Note #8: Conservation Easement Appraisal Rules: History, Rules, Mistakes, Tips (Part I)
The holiday gift that just keeps on giving
‘Tis the holiday season. ‘Tis also the time of year when “taxpayers” have only a few weeks left to do tax planning, including charitable contributions, before the calendar hits January 1, 2015. Of course, December 31 is the deadline to complete your charitable giving for the year, and as I often note the IRS does not give extensions for that deadline.
On the other hand, for those who donate certain appreciated assets to charity, like, for example, conservation easements, while the easement needs to be signed, notarized, and recorded by December 31, the “qualified appraisal” that is necessary to substantiate the value of the gift does not need to be completed by December 31. In fact, the qualified appraisal does not need to be in the hands of the donor until the due date, including extensions, for the filing of the donor’s federal income tax return for the year the gift was made. Many taxpayers do go on extension, which means for any charitable gift made in 2014, the 2014 return must be filed by October 15, 2015, and so, according to the rules, the appraisal for a charitable gift made in 2014 could be in the donor’s hands as late as October, 2015.
There have been a lot of conservation easement donations in 2014, and there will be more before the end of the year, but in the vast majority of those cases I think it’s safe to say the appraiser has not yet started to write the appraisal report. So I decided, not just in the spirit of holiday giving but also mindful of the appraisal delivery deadline rules, to devote three Notes, this Note #8, and Note #9, and Note #10, to the conservation easement appraisal rules, in the hope that these Notes will be helpful and instructive, particularly for those conservation easement appraisal reports that will be written over the next ten or so months. I hope these Notes are like the holiday gift that just keeps on giving.
If you are a landowner/donor, or an advisor to a landowner, or a land trust that receives conservation easement gifts, or an appraiser, or, for that matter, anyone who might be interested in some history and background and discussion of the current conservation easement appraisal rules, and some of the more misunderstood parts of the rules, and some of the more technical issues and requirements that come up in these rules, these Notes are for you!!
This Note #8 will cover some background and some history of the conservation easement appraisal rules, and will end with the current rules, directly from the Treasury Regulation on conservation easement donations.
Note #9 will go into the four rules for appraising conservation easements that must be understood by any appraiser who writes a qualified appraisal report for the donation of a conservation easement.
Note #10 will discuss a few of the more complex issues that come up, under the four rules, in appraising conservation easements.
“Fair market value” of an asset donated to charity
If you donate an asset to charity, you generally get an income tax deduction for the “fair market value” of that asset. There are all kinds of tax code exceptions to this rule (i.e., if you have owned the asset for less than a year, your deduction may be less than its “fair market value”), but this Note is not about the various exceptions. This Note is about “fair market value,” how fair market value is determined if you donate a conservation easement, and the particular appraisal rules that apply to conservation easement donations.
Here is the definition of fair market value from the Treasury Regulations, and this rule is consistently followed in court cases on valuation: fair market value is “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.”
In many charitable gift situations, determining fair market value is not difficult. If I give to my college 100 shares of Google stock, I look in the paper and see what the stock was trading for on the day of the gift, and that determines the fair market value of my gift. If I have a fairly standard house in a busy neighborhood in a busy town, and I donate my house to my college (so the college can sell it and raise funds), the appraiser will look at what similar houses sold for in my neighborhood, make various appropriate adjustments (renovations, lot size, how many bedrooms, etc.), and determine the fair market value of my house. Put another way, the appraiser will determine what a knowledgeable buyer would have paid for my house if I had put it on the market and sold it.
The following is an enormous simplification of something that often gets a lot more complicated.
Aunt Sally has a farm, 500 acres of beautiful land, and new subdivisions are getting closer. Cutting to the chase, here is the question: if I am real estate developer, and a true American capitalist, what would I pay Aunt Sally for her farm? That would depend on a number of factors, including how many house lots could I get on the farm (and that would depend on local zoning rules, etc.), how long would it take me to get all regulatory approvals for those lots, what would my infrastructure costs be (roads, utilities, etc.), how long would it take me to sell those lots, how much risk am I taking on, and what kind of profit can I expect to make? In a typical situation, one way to determine the price (that is, the fair market value) for Sally’s farm would be for a land planner to lay out a plan of proposed subdivision, and based on that plan an appraiser would do a “cost of subdivision” or “discounted cash flow” analysis, the purpose of which would be to present value the income stream that I would get if I buy the property, get the approvals, put in the infrastructure, cover all other costs and risk and profit, and sell the lots over a period of time.
In some situations, usually in a more rural and less developed setting, the appraiser might choose to determine the per-acre value of Sally’s farm. The appraiser would look at comparable sales of similar farms in the market area and make appropriate adjustments, not unlike the exercise of valuing the house I gave to my college. This would give the appraiser a per-acre value for Sally’s farm, which would in turn lead to the fair market value of the entire farm. Some appraisals will evaluate comparable sales and will also do a cost-of-development analysis.
The goal in either case is to answer the question, “What would a knowledgeable and well-informed buyer pay a knowledgeable and well-informed Aunt Sally for her farm?” (In this case, we are of course assuming that the buyer would be a developer, not another farmer. Sally would know her farm is ripe for development, and she is a knowledgeable seller, and also a capitalist, so she would sell for the highest price she could reasonably get for the farm, which we are assuming is based on its residential real estate development potential).
Again, simply, “fair market value” is what you would get if you are a knowledgeable and informed seller and you put an asset (any asset – the farm, a valuable work of art, a cheap work of art, a used car) on the market and sell that asset to a knowledgeable and informed buyer.
If we are talking real estate, art, jewelry, valuable books, used cars, either an appraiser can figure out fair market value or you can figure that out by doing a little on-line research, and, in the case of a used car, by reading the car ads in the paper.
But, if we are talking about conservation easements . . . .
If we are talking conservation easements, the story line changes. All of the other “assets” I have talked about, above, are actually bought and sold in the marketplace. Stock, houses, farms, art, used cars, there is an established market, and the tax rules look to that market to determine fair market value. Although in some states, and in some particular cases, there are funds to purchase conservation easements, there are really not very many of those purchase transactions, and, much more important, it is a rare situation indeed (although it does happen) when a government agency, or a land trust or any other conservation group buyer, actually pays full fair market value for the easement. (See Note #2 for a discussion of bargain sales of conservation easements.)
So, currently, the “market” really doesn’t really set a dependable and/or defensible dollar value on conservation easements. That might change some day. Some day there might be millions of fresh new dollars to buy conservation easements at full fair market value, but I doubt it.
So, currently, if there are not a lot of willing and informed buyers and very very few easement purchases that we can reliably state are at full fair market value, how do you “value” a conservation easement?
Put another way, how do you determine value if there is not a “market”?
Back to the past
In 1978, when I went to work in Chief Counsel’s office at the IRS in Washington, DC, one of the projects I was assigned was to draft the regulations on the “new” conservation easement provisions that had been included in the Tax Reform Act of 1976. Without going into any other issues or details, one of the things I was charged with doing in drafting the regulations was to determine how to value a conservation easement.
As a former employee of the IRS, there are many many things I am not at liberty to disclose, although at this point most of them would be really boring. I’m not sure whether the following falls into the “can’t talk about” category, but here goes anyway.
I spent considerable time going through existing IRS files on valuation, valuation of charitable gifts, and related issues, and I found an old file that was exactly what I was looking for. It seems that in 1970, the IRS opened an internal study project on how to value a conservation easement. (This might have been because of some tax law changes in 1969 that had to do with conservation easements. That history is beyond the scope of this Note.) The file wasn’t very thick, and (possibly because of the threat of imprisonment) I did not leave the IRS with copies of any of the relevant material, but as I recall there were references in the file to aquatic systems and biotic systems and some copies of old revenue rulings from the IRS on valuation that were only marginally relevant. And there were copies of Revenue Ruling 73-339. That ruling appears to have been the result of this three-year study. And as I recall, though I’m not sure, there may have been some information in the file about the methodology of determining damages that is used in condemnation (or, eminent domain) cases, (that is, how much value the landowner has lost, and therefore how much payment the landowner is entitled to).
Very simply put (really, very simply, there are many generalizations here), in condemnation cases, and this has been the rule for decades, the amount of damages is determined by valuing what the landowner owned before the “taking,” and then by valuing what the landowner was left with after the taking. The difference between the “before” value and the “after” value was the amount of the damages award.
Summarizing, Revenue Ruling 73-339 essentially applied the damages (or loss in value) concept to conservation easements. Revenue Ruling 73-339 said that the way you value a conservation easement is to look at the value of the property before the easement is donated (and that really is a “fair market value” determination – what would Aunt Sally get if she put the property on the market and sold it), then look at the value of the property after the easement is donated (and that also is a “fair market value” determination – what would Aunt Sally get if she put the property, restricted by the easement, on the market and sold it). The revenue ruling said that the difference between the “before” value and the “after” value is the value of the conservation easement.
So now we have finally reached the starting point of this discussion, or, as someone once said (extra points for identifying the speaker), “Perhaps now we can begin.”
Notice of Proposed Rulemaking – conservation easement regulation published in 1983
Generally, when the IRS has completed work on a proposed regulation, that document is published in the Federal Register, and there is a comment period and sometimes a hearing. The IRS reviews the comments and publishes the final regulation. Sometimes, the period between the Notice and the final regulation can take many years.
The Notice of Proposed Rulemaking for the conservation easement regulation was published in 1983. Here is the relevant (for this Note) part of the valuation rules from the regulation. The bracketed numbers do not appear in the regulation; I have added them for the following brief discussion of these initial, proposed rules:
“[1] The value of the contribution under section 170 in the case of a perpetual conservation restriction is the fair market value of the perpetual conservation restriction at the time of the contribution….[2] If no substantial record of market-place sales is available to use as a meaningful or valid comparison, [3] 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 land it encumbers before the granting of the restriction and the fair market value of the encumbered land after the restriction. [4] The amount of the deduction in the case of a charitable contribution of a perpetual conservation restriction covering a portion of the contiguous land owned by a taxpayer and the taxpayer’s family . . . is the difference between the fair market value of the entire contiguous tract before and after the granting of the restriction….” (emphasis added)
I will keep the discussion of these proposed rules very brief, since they were overtaken by the final regulation, published in 1986, and I cover that in greater detail in Note #9.
The first sentence quoted above at [1] states the obvious and the general rule: the deduction for a charitable gift is the fair market value of the gifted asset. But, as we discussed earlier in this Note, the traditional methods of determining fair market value don’t apply to conservation easements.
The language at [2] is understated, but it makes the point, again, discussed earlier, that first and foremost to determine fair market value of any asset we look for marketplace sales of that asset. It was certainly obvious in 1983, when the Notice was published, that there were few if any marketplace sales of conservation easements, but as the regulation points out, that’s where we look first.
Again, as discussed earlier, the rule at [3] is the basic rule for valuing conservation easements that emerged out of earlier IRS pronouncements: the value of the easement is equal to the value of the subject property before the easement, minus the value of the encumbered subject property after the easement. One interesting historical note: while it was clear that this was the basic rule, the attorney at the Treasury Department who had oversight of this regulation project (the Treasury is the boss of the IRS for these purposes) made the observation that at some point in the future, someone, including possibly the Treasury Department, might come up with a different and better way to value conservation easements. He insisted that we add to the regulation the parenthetical: “as a general rule (but not necessarily in all cases)….” For decades now, there has been a lot of writing about other possible ways to value conservation easements (citations omitted), but for federal income tax deduction purposes the general rule, at [3], is still the general rule.
There is some deep ancient history on [4] that is beyond the scope of this Note. An early example that we considered at IRS was that of a landowner who owned an undeveloped oceanfront house lot which was very valuable, and also owned a house lot behind the oceanfront lot, which was not as valuable, given the fact that someone could build on the oceanfront lot and block the view from the rear lot. The thinking at IRS (and possibly elsewhere) was that if the owner put a conservation easement on the oceanfront lot, the easement would indeed dramatically reduce the value of that lot, and, without more, would yield a very large income tax deduction. But, the analysis went on, that would mean that the view of the ocean from the rear lot would never be impaired, so the value of the rear lot would go up. So the rule at [4] really goes to the question, “How much economic value did the landowner really give up with this conservation easement?” There is a longer discussion of this “contiguous property” rule in Note #9.
The final regulation — 1986
To conclude this Note #8 and provide a bit of a transition into Note #9, when the final regulation on conservation easements was published in 1986, the relevant valuation rules from the Notice of Proposed Rulemaking were changed a little bit (though not much) and an additional rule was added.
Here are the rules from the final regulation published almost 30 years ago now, and these are the current easement valuation rules from the regulation. Note that there are four different valuation rules, and that means four different rules the appraiser should address. Again, the bracketed numbers do not appear in the regulation; I have added them to make the discussion easier. I have also broken out the rules into separate paragraphs, to make the identification of the rules easier:
The rules in the regulation now state:
“…. 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….
“[1] 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.
“[2] 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.
“[3] The amount of the deduction in the case of a charitable contribution of a perpetual conservation restriction covering a portion of the contiguous property owned by a donor and the donor’s family (as defined in section 267(c)(4)) is the difference between the fair market value of the entire contiguous parcel of property before and after the granting of the restriction.
“[4] 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…. For purposes of this paragraph …, related person shall have the same meaning as in either section 267(b) or section 707(b).”
We discussed briefly the rules at [1] and [2] and [3] above in the discussion about the Notice of Proposed Rulemaking that was published in 1983, and we will discuss these in greater detail in Note #9. Rule [4] was new in the final regulation; we will discuss that in Note #9.
The most common mistake I have seen in reviewing conservation easement appraisals is that appraisers do not understand and/or do not follow rule [3], the so-called “contiguous property” or “larger parcel” rule. It is also correct that rule [4] is technical, can be confusing, and often requires much more due diligence and analysis than many appraisers give this rule. I’m guessing the reason rule [4] isn’t broken as much as rule [3] is that once the appraiser completes the analysis required by rule [4], the facts are such that the rule does not apply. This will become clearer when we talk about all of this, and more, in Note #9.
Happy New Year and a great 2015 to all!!
