Recent Tax Court Ruling Provides a Big Win to Land Conservation Easements
In recognition of the need to preserve the country’s heritage, Congress allowed an income tax deduction for owners of significant property who give up certain rights of ownership to preserve their land or buildings for future generations. The IRS has seen abuses of this tax provision that compromise the policy Congress intended to promote. There have been instances where taxpayers, often encouraged by promoters and armed with questionable appraisals, have taken inappropriately large tax deductions from these conservation easement deals.
In a conservation easement, landowners make binding promises to stop development on their property, typically with deed restrictions donated to a land trust. In exchange for this agreement, the diminished value, as opposed to the landowner’s cost basis, can be taken as a charitable deduction by the landowner. The most aggressive deals rely on extraordinarily high appraisals to represent the diminished value, so that taxpayers attempt to claim income-tax deductions worth significantly more than they invested. Investor solicitations for what are known as syndicated conservation easements can turn $100,000 investments into $400,000 or more in tax deductions. What the IRS challenges in these deals is the basis for the appraisals that support the deduction.
For example, a taxpayer that invests $100,000 in a syndicated conservation easement could get a K-1 from that vehicle that reflects a $500,000 deduction. For someone with a combined federal and state tax rate of 40% that charitable deduction would save $200,000 in taxes, resulting in a 100% “return on investment”. The $500,000 deduction is the byproduct of an independent appraisal of the diminished value of the property that will remain in its current state for conservation purposes, as opposed to being developed as highly valuable investment property.
The IRS has tried for several years to boost enforcement of conservation easements, particularly syndicated deals pitched by promoters to high-income investors. The IRS has audited hundreds of cases and won many, getting judges to deny inflated deductions. But the pace of easement deals barely slowed, and easement promoters notched several wins. The larger promoters with the deeper pockets and a large bench of lawyers and lobbyists were able to have the better results in court by successfully defending their appraisals.
To mitigate taxpayer interest in these types of investments the IRS required taxpayers in deals where the deduction’s value was at least 2.5 times the investment to file special tax forms with their tax returns that effectively serve as red flags to IRS auditors. And could potentially trigger an audit of the entire tax return for the above tax filers. Which, theoretically, should serve to discourage investment by many taxpayers.
Now, the U.S. Tax Court has struck down IRS rules requiring taxpayers and promoters to disclose certain land-rights deals to tax authorities through the filing of the above special tax forms, the government’s main tool for identifying potentially abusive easements, and thereby damaging a high-profile agency enforcement initiative. Read the Tax Court ruling
In Announcement 2022-28, the IRS said it and the Treasury Department disagree with the Tax Court’s decision and are continuing to defend the validity of its existing listing notices outside.
“At the same time, however, to eliminate any confusion and to ensure that these decisions do not disrupt the IRS’s ongoing efforts to combat abusive tax shelters throughout the nation, the Treasury Department and the IRS are today issuing proposed regulations to identify certain syndicated conservation easement transactions as listed transactions,” said the IRS. “The Treasury Department and the IRS intend to finalize these regulations, after due consideration of public comments, in 2023 and intend to issue proposed regulations identifying additional listed transactions in the near future.”
The Partnership for Conservation, an industry group, praised the court’s decision as correct and marking major progress.
The information presented here should not be construed as legal, tax, accounting, or valuation advice. No one should act on such information without appropriate professional advice and after a thorough examination of the particular situation.