even be permitted to drive through some of these communities, much less see or otherwise enjoy the easement.

On the flip side, I have a friend who used to install golf courses in Cincinnati, primarily on the northern Kentucky side. For the locals, I helped him with one of the greens at Devou Park Golf Course, although I do not remember how he talked me into it. I presume I was temporarily insane. Nonetheless, he was very passionate about golf courses serving as respites and nature sanctuaries in otherwise developed urban environments. Kiva Dunes, for example, included broad swaths of wetlands which served as a stopover for migratory birds, as well as being home for a number of threatened species.

One can argue - if there is a socially-desirable ecological, wildlife or preservation outcome – whether it matters that the benefits will be enjoyed by the few. What is of true import here: ecology, wildlife and preservation or the politics of envy? Non-wealthy people do not donate easements. The alternative, unfortunately, is to do … nothing.  

Kiva Dunes had a point.

However, a $28 million point?

One can see the controversy.

The IRS Sues Over Conservation Easements

It has been several years since I visited Washington D.C. I saw a bit of tax news recently that got me thinking about it. Several years ago I was involved in the planning of a conservation easement in D.C. As Washington has 26 historic districts, this was not that unusual. Our client was renovating residential property, and the easement was for the building façade. We normally associate an easement with access to real property, but it can also be a legally enforceable right to preserve real property. In my case, what was being preserved was the outside of the building, which was of historical interest in a neighborhood of historical consequence. You could say that they were donating the right for future generations to look at the building.

The tax advantage? Quite simple: if you follow the rules you can obtain a charitable contribution for the easement. The deduction is (theoretically) the decrease in property value attributable to the grant of the easement. Memory tells me that a reasonable range for a facade is 10 to 14 percent of the building’s value, which is not insignificant.

This area is fraught with danger. An appraisal – or appraisals – is mandatory. The easement will be transferred to a government or charitable organization, so an attorney is required. You may have to obtain the mortgage lender’s agreement to subordinate their right to that of the government or charity receiving the easement.

The IRS challenged some of these donations early on. In some cases, the IRS argued that the donation was zero, although the IRS took considerable punishment in the courts for this position (Akers and Symington, for example).

I was reading Janet Novak’s article in Forbes where she stated that the Justice Department filed a lawsuit to enjoin the Trust for Architectural Easements from certain practices the IRS considers improper. The lawsuit demands that the Trust turn over the names of approximately 800 property owners in Baltimore, New York City and Boston who have claimed this type of deduction. The IRS has already identified more than 300 taxpayers for audit.

The IRS has been concerned with these easements because of their potential for abuse. In some cases, taxpayers have claimed deductions approaching 50% of the property’s value. In others the charity buys the property, places the easement and then sells it to the taxpayer – at a reduced price. The taxpayer makes two checks out – one to purchase the property and the other as a “donation.” He/she of course deducts the second check on his/her return.

The IRS has taken fire from practitioners who argue that it is over-zealous and not regarding Congress’ intent to encourage these easements. I admit that I felt that way at first. It was easy to see a heavy-handed IRS. Consider the following quote from the court in Symington, for example:

  "We are hard pressed to imagine a prospective purchaser of a 60-plus acre parcel of land who would not   have considered the restrictions of such an open-space easement in determining his offering price. The fact that a purchaser of Friendship Farm would have been precluded from even giving away part of his land if he ever so desired, for example, to his children, or, along the same lines, precluded from ever building an additional home on his property, would certainly have affected the purchase price he would have been willing to pay."

However, I am at a loss why I would structure a transaction requiring the charity to buy the real property and for my client to subsequently write two checks. I wouldn’t. I don’t see it how it reflects normal commercial terms. It feels oily, at least to me. The IRS may have valid grounds for this action.