Conservation Easements — Federal and State Incentives for Protecting Virginia's Land and History
November 1, 2006
By Rebecca E. McCoy, CPA
There's a way CPAs can help Virginia clients protect the natural and historic importance of their property — conservation easements.
Due to rapidly escalating real estate prices over the last several years, many landowners in Virginia are very land-rich and-cash poor. For many individuals, real estate is the biggest asset they own, overweighting their investment portfolio with an illiquid asset.
By placing a conservation easement on property in Virginia, landowners can significantly reduce their federal and state tax liabilities and receive transferable tax credits, which in turn liquidates some of their real estate value and allows investment in other areas without having to sell the property.
The Pension Protection Act of 2006, signed by President Bush on August 17, significantly changes federal laws. And the Virginia tax credit program will change dramatically on January 1, 2007, based on legislation passed during the special Virginia General Assembly session in July and amended by Gov. Tim Kaine.
Conservation easements are described in section 170(h) of the Internal Revenue Code as those contributions that represent a donation of a qualified real property interest to a qualified organization exclusively for conservation purposes. A conservation easement is one of the few partial-interest donations allowed by the Internal Revenue Code.
The landowner can give up future rights in the property without giving up ownership of the land. The easement must be held by a qualified organization, either a governmental entity or a publicly supported nonprofit organization whose purpose is conservation or preservation. Private foundations do not qualify as easement holders. The exclusive conservation purposes allowed by 170(h) include:
- Preservation of land for outdoor recreation by, or the education of, the general public
- Protection of relatively natural habitats of fish, wildlife or plants and ecosystems
- Preservation of open space (including farmland and forestland) for the scenic enjoyment of the general public or as part of a clearly defined federal, state or local governmental conservation policy
- Preservation of an historically important land area or a certified historic structure
The most recent tax court cases on conservation easements focused on the public benefit element of easements when the Internal Revenue Service (IRS) challenged the validity of the easements as qualifying under 170(h).
In 2005, the Glass v. Commissioner decision provided a very detailed analysis of how the courts view the public benefit of a relatively small acreage easement. Glass was able to prove to the court's satisfaction that the small area protected was a very important natural habitat for bald eagles and two rare plants. The land trust holding the easement testified very effectively that they documented the conservation values of the property. The land trust also was able to demonstrate that they were able and willing to enforce the easement in reasonable perpetuity due to staff expertise and significant financial resources.
As a counterpoint to the Glass decision, the 2006 Turner v. Commissioner decision provided a great example of how a landowner can go too far in seeking tax benefits. Turner claimed an ability to create 60 parcels on a piece of property when the by-rights zoning only allowed 30 parcels. Turner then "gave up" the extra parcels and retained the by-rights parcels. He also wrote letters that a nonprofit organization and government official signed to support his argument, even though they knew and agreed that Turner could not actually obtain 60 lots without going through a rezoning process.
Turner filed Form 8283 with his tax return, but neglected to obtain the signature of the holder of the easement, thereby filing an incomplete return. The judge in the case used some of the same arguments detailed in the Glass case to determine that Turner's easement did not meet the standards of 170(h), in particular, the requirement for public benefit.
Valuation of the donation was not addressed in either of the two tax court cases. Because conservation easements have value in excess of $5,000, the taxpayer must obtain a qualified appraisal to determine the value of the donation. Both the IRS and Virginia Department of Taxation are analyzing appraisals for accuracy, and I expect we will see tax court cases on the valuation issues in the next few years.
The big lesson to learn in advising your clients on conservation easements is to understand the process and the importance of obtaining a well-written easement deed, a thorough documentation of the public value of the easement, and a well-qualified appraisal for the value of the donation. Tax preparers need to be knowledgeable in preparing accurate Forms 8283 for clients, with appropriate signatures and required supporting documents attached.
2006 Federal Law Changes
The significant federal law changes included in the 2006 Pension Protection Act are:
- Increases the charitable deduction for a qualified conservation easement from 30 percent of Adjusted Gross Income (AGI) to 50 percent of AGI
- Extends the carry-forward period of unused portions of the donation from five years to 15 years
- For qualified farmers with a qualified farm easement, increases the charitable deduction to 100 percent of AGI. The qualified farmer definition is based on more than 50 percent of the taxpayer's gross income for the year of the donation, coming from the trade or business of farming (as defined in IRC Section 2032A(e)(5)). Beginning on August 18, 2006, the easement must restrict the property for use or as available for use in agriculture or livestock production (including forestry). Corporate farmers and ranchers may qualify for the expanded deduction based on a formula calculation of taxable income.
- S corporations only adjust their shareholders' basis by the pro rata portion of the cost basis of the easement, rather than the entire appraised value of the easement. This change will help shareholders who ended up limited in their ability to claim the donation as a deduction due to lack of basis in the stock of the S corporation.
The changes listed above are in effect for tax years beginning after December 31, 2005, and before January 1, 2008.
In creating the Pension Protection Act, Congress attempted to address some actual and perceived compliance problems for historic façade easements. Under 170(h), protecting historic buildings is a qualified purpose for an easement. Congress added additional language to require that the entire façade of a building be protected, not just part of the structure.
For easements donated after August 17, 2006, the property owners who received federal historic rehabilitation tax credits must adjust the appraised value of a conservation easement if the owners are in the five-year recapture period on the historic rehabilitation tax credits. For façade easements recorded after 180 days from the enactment date and in excess of $10,000, the donor must pay a $500 filing fee with the tax return, including the deduction claim.
Another area of non-compliance addressed in the Pension Act is related to appraisers. Section 6695A of the Internal Revenue Code was added to significantly increase the penalties to appraisers and to define qualified appraisers and appraisals. Congress hopes to discourage abusive appraisal valuations by increasing the cost to non-compliant appraisers.
Virginia Legislative Changes
During the Virginia General Assembly special session, legislation passed to change the following elements of the Land Preservation Tax Credit program in Virginia, effective January 1, 2007:
- Tax credits will be issued based on 40 percent of the appraised easement value, a reduction from the current 50 percent calculation.
- For 2007, a maximum of $100 million in credits will be authorized for easements recorded in 2007. The cap will be indexed to the CPI-U in future years. Credits will be issued in the order that completed applications are received. For donors filing applications after the annual cap is reached, their requests will be accumulated to apply against the following year's allocation of credits or roll forward to future years until they receive their credit allocation.
- The carry-forward for unused credits will extend to 10 years from the current five years for new credits issued.
- No credits will be allowed for donations as part of a subdivision or development, or for fulfilling density requirements for approval to zoning, subdivision, site plan or building permits.
- Nonprofit organizations that are conservation organizations and hold one easement will not be eligible for the tax credits.
- A new registration process goes into effect for easements creating greater than $1 million in tax credits. The donor must file an application with the Virginia Department of Taxation (TAX) and Virginia Department of Conservation and Recreation (DCR). DCR must verify that the easement meets criteria established by the Virginia Land Conservation Foundation in guidelines due out by December 1, 2006. All applications must include a description of the conservation purpose, the fair market value of the land without restrictions, the public benefit from the donation, water quality best management practices (BMPs) on the property, and whether forested and a forestry plan is part of the easement.
- TAX will issue guidelines for valuation of the easements by December 1, 2006. The new law limits the credits for structures or improvements to land to 25 percent of total credits allocated for the property. For historic properties, the owner cannot receive state credits for an historic rehabilitation and a conservation easement within the same five-year period.
- A fee of 2 percent of the donated value, up to a maximum fee of $10,000, is required for transfers of the tax credits due to sale by a taxpayer or distribution by a pass-through entity. Gifts are not subject to the fee.
The end result of the state legislative changes is, hopefully, to weed out the easements that do not possess good conservation values and give the landowners a longer period of time to use the tax credits against their tax liability prior to selling the credits to others. The other part of the legislative bill for conservation easements was the elimination of Virginia estate taxes as of July 1, 2007.
The Land Preservation Tax Credit program, in conjunction with the tax savings from the donation, is still the highest dollar program in the country, even after the reductions in the current legislation. The ability of the landowner to convert rights in real estate to tax savings and sale proceeds from tax credits is a very strong incentive to individuals who want to retain their land and are concerned with the future use of the property but need some of the value from the property now.
Because the easements must be perpetual, landowners need advisors who can walk them through the process and analyze the actual financial benefits of the tax savings over multiple years, the impact of investing proceeds from tax credit sales, and the future value of their land as an asset in their portfolio.
Rebecca E. McCoy, CPA, a sole practitioner in Mathews County, provides consulting services to landowners, nonprofits and governmental entities in utilizing conservation easements and land donations to preserve land in Virginia. She is also a member of the VSCPA Board of Directors.
VSCPA Comments on Virginia Easement Legislation
The legislative changes proposed by Senate Bill 5019 and House Bill 5019 to Virginia's land conservation program contained provisions that were, in some cases, more restrictive than current federal legislation or were difficult to enforce, the VSCPA told Gov. Tim Kaine in a June 23, 2006, letter.
The letter analyzed several legislative changes that would have significantly altered the Virginia Land Preservation Tax Credit program, including structure value restrictions and tax credit reductions.