Syndicated Conservation Easements Still a Priority for IRS

August 07, 2020

By  Ralph Estel

Beginning in the 1980s, Congress decided that taxpayers who owned land with a conservation potential could donate the right to develop that land (i.e., a deed restriction or easement) to a tax-exempt organization or government agency for a tax deduction. The deduction would be calculated by taking the property’s fair market value (FMV) without a deed restriction, less the amount of the property’s FMV with a deed restriction.

The table below illustrates an example:

Property's FMV without a deep restriction or easement $200,000
Property's FMV with a deep restriction or easement $90,000
Allowed charitable contribution $110,000

Historically, charitable donations required the complete donation of the property, and the corresponding deduction would be the lower of the FMV or the cost basis. The new rule disregards the cost basis restriction, and instead focuses on the FMV only. Until Congress put the new rule into effect, no one guessed that straying from those historic norms would permit such aggressive transactions as the “syndicated conservation easement.”

What is a syndicated conservation easement? In Notice 2017-10 the IRS defines a syndicated conservation easement as a transaction where a promoter forms a pass-through entity and acquires real property that has a conservation value. Then the promoter sells or syndicates ownership in the entity to investors using promotional material, suggesting that investors may be entitled to a charitable contribution deduction that exceeds an amount more than 2.5 times the investors. The promoter then obtains an appraisal that greatly inflates the value of the easement based on unreasonable conclusions about the development potential of the property. Finally, the entity donates a conservation easement on the property to a tax-exempt entity. An example of how this works will illustrate why the IRS has a problem with this transaction.

Assume a company buys a property for $100,000, and shortly thereafter has an appraiser value the property without a deed restriction at $800,000; after deed restriction of $50,000. This appraisal would indicate that if the company made a conservation easement, it would be entitled to a $750,000 charitable contribution. Then, before the company placed a deed restriction on the property, they sell their interest for $200,000 to outside investors guaranteeing them a charitable contribution of $3.75 for every $1 invested.  Most people can see why the IRS has the problem with this. The taxpayer buys a property for $100,000 and shortly thereafter it is worth $800,000.

The IRS considered this type of transaction so abusive that in 2017, they classified this type of transaction as a “listed transaction,” which required taxpayers engaging in syndicated conservation easements to file additional disclosures.

Initially, taxpayers assumed the IRS would fight the perceived abuses by challenging the appraisals of the properties. However, in the cases since 2017, this approach does not appear to be the case. The most recent case, Oakbrook Land Holdings LLC v. Commissioner, the opinion plainly states that the IRS is not attacking the appraisals, but rather questioning whether the easements are being executed exactly as the regulations require. The IRS’s main focus is the perpetuity requirement, or the requirement that the conservations purpose of the easement continue indefinitely.

To illustrate the IRS’s extreme measures: We see the IRS meticulously reviewing each detail of the easement to ensure it adheres to the regulations. In the Oakbrook case, the IRS scrutinized one specific clause in the deed restriction that, in the event of an unforeseen involuntary conversion or disposition (i.e., eminent domain or condemnation), allocated proceeds to the owner and the holder of the easement. In this  case, the deed allocated proceeds to the tax-exempt organization based on a fixed figure that was determined at the onset of the easement. The IRS argued that in order for the tax exempt organization to continue its conservation agenda in perpetuity, it would need to receive a proportion of the proceeds based on the FMV of the deed restriction compared to total fair market value of the property.  The court agreed with the IRS and disallowed the deduction.

The major highlight from the Oakbrook case: The IRS is being extremely aggressive with conservation easements. This additional scrutiny should make anyone wary of making an investment in an entity whose sole purpose is taking their investment and turning it into a charitable deduction for substantially more than they put in.

Since the decision of the Oakbrook case, the IRS chief counsel has offered a settlement offer to any docketed cases involving conservation easement. The key terms of the settlement offer are (1) that the deduction is disallowed in full, (2) the entity must pay the full amount of tax and (3) the partners must pay a penalty of 10-40%. Since a settlement offer cannot be appealed, it is hard to see a situation where taking the settlement offer would be advisable.

About Ralph Estel

Mr. Estel is a Senior Manager in the Private Business Services Group with over 10 years of experience providing accounting, consulting and tax services to middle-market clients. His clients include real estate and construction companies.