March 01, 2011

Background

Conservation easements date back to the 1800s, but it was not until the mid-1900s that they began to gain public recognition. The Federal Government first used conservation easements in the 1930s to protect scenic corridors, and soon afterward they gained acceptance within private organizations. After the Tax Reform Act of 1969 created their tax preferred status, widespread private use began in earnest. Today conservation easements are a popular estate planning tool that protects land from future development, while providing a significant tax benefit to the landowner.

While traditional easements generally denote use, conservation easements differ, as they represent restrictions or limitations on land use rights. The Fifth Edition of the Dictionary of Real Estate Appraisal (Appraisal Institute) defines a conservation easement as, “an interest in real property restricting future land use to preservation, conservation, wildlife habitat, or some combination of those uses.” In essence, it is a voluntary agreement that restricts the ability to develop a portion of land for a conservation benefit. Development restrictions can be minimal or substantial, as landowners have virtually unlimited options regarding specific restrictions that they can place on their land. As a result, land is protected indefinitely for future generations. Conservation easements are legally binding agreements that typically exclude a termination date. If the underlying property is sold, the easement restrictions remain in effect.

When a conservation easement is created, fee ownership in the underlying land remains with the original property owner. Through the easement agreement, the owner voluntarily forfeits specified rights to all or a portion of their land holdings. The easement rights are then typically donated to a private charitable organization, which holds and enforces the restrictions as denoted in the easement agreement. There are a vast number of options when it comes to creating a conservation easement, as virtually any parcel of land can qualify. Various types of easements are outlined in the following table:

Types of Conservation Easements

A conservation easement does not necessarily prohibit development altogether, but may restrict the type of development permitted. Generally, an easement prohibits any activity that would harm the characteristics of the land that the landowner is attempting to protect. The easement can permit or prohibit public access, though the ownership of the land itself typically remains private. All rights and restrictions are left up to the preference of the individual property owner creating the easement. This being said, individual conservation easements vary significantly as each one is specifically tailored to meet the needs of the property owner.

Benefits

Conservation easements target a variety of resources, and provide various benefits to the general public such as continued open space, protection of natural or historic resources, and possible access to the land. Motivations for a landowner to create a conservation easement are diverse, and can be financial or non-financial. Some of the possible non-financial benefits of creating a conservation easement are outlined in the following table.

Non-financial Benefits

Sentimental motivations can include preserving a farm that has been in the family for decades. The property can be protected from future development whether or not it continues to be utilized as a working farm. Even with the creation of a conservation easement, the landowner can maintain private ownership of the land, choose to sell it (subject to restrictions of the easement), or even pass it on to heirs. The creation of an easement is very flexible and each is unique. The various allowed and restricted uses can be outlined in the agreement, as well as the opportunity for providing or restricting public access. Land with historic importance, or which contains structures of historic significance, is also a popular motivation for creation of a conservation easement. The easement will protect the history of the site for future generations. But probably the most common of all non-financial reasons for creating a conservation easement is the protection and preservation of wildlife and other natural resources. While non-financial benefits of conservation easements are generally the underlying reason for their creation, they would likely not be as widely used if it were not for the associated financial benefits, as outlined below.

While a conservation easement can restrict certain development of a land parcel, it can also allow for continuation of its current use. Therefore, a family, or even corporate farm can continue its income generating operations while at the same time taking advantage of other potential financial benefits associated with restricting alternative development. This situation will typically occur in metropolitan fringe areas where farming may no longer be the highest and best use of the land. The other financial benefits of conservation easements are generally related to tax incentives. Landowners who choose to protect their land with conservation easements can receive state and federal income tax deductions, as well as reduced estate, capital gains, and property taxes. These financial benefits provide a major incentive for landowners who may otherwise not consider restricting the future use of their land.

To qualify for State and Federal tax advantages, conservation easements must be permanent, and provide a public benefit by protecting an identifiable resource. A conservation easement that meets Federal Tax Code requirements (see Section 1.170A-14(d), Income Tax Regulations) can qualify as a deductible charitable contribution, in which the development rights are treated as the charitable gift. The charitable contribution allowed is equal to the value of the conservation easement, and is reflected on the landowners Federal and State income tax returns. Estate taxes, capital gains taxes, and even property taxes may be reduced through the use of a conservation easement, because a valued portion of the property rights is separated and transferred to a (typically) non-taxable entity. Even if the entity accepting the easement rights were taxable, the tax burden to the underlying land owner will be reduced because they now own only a portion of the bundle of rights in the real estate, which can be measurably less valuable than the entire bundle of rights. We will discuss the valuation of conservation easements later in this article.

Creating a Conservation Easement

Conservation easements are created through and subject to State Law. With the help of a qualified attorney, a landowner can place a conservation easement on any portion of their property. Though the process can vary by state, and can be dependent upon the type of easement created, the general steps necessary include:

  • Identify reason for protecting land
  • Identify objective and goals for future land use rights and restrictions
  • Select a credible organization to become the easement holder
  • Document property (e.g., photographs, maps, municipal data, legal documents, natural resource information, land management history, etc.). Collecting as much data as possible about the land is an important step, as this documentation is an IRS requirement for donated easements
  • Agree upon restrictions and enforcement procedures
  • Sign final easement
  • Appraise value of easement (if for donation purposes)
  • Long-term monitoring

One key aspect to note is that conservation easement creation takes time. They are created for the purpose of perpetually protecting land and therefore involve a lengthy, detailed process. Though they are most often established as a permanent agreement, there are various ways that they can be terminated.

Termination Criteria

A conservation easement does not protect against eminent domain. As with any property ownership interest, the easement is negated if and when the government takes ownership of the land. This may occur in the case where the public benefit of a government takeover significantly outweighs the purpose of the easement in place. In addition to eminent domain, the easement is void if the property falls into foreclosure. If conditions change such that the original purpose of the easement becomes impossible to accomplish, the easement will be void as well. In other words, if the reason for the easement no longer exists, the easement is no longer valid. For example, an easement that allowed access to utilize an artesian well became void when the well was capped for health reasons. The property owner and easement holder may decide there is no longer a need for the easement, at which time a release is executed and the easement is terminated. Termination is also possible if a violation occurs. If the easement prohibits development yet development does occur, the easement becomes void since the easement holder did not fulfill their obligation to uphold the rights as denoted by the property owner. In some cases, though not typical, there is a predetermined expiration date set at which time the easement is extinguished. Additional possible reasons for termination can include abandonment of the easement and land mergers. However, not all of these scenarios result in an automatic termination. A lengthy legal process is typically expected when dealing with easement termination.

Without the presence of at least one of these conditions, the conservation easement runs with the property indefinitely. If the landowner chooses to sell the property, the rights transferred are limited by the easement in place, which remains with the third party easement holder. This restriction reflects the purpose of preserving land beyond the current owner’s interest in the property. This can be thought of the same way as any land development - the purpose of a development is to remain functioning, and provide some type of resource well after the developer sells its ownership interest.

Valuation

The proper valuation methodology1 of a conservation easement is outlined in Section 1.170A-14(h)(3)(i) of the Income Tax Regulations. In most situations, the value of a conservation easement is the difference between the value of the land before the easement is put in place and the value afterward (the before and after value method). Also as noted in 1.170A-14(h)(3)(i), “If the granting of a perpetual conservation restriction after January 14, 1986, has the effect of increasing the value of any other property owned by the donor or a related person, the amount of the deduction for the conservation contribution shall be reduced by the amount of the increase in the value of the other property, whether or not such property is contiguous.” As an example, an individual owns 100 acres surrounding a small lake, which has a value of $10,000 per acre ($1,000,000 total value). After placing a conservation easement on 90 acres, the value of the 90 acres is reduced by $5,000 per acre ($450,000), and the value of the remaining 10 acres is increased by $10,000 per acre ($100,000). Therefore, the charitable tax deduction is $450,000 ($1,000,000 – ($450,000 + $100,000)).

At the close of 2010, the Tax Court in Trout Ranch LLC2 specifically addressed the issue of the comparable sales method versus the before and after methods in valuing a conservation easement. The comparable sales method looks at actual sales of other easements to directly determine the value for the subject easement. The case reaffirmed the difficulty a taxpayer has in relying on a comparable sales analysis to establish the amount of the charitable deduction. An array of factual differences can call seemingly comparable sales into question, with the IRS (and the courts) dismissing the method as inapplicable. Because of distinguishing factors that rendered the taxpayer’s cited sales not comparable, the Trout Ranch case found that the appropriate approach to value the amount of the charitable contribution of the easement was the before and after methodology.

A qualified and experienced appraiser (as defined within IRS Publication 561) must be called upon to estimate this value, and that appraiser is responsible for abiding by IRS Regulations, Federal Laws, and the laws of the state in which the property is located. If the appraisal is improperly completed, it will likely be rejected by the State or IRS as support for the charitable contribution made. A complete understanding of the applicable laws is an integral step in the valuation process, and failure to comply can result in sanctions or penalties against the appraiser. The 2006 Pension Protection Act included educational and competency requirements for appraisers of conservation easements, as well as clarification of sanctions that can be brought for improperly completed appraisals.

Conclusion

Conservation easements have been used to protect land for decades. They are unlike typical easements in that they are restrictive, prohibiting certain activities on and access to the land. They allow landowners to maintain ownership while simultaneously putting in place these restrictions. Therefore, they allow current landowners to decide how and for what purpose their land will perpetually be used. These characteristics make them a great tool for estate planning.

Conservation easements are created for various purposes and have many financial and non-financial benefits. Easements are created for reasons as simple as preserving a family farm, or protecting childhood memories. Others create them to preserve the memory of historic events that may have occurred on a particular piece of land. In order to be tax deductible, the stated purpose must be to provide a public benefit by protecting an identifiable resource.

Oftentimes, the most compelling reason for creation of a conservation easement is the financial benefit. The most notable of these incentives are the potential tax benefits allowed with the use of conservation easements. These tax incentives were created by the Tax Reform Act of 1969, and significantly increased the use of conservation easements. Charitable contribution deductions for State and Federal income taxes, as well as reduced estate, capital gains, and property taxes are all particularly enticing benefits. Conservation easements are generally perpetual and therefore require great care to ensure proper establishment, valuation, and long-term enforcement and maintenance.

 

Jeffrey G. Pelegrin, MAI, FRICS
Talia L. Mitchell

 

1 The Regulation states in part: “The value of the contribution under section 170 in the case of a charitable contribution of a perpetual conservation restriction is the fair market value of the perpetual conservation restriction at the time of the contribution. … If there is a substantial record of sales of easements comparable to the donated easement (such as purchases pursuant to a governmental program), the fair market value of the donated easement is based on the sales prices of such comparable easements. If no substantial record of market-place sales is available to use as a meaningful or valid comparison, as a general rule (but not necessarily in all cases) the fair market value of a perpetual conservation restriction is equal to the difference between the fair market value of the property it encumbers before the granting of the restriction and the fair market value of the encumbered property after the granting of the restriction. …”

2 Trout Ranch, LLC, Michael D. Wilson, Tax Matters Partner v. Commissioner of Internal Revenue, United States Tax Court, T.C. Memo 2010-283, (December 27, 2010).