Note #9: Conservation Easement Appraisal Rules: History, Rules, Mistakes, Tips (Part II)
These Notes are not going to cover, and could not possibly cover, all of the rules that are relevant for conservation easement appraisals. There are extensive regulations and rules on “qualified appraisals” and even on “qualified appraisers”. There are relevant rules on how to fill out, correctly, federal tax Form 8283, Noncash Charitable Contributions, and pages of instructions that relate to that Form, and the “Supplemental Statement” that must be attached to that Form if you claim a deduction for the donation of a conservation easement. And, of course, there are simple and complicated valuation issues, like choosing good comparable sales, making appropriate adjustments to such sales, valid assumptions in a present value analysis, etc. Some future Note or Notes might deal with some of these, but not this time around. The focus of Note #8, Note #9, and Note #10 is the valuation rules in the conservation easement regulations, and the application of those rules.
The four rules in the regulations
We concluded Note #8 with the four different valuation rules from the regulations for conservation easements. That means there are four different analyses the appraiser must make. We will discuss Rule #1, Rule #2, and Rule #3 in this Note. The application of Rule #4 requires, in part, a completely different skill set. We will discuss Rule #4 (and other more technical issues that come up under these appraisal rules) in the next Note, Note #10.
Once again, here are the rules from the regulation, and, once again, the numbers I have added 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 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.
“ 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.
“ 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).”
What does the appraiser need to know and when does the appraiser need to know it??
Aunt Sally has a 500-acre farm. She intends to donate a conservation easement on it, and she is well advised, and she wants to know ahead of time, from a competent, experienced, qualified conservation easement appraiser, roughly what her deduction will be for the donation of the easement. What does the appraiser need to know?
The appraiser needs to know the four rules.
Accordingly, the appraiser needs to know about possible sales of other easements in the marketplace; this is usually fairly simple because this rule doesn’t apply anywhere yet because there are not enough of such sales.
The appraiser needs to know exactly what it is that Aunt Sally intends to encumber, how many acres, where they are, etc. The appraiser should also get confirmation from counsel that Aunt Sally really is the owner of the subject property (as opposed to, say, the property being owned by the Sally Smith 1999 Irrevocable Trust).
The appraiser needs to know if Aunt Sally owns any other land “in the area” (“in the area” is my own modifier; more on this modifier in the discussion of Rule #4), whether or not such land is contiguous to the to-be-encumbered property.
The appraiser needs to know if any family member owns any other land in the area, whether or not such land is contiguous to the to-be-encumbered property. For purposes of this question, and for purposes of the IRS rules, “family” is basically defined up and down and sideways – in other words, parents, grandparents, children, grandchildren, and siblings. “Family” in this context does not include nieces and nephews and aunts and uncles and cousins. An easement donor should check with experienced counsel on this point.
The appraiser also needs to know whether there are any partnerships, limited liability companies, trusts, or corporations, in which Aunt Sally (and possibly any of her family members, as defined in the prior paragraph) has an interest, that own any other land in the area whether or not contiguous to the to-be-encumbered land. This is important, and parsing through this in a manner that complies with the rules can be complex and difficult. But it must be done. There is more on this in the discussion of Rule #4.
We have run into a number of situations over the years in which, for example, one of Aunt Sally’s grandparents once owned a large parcel of land, and that larger parcel has been divided up and inherited by younger generations, and many of those younger-generation owners have done their own planning, so we might be looking at a number of parcels, contiguous or close to each other, that are owned by “related” persons (that is, “related” for purposes of the IRS rules; see the discussion of Rule #4). In such cases, we have found it very helpful, early on, to have a map showing each parcel and each owner and the relationship of each owner to the landowner who is donating the easement. Again, there is more on this in the discussion of Rule #4.
In order to follow some of the valuation rules, it is essential that the appraiser have this information. In the vast majority of cases, in fact, there will be no such property owned by any family member or “related person”, but, again, the appraiser needs to make that determination. If there is no such property, the appraiser should make that statement at the end of the appraisal report, and possibly at an appropriate place near the beginning of the appraisal report. See some suggested language in the next section of this Note.
Talking about the appraisal report….
While we are talking about the appraisal report, I strongly recommend that somewhere near the beginning of the appraisal report, the appraiser include the exact text of the regulation (as included at the beginning of this Note). This helps organize the discussion but perhaps more important it sends a clear message to all potential IRS readers that the appraiser is familiar with the rules. Then, the appraiser should follow that with some very short narrative, along the lines of the following, again, to send a clear message to all potential IRS readers that the appraiser is familiar with the rules.
The narrative following the recitation of the regulation rules could say something like this (of course, depending on the particular facts of the situation):
“As noted, the Treasury Regulations require that the appraiser follow four steps.
“As far as the first step, we have made appropriate inquiry and have determined that in the relevant marketplace there is no substantial record of sales of easements comparable to the subject easement.
“Because the subject conservation easement encumbers all of the contiguous property owned by the donor and the donor’s family, the appraisal assignment is to estimate the value of the donor’s entire contiguous property before and after the easement, and that follows in this report.
“In addition, the Treasury Regulations require that any ‘enhancement’ in value of other property owned by the donor or ‘related persons’ (as defined by the Treasury Regulations) be accounted for. The donor owns other property in ABC County and in XYZ County, but, as discussed in the report, there is no increase in value to such other property attributable to the donation of this Easement. Further, there are no other family members, nor are there any related persons, as defined by Treasury Regulations, who own any other property nearby. Accordingly, there is no enhancement to any other property owned by the donor or any family member or related person as a result of the donation of the conservation easement, so no further adjustment is necessary to the conclusion of value.”
To repeat, I think it is important to state the rules from the regulation, and answer the questions raised by the regulation, near the beginning of the report.
The first rule: sales of comparable easements
You will recall from Note #8 that “fair market value” is determined by evidence of what a willing buyer would pay a willing seller, and that fair market value may be relatively easy to determine when it comes to houses, land, cars, stock, etc. However, it is also correct that nowhere in the country is there, yet, an active market in buying and selling conservation easements for full market value. Although such sales happen sometimes, in some jurisdictions, there simply are not enough market-value sales of conservation easements anywhere for Rule #1 to apply. Such sales and such data might exist at some point in the future, although I think it is unlikely.
That having been said, as noted above, I do think every proper appraisal should include language more or less to this effect, in the form above or substantially similar to that: “Pursuant to the rules in the Treasury Regulations, as an initial step in the valuation analysis the appraiser has determined that no substantial record of marketplace sales of conservation easements exists in the subject market. Accordingly, we turn to the second rule in the Treasury Regulations.”
There really isn’t much more to say about Rule #1, except this. Some people, including appraisers, misread this rule to ask for comparable sales of other property that is restricted by a conservation easement. That is not correct. Rule #1 specifically refers to sales of conservation easements. Of course, information about sales of other property subject to conservation easements is often relevant in determining the value of property after the easement is donated.
The second rule: all of the property before and after the easement donation
It is my best guess that through the 1980s and 1990s and even after 2000, at least 80% of all easement donations fell into this category. That is, Aunt Sally has a 500-acre farm, she puts a conservation easement on all 500 acres, the value of the easement is determined by appraising the farm before the donation of the easement, and appraising the farm after the donation of the easement, and the difference is the value of the easement, or, in this case, the amount of the deduction for the easement. (Of course, we assume that neither Sally, nor any of her family members, nor any trusts or limited liability companies or partnerships in which Sally has an interest, etc., own any other property within 100 miles of the farm, which historically has been the case, most of the time.)
More and more often, especially in the past decade, it seems like more and more easement donations fall under Rule #3 (see below), that is, Aunt Sally has a 500-acre farm and puts a conservation easement on something less than the 500 acres.
In any case, it certainly appears that the simple “before and after” rule, Rule #2, continues to apply to the vast majority of easement donations.
This rule is not that complicated. Of course certain properties can indeed be difficult to appraise, and some properties can be difficult to appraise after the easement.
Let’s start with a simple example and take it from there. Remember, I am just making up these valuation numbers, but they are reasonable (or, as lawyers might say, they are not unreasonable).
Aunt Sally has a 500-acre farm in an area that is fairly rural but it is seeing some signs of development, and subdivisions are migrating outward from the city toward Sally’s property. Let’s just say that Sally’s farm is worth $2 million, unrestricted, in the current market. The property is certainly not worth $2 million as a farm, but it is worth $2 million to an experienced developer in the region, who is knowledgeable about the property, relevant zoning rules, and the relevant market. We won’t go through the valuation analysis, but the developer has gone through this exercise, and he knows if he buys Sally’s property for $2 million, gets the relevant approvals to create what the market is looking for, puts in the infrastructure, and sells the house lots, he will make a satisfactory profit.
But let’s say that Aunt Sally doesn’t want to see her property paved over and subdivided, so she puts a conservation easement on it, reserving the right to continue farming and agricultural activities, and to harvest timber. She also reserves the right to create and sell three 10-acre house lots, in locations where the house lots don’t interfere with the agricultural activities, don’t block the scenic view across the farm from the county road that runs past the farm, and don’t interfere with wildlife habitat. Let’s say that subject to that conservation easement, the farm is worth $1 million.
In this case, I made the math easy. The farm was worth $2 million before the easement, and $1 million after the easement, so the value of the easement, and the value of Sally’s income tax deduction for donating the easement, is $1 million. And in this case, on the facts, no other adjustments or calculations are necessary (see, i.e., the discussion under Rule #4).
Of course, this doesn’t need to be said, but I’m saying it anyway. Not every easement reserving three house lots on every 500-acre farm will reduce the value of the farm by 50%, or by $1 million. If there is quite a bit of subdivision pressure near the farm, the farm could well be worth more, because of its higher development potential, and a conservation easement extinguishing all but three house lots could reduce the value of the farm by far more than 50%. And there are innumerable other variations on this theme. So this is just an example of how Rule #2 works, the “before and after” rule.
Rule #3: all the contiguous property owned by the donor and the donor’s family
THE MOST COMMON MISTAKE I SEE IN APPRAISAL REPORTS IS THE FAILURE OF THE APPRAISER TO COMPLY WITH THIS PARTICULAR RULE. EITHER THE APPRAISER DOESN’T KNOW ABOUT THE EXISTENCE OF THIS RULE, OR THE APPRAISER KNOWS ABOUT THIS RULE BUT FAILS TO FOLLOW THE RULE CORRECTLY.
Again, to state the rule simply, if the donor puts a conservation easement on a portion of all the contiguous property owned by the donor and the donor’s family, the appraiser needs to value all the contiguous property before the easement and then value all the contiguous property after the easement. We often refer to this as the “contiguous property rule” or the “larger parcel rule.”
Let’s say that Aunt Sally owns a 500-acre farm, and she puts a conservation easement on the western 250 acres. Some appraisers would say, “I know how to handle that. We look at the value of those 250 acres before the easement, and then we look at the value of the same 250 acres after the easement, and the difference is the value of the easement and therefore the value of the deduction.”
Some appraisers would say, “I know how to handle that. First, we look at the value of the 250 acres before the easement, and then we look at the value of the 250 acres after the easement, and we come up with a number. Then, we look to see if there has been any enhancement, any increase in value, to the other 250 acres Sally owns. If there is an increase in value there, we reduce the value of the easement by that amount, and therefore we reduce the value of the deduction.”
Closer, but still wrong.
According to the “contiguous property” or “larger parcel” rule, the appraiser must first value all 500 acres – what is the fair market value of all 500 acres – what would someone pay Aunt Sally for the entire 500 acres – before the easement, and then value all 500 acres – what is the value of all 500 acres now that 250 acres are restricted by the easement – what would someone pay Aunt Sally for the 500 acres NOW, and the difference, according to the regulation, is NOT “the value of the easement,” but it is the value of the deduction.
In many many appraisals I have seen, the appraiser gets the gist of the rule but doesn’t use the correct methodology.
Here is another way appraisers get this wrong. In determining the after-easement value, the appraiser will do an analysis of the 250 acres before and after the easement, and then, without actually valuing the remaining 250 acres, will determine that there is no change in value to the remaining 250 acres, and then conclude the appraisal by stating that the drop in value in the encumbered 250 acres is the value of the easement. Even if this does in fact produce the correct deduction, it is the wrong methodology and it doesn’t follow the rule in the regulation. I have been involved in audits in which the appraiser has done it this way and the IRS has said, “Nope. You lose. You didn’t follow the rule in the regulation so we are denying the deduction.” I don’t see this mistake a lot but I have seen it too many times.
Here is the more common error. In determining the after-easement value, the appraiser will do an analysis of the 250 acres before and after the easement, and then will do an analysis of the unencumbered 250 acres, and just add the two values together. This may turn out to give us the correct number, but it is not the correct methodology.
It is absolutely necessary for the appraiser to follow this rule for two reasons. First, it is the rule and following the rule is not optional. Second, in some but not all situations, the rule in the regulations will produce a dramatically different result than the donor expected. Here is my favorite (and real) example.
More than a decade ago, I received a call from a group in a western state. Some years prior, they had purchased 10,000 acres; they were planning to create a resort, second-home community, equestrian community, a hunting and fishing community, with considerable open space.
“We have been working with, and fighting with, the county for a number of years,” they told me, “and we finally have approval to put 1,000 dwelling units, that is, 1,000 homes, on the 10,000 acres.” This was a so-called “density” approval. That is, they did not submit a “master plan” showing where the houses would be, where the community center would be, where the open space would be, etc. They simply had approval to put 1,000 homes wherever they wanted to (subject to certain limitations, such as avoiding steep slopes and riparian areas and buffers).
“We want to put a conservation easement on the western 5,000 acres,” they told me, “and we expect that will throw off a huge income tax deduction. We know the tax code rules and this is a slam-dunk conservation easement – habitat protection, open space protection, wonderfully scenic property.”
“Very interesting,” said I. “How many units are you going to give up?”
“Well,” they said, “we are not planning to give up any units. We are going to put all 1,000 units on the eastern 5,000 acres.”
Do you see where this is going? What is the highest and best use of the 10,000 acres before the easement? 1,000 single-family homes on 10,000 acres. What is the highest and best use of the 10,000 acres after the easement? 1,000 single-family homes on 10,000 acres. Well, maybe 950 single-family homes; maybe 900 single-family homes, but you get the point. They may (or may not) actually be giving up some value with the easement, maybe the house lots are smaller, or closer together. The point is that by following Rule #3, which is not optional, they were not going to get a BIG deduction at all, and they may in fact get NO deduction at all.
The impact of Rule #3 can vary dramatically from property to property, depending on things like local zoning rules and the marketplace. I know of one situation in which the owner wanted to put a conservation easement on about 30 acres out of a larger 100-acre property, and the appraiser had concluded, more or less along the same analysis lines as the 10,000-acre western property, that under the zoning rules of that particular jurisdiction the conservation easement would cause very little drop in value.
I know of another situation, with a 3-acre lot minimum under local zoning, where a similar easement on about 30 acres out of a larger 100-acre property clearly eliminated the right to create ten 3-acre house lots, but the appraiser had concluded that in that particular market the highest and best use of the 100-acre property was more or less 25 lots, rather than the 33 lots that could conceivably be created under the zoning rules, so this easement also had a minimal impact on value, if any impact at all.
And, of course, finally, I know of many situations in which an easement on a portion of a larger property has caused a significant drop in market value. The point is, the appraiser needs to do the analysis right.
As a relevant aside here, I usually like to retain a good appraiser early in the conservation easement planning process, and I usually like to ask the appraiser for an oral report on the value of the contemplated easement. We always spend time going over the rules and what the appraiser needs to know and when the appraiser needs to know it. I like to say, if there is going to be a pleasant surprise, that can wait, but if there is going to be an unpleasant surprise, I need to know about that early. Translated for this Note #9, if the amount of the deduction is important to the landowner, and if the value of the deduction is going to come in less, or considerably less, than the landowner anticipates, we should find that out early, before spending a lot of time, and effort, and planning, and money on the conservation easement project.
One more technical point while we are at this. There is a very important language distinction in the regulation. The regulation says if you are under Rule #2, the fair market value of the restriction, and therefore the amount of the deduction, is determined by following the “before and after” methodology. If you are under Rule #3, and for that matter if you are under Rule #4, the regulation tells you how to determine “the amount of the deduction,” which under Rule #3 and Rule #4 may or may not be the same as the fair market value of the restriction. If this is confusing, please read on.
Rule #4: related parties, family, other property, “enhancement”
Rule #4 can get very very technical. For purposes of this Note #9, I will give a very simple example of how Rule #4 might work, and then stop. In Note #10, I will go into the technical details of Rule #4 in greater detail, because those technical details are important and not always clear. In Note #10 I will also cover some of the other more technical issues that come up under these appraisal rules, and one or two other issues that go beyond the four rules but can give donors, appraisers, and the IRS headaches.
Aunt Sally owns a ranch in the valley. The valley is mostly undeveloped. The Sally Smith Family LLC owns a house and large lot up on the hillside overlooking the valley. A few other “unrelated” homeowners own adjacent lots up on the hillside. Sally owns 65% of the membership interests in the Sally Smith Family LLC.
Aunt Sally puts a conservation easement on the ranch. Let’s just say for purposes of the discussion that the easement lowers the value of the ranch by $2 million. But because of the donation of the conservation easement, now the view across the valley from the house owned by The Sally Smith Family LLC will never be impaired, and an appraiser concludes that the value of the house and lot increases by $100,000. According to Rule #4, Sally’s deduction for the conservation easement (not the “value” of the easement, but the “deduction for” the conservation easement) is $1,900,000 (that is, $2,000,000 minus the $100,000).
That is a very simple example of how Rule #4 works. More in Note #10.
(Note that we can assume that the value of the house lots owned by Sally’s few “unrelated” neighbors on the hillside may also increase, but that has no impact on Sally’s deduction. That is simply the good fortune of the neighbors.)