Note #11: Claiming a Deduction for Donating a Conservation Easement (or a Gift of Land) – FILING YOUR TAX RETURN, THE IRS, AND GETTING IT RIGHT (Part I)
Your tax returns are due in about ten weeks.
Most of you know this already and don’t like being reminded. Some of you have already started work on your tax returns and plan to get them filed before April 15. Probably most of you already know you will go on extension, and won’t get your tax returns in the mail much before October 15, the extension due date.
In the last three Notes, I covered the specific conservation easement appraisal rules in the conservation easement regulations, with the introductory comment that I’m sure in many cases, for people who donated conservation easements last year, the appraisal is not done yet, and in many cases not even started yet (which is ok), so I thought that series of three Notes would be timely and helpful, to donors, and to their advisors, and to appraisers, and to donee organizations.
But now, still with plenty of time, I have more advice and more tips, again, I hope, in a very timely fashion. The purpose of this Note #11, and Note #12 to follow, is to help you think about what it is you need to file, along with your tax return, to increase the chance that your conservation easement donation will not be audited, or, if you are audited, so that you will have a better chance of a better audit result.
There are a few very very important caveats here. First, there is no way anyone can ever guarantee that you will not be audited, for a conservation easement donation, or gift of land, or anything else that might show up on your tax return. Second, most of the time, going through an IRS audit is an awful experience, and there is no way anyone can guarantee any kind of result short of terrible. Third, as these Notes always say, this is not legal advice. If you donated a conservation easement in 2014 (or if you ever plan to donate a conservation easement), you should be working with an experienced tax advisor who understands every single point in these Notes. If you did make a donation in 2014, this Note should be immediately helpful. If you are going to make a donation in the future, this Note can serve as a “primer” for some of the things you should be thinking about.
Keep in mind, there are no guarantees. At the end of Note #12, I will discuss my own strategy for conservation easement donation audits and some of the experiences I have had in audits.
Finally, a good bit (but not all) of what follows in this Note #11 is taken directly from Chapter 12 of my latest book, The Business of Open Space: What’s Next??
I have had much more experience than I would like with IRS audits of conservation easements.
From the 1980s up until around 2005 or 2006, I had been involved in hundreds of conservation easement donations. I would guess that maybe 5 or 6 of those donations were audited, and two of those audits were closed with no change. This was a sleepy field and the IRS was not paying much attention to conservation easement donations.
But after a series of events beginning around 2003 and 2004, the IRS began a fairly heavy frontal audit attack on conservation easement donations. The history and the origin of the changed IRS attitude isn’t important now. What is important is that if you donate a conservation easement, and if you haven’t done everything precisely and correctly, you may be in for a very rough ride if you are audited. In fact, unfortunately, even if you have done everything precisely and correctly, and you are audited anyway, it is highly likely that you will be in for a rough ride, at least at the start of the audit.
Let me cut to the chase. What is the goal here? The goal is not complicated at all. If an IRS agent picks up your tax return and reviews it for possible audit, we want that agent to put your return into the outbox, rather than into the audit box. The goal is for an IRS agent who picks up your tax return to look at the forms and documentation for your conservation easement donation, read the papers, check the IRS checklist of things to look for in conservation easement donations, review your package, and conclude that you got everything not just right but very nicely done. Your tax return then goes in the outbox.
The first backup goal is that the agent might review your return package, might find a few mistakes (but not big or substantive ones), might have some questions, but will still conclude that on balance pursuing an audit of this particular donation is not the best use of IRS time and resources, so the tax return goes in the outbox. (The IRS budget seems to get cut more each year, so “the best use of IRS time and resources” is more and more of an issue.)
If the agent does in fact select your return for audit, the final backup goal is that your advisor will be able to negotiate the best possible settlement with the IRS on your behalf because you have followed the rules and have everything in order and haven’t made any serious missteps (or have mostly followed the substantive rules and mostly have everything in order).
Filing Your Tax Return
Here is my “checklist” for getting to these goals. As you will see as you go through the checklist, this Note #11 does not go into details on some of the points below, although Note #12 will take a closer look at some of the checklist items.
1. Work with an experienced advisor. You need to work with an advisor who understands every point on the list below. If your advisor does not understand the key points of contention other donors have had with the IRS and in the Tax Court about what is required in the conservation easement document (see #2 below) and the necessary tax return filings, or does not understand how to tell a qualified appraisal from an appraisal that might get you into trouble (see #4 below), you and your advisor should reach out and get appropriate assistance or you should work with a different advisor.
2. The easement document must be done right and must meet all the relevant tax rules. The conservation easement document needs to be done correctly, especially with respect to those issues the IRS is currently most concerned about. Some of these issues include, for example, appropriate limitations on certain reserved rights, amendments and extinguishment, the “proceeds” rule, timely and correct mortgage subordination (if that is relevant in your case), and the potential for uses of the protected property that could conflict with the perpetual protection of the property’s conservation values. What makes up a “correct” easement document is beyond the scope of this Note but see Preserving Family Lands: Book III, for a checklist for a conservation easement project. Go to www.stevesmall.com for more information about Preserving Family Lands: Book III.
3. Baseline Documentation Report. The Baseline Documentation Report, required by the tax regulations, needs to be done correctly and must be completed no later than when you donate the conservation easement. The conservation easement regulations say that the Baseline Documentation Report is supposed to be a “snapshot” of the property that goes under easement at the time that property goes under easement, and the landowner and the donee of the easement should sign the Report and make the appropriate representations required by the regulations. The Report, and the conservation easement document itself, need to make it clear to any potential IRS reader why this particular conservation easement on this particular property meets all of the tax code rules for deductibility. There is no requirement that you file the Baseline Documentation Report along with your income tax return, but I recommend that you include it as part of your filing package. I also like to state in the conservation easement document itself that the Baseline Documentation Report is complete, that it is an accurate representation of the condition of the property, and that both the landowner and the easement holder have reviewed it and have certified that it is correct. This is just plain good due diligence. In most cases, the land trust or other easement holder will prepare the report, but in some cases we have hired our own consultants to do that.
4. Appraisal Report. Your “qualified appraisal” report, done by your appraiser to substantiate the value of your conservation easement gift, needs to be done correctly. In that regard, see the discussion in Notes #8, #9, and #10. In some cases, the appraisal report MUST be filed with your income tax return, but I recommend that in all cases you file the appraisal report with your income tax return. IRS representatives have stated frequently and repeatedly that one of the most common problems they see with appraisals is that they are often poorly written and poorly organized, and therefore difficult (and not fun) to follow. Accordingly, in addition to making certain that your qualified appraisal satisfies all the technical requirements, it is important that the appraisal be clearly written and well organized.
5. Form 8283. The federal Form 8283, “Noncash Charitable Contributions,” must be filed along with your income tax return, and it must be completely and accurately filled out. (The Form 8283 must be filed for all charitable gifts where the claimed deduction is greater than $5,000, and for some smaller gifts, not just for conservation easement donations.) If the Form is not completely and accurately filled out the IRS can deny your deduction!! In fact, the instructions to the Form 8283 note specifically that in certain cases, if the Form is not filled out properly, the deduction for the charitable contribution can be denied. IRS representatives have stated frequently and repeatedly that they see a very large number of improperly filled out 8283s. I go over the Form 8283 in greater detail in Note #12.
6. Supplemental Statement with Form 8283. When you donate a conservation easement, a Supplemental Statement must be filed along with the Form 8283, and the Supplemental Statement must be completely and accurately filled out. IRS representatives have stated frequently and repeatedly that in many, many cases, either the donor fails to include the required Supplemental Statement or the Supplemental Statement does not include all of the information required by the instructions to the Form 8283. I go over the Supplemental Statement in greater detail in Note #12.
7. Gift Letter. When you donate a conservation easement, the tax rules REQUIRE you to have a so-called “gift letter” from the organization that received the easement gift. The IRS calls this a “CWA,” or a “contemporaneous written acknowledgement” of the gift, because the tax statute uses the term “contemporaneous written acknowledgement” of the contribution. In fact, and this is really important, when you make ANY charitable gift with a claimed value of $250 or more, you need a gift letter from the organization that received the gift. There is no excuse for failure to have the gift letter for your donation. There is no requirement that you file the gift letter along with your income tax return, but I recommend that you include the gift letter as part of your filing package. If you don’t have a gift letter, there are a variety of arguments that you can make in support of a claim, for example, that some other document is an adequate substitute for the gift letter. But you might lose these arguments and the deduction could be denied. If you have the gift letter, it takes away from the IRS the very simple and very powerful and usually winning argument, “Your deduction is denied because you don’t have a CWA.” I go over the gift letter in greater detail in Note #12.
8. Mortgage Subordination. If there was a mortgage on your property when you donated a conservation easement, the tax rules require that the mortgage be “subordinated” to the conservation easement, and that the subordination be recorded before or along with the recorded conservation easement. The tax rules are quite particular about what this subordination has to say, and IRS representatives have stated frequently and repeatedly that they see a very large number of “mortgage subordinations” that do not satisfy the tax rules, including documents in which the lender consents to the conveyance of the conservation easement but does not subordinate the mortgage to the conservation easement. There is no requirement that you file the mortgage subordination (if one was necessary) along with your income tax return, but I recommend that you include (if one was necessary) a copy of your correct and timely filed mortgage subordination as part of your filing package.
9. Recorded Conservation Easement Deed. Finally, your filing package should include a copy of the final executed and recorded conservation easement deed. A good qualified appraisal report should include a copy of the recorded easement, but you should include a copy with your tax filing if it is not included in the appraisal report.
I hope this Note #11 helps you get a good start on putting together the tax return filing package. As noted above, I will cover more details in Note #12.