Note #10: Conservation Easement Appraisal Rules: History, Rules, Mistakes, Tips (Part III)
In Note #8 and Note #9, we reviewed the history of the conservation easement appraisal rules that are included in the Treasury Regulations, and we began a discussion of the four rules, in the regulations, that every appraiser must follow in every qualified appraisal report substantiating the deduction for a conservation easement donation.
Note #9 covered the first three rules, but I deferred a discussion of Rule #4 to this Note #10 because Rule #4 takes us into new and much more tax-technical territory.
For reference, again, here are the four rules. Again, the numbers I have added do not appear in the regulation; I have added them to make the discussion easier, and 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).”
And, at the end of Note #9, here is the example I gave of how Rule #4 works.
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).
I added 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.
So, what does Rule #4 tell us? Rule #4 tells us that if you donate a conservation easement, and, as a result of that easement, the value of any other property, anywhere, goes up, and if such other property is owned by Aunt Sally, or a family member or a “related person,” the deduction for the conservation easement is reduced by the amount of the increase in value of such other property.
This means, to start, that you need to know at least these three things.
First, you need to know the definition of family for purposes of this Rule #4. This is easy; more on this below.
Second, you need to know the definition of related person for purposes of this Rule #4. Understanding the definition, and understanding the application of the related person rule, can be work. More on this below.
Third, you need to know if the donor, or any “family” member, or any “related person,” owns any other property “in the area.”
Then, if the donor, or any family member, or any related person, does own any other property in the area, the appraiser needs to determine whether or not that property increased in value because of Aunt Sally’s easement. Sometimes we call this the “enhancement” rule.
Let’s review family, related person, and “in the area.”
The definition of “family,” for purposes of these conservation easement rules, is simple. As I like to say, it goes up and down (parents, grandparents, children, grandchildren) and sideways (siblings of the donor). In this context, “family” does not include aunts and uncles and nieces and nephews and cousins. The interpretation of this rule usually does not create confusion.
The definition of “related person” is much more difficult and complicated, and in fact it is even more difficult and complicated than it seems. I am going to generalize and simplify here. If you think these rules cover you, you must check with an experienced advisor to make this determination.
Essentially, this rule can reach out and apply to donors and partnerships, or limited liability companies, or corporations, in which the donor owns “directly or indirectly” (more on this below) more than 50% of the interests, or stock (more on this below). The rule also can reach out and apply to grantors and trustees of trusts, trustees and beneficiaries of trusts, corporations in a controlled group, executors and beneficiaries of estates, and on, and on, and on.
An important caveat: in the vast majority of situations, if the donor, or counsel, or the appraiser, do the due diligence, make the appropriate inquiries, and study the correct maps, they will find that Rule #4 simply does not apply to their particular situation. That is, no family member, or trust, or partnership or limited liability company in which the donor has an interest, owns property in the area. But the due diligence must be done.
In addition, there are many situations in which family members or partnerships do own other property in the area, and for one reason or another there is no increase in value to that other property because of the easement donation. The property is too far away, it is over the hill and not visible from the easement property or the view is otherwise blocked, etc. More on this below. But the due diligence must be done.
Another very tricky and highly technical issue involves what the tax code calls “direct or indirect” ownership. This (following) discussion could convince some of you who are reading this Note to do something else, so I will try to keep it as simple as possible. If you have come this far, stay with me….
Not an easy example
Aunt Sally owns a farm. The Sally Smith Family LLC, which is treated for federal income tax purposes as a partnership, owns an abutting farm. Aunt Sally owns 48% of the LLC, Aunt Sally’s husband Bob owns 30% of the LLC, and their son Rand owns 22% of the LLC. Aunt Sally places a conservation easement on the farm, and, as a result, the abutting farm owned by the LLC will always have a view of a river that runs by Sally’s farm, so the farm owned by the LLC increases in value. Under the tax code partnership attribution rules (which have nothing to do with conservation easements but have a lot to do with the tax consequences of various transactions when “related” family members own partnership interests), Aunt Sally is treated as (or, “deemed to be,” as the tax rules might say) the owner of 100% of the LLC interests. Because Aunt Sally is treated as owning 100% of the LLC interests, the LLC is now a “related person,” for purposes of the tax rules generally but also in particular for purposes of the conservation easement valuation regulations. Accordingly, the appraiser must first value Sally’s farm before and after the easement, then the appraiser must determine the amount of the increased value of the LLC farm, and the deduction for the donation of the easement will be reduced by the amount of the increase in value, or the “enhancement,” to the LLC farm.
Again, because of the partnership attribution rules, Aunt Sally is treated as the owner of 100% of the LLC interests. (Generally, the partnership attribution rules, as well as the corporate stock attribution rules, come into play when close family members, such as parents and children, own interests in the same corporation or partnership. This is the very very simplest example, but for purposes of a wide variety of tax code rules, parents are treated as owning stock, or partnership interests, owned by the children. The partnership attribution rules are beyond the scope of this Note, but they are not beyond the scope of a complete analysis of the issues raised by Rule #4.)
I often quote Abraham Lincoln, who said something like, “if this is the sort of thing you like, you’ll like this sort of thing.” If this is the sort of thing you like, the above example is taken almost directly from Chief Counsel Advice (“CCA”) Number 201334039, August 23, 2013 (the above example is essentially Scenario 4(b) from the CCA). The CCA is very technical but very clear for those who work in this field, and includes other examples both simpler and more complicated than the one I discussed above. If you think you might be covered by any of these related person rules, you must review the CCA.
“In the area”
As I said in Note #9, this is a modifier that I made up. The regulation doesn’t say “in the area.” The regulation says if “any other property” owned by the donor or a family member or a related person increases in value because of the conservation easement, the appraiser needs to take that into account.
Aunt Sally puts a conservation easement on her farm. Obviously, if Aunt Sally, or her daughter, or The Sally Smith Family LLC, own property 10 or 100 or 200 miles away, such property will not increase in value as a result of Sally’s easement.
If Sally or a family member or (for example) a related person LLC does own property in the area (perhaps a better and fancier modifier would be “within the sphere of influence” of Sally’s farm), the appraiser needs to know about that, and the appraiser needs to determine whether there is any increase in value to that property attributable to Sally’s easement. If there is no such property within the sphere of influence, or if there is such property but it does not increase in value because of the easement, the appraiser should state the result of this due diligence in the appraisal report. See, for example, the language under “Some language for the appraisal report,” near the end of this Note #10.
If there is such property, and if such property does in fact increase in value because of Sally’s easement, the appraiser needs to measure (appraise) that increase in value, and the deduction for the easement is reduced by that amount. Interestingly enough, the way the appraiser measures that increase is to value the “enhanced” property before Sally’s easement, then value the “enhanced” property after Sally’s easement, and the difference in value is the “enhancement,” and Sally’s deduction is reduced by that amount.
Some observations about enhancement
If there is other property owned by Sally, or a family member, or a related person, and it is not in the area (or within the sphere of influence) of the farm that Sally put under easement, it is highly unlikely there is any enhancement. (The appraiser may or may not want to say something about this; see the discussion, below, about “Proximate Other Property and Non-Proximate Other Property.”)
This is a major generalization, but if there is other property owned by Sally, or a family member, or a related person, and it is nearby but it does not abut the farm that Sally put under easement, it is unlikely (though not impossible) there is any enhancement. But the appraiser needs to make that determination and explain his or her conclusion in the appraisal report. Further on that point, if there is other such property nearby, or in the area, or within the sphere of influence, there might be enhancement but that is unlikely if the view between Sally’s farm and such other property is blocked by the topography (a hill) or by man-made features (an apartment complex). Again, see “Some language for the appraisal report”.
Proximate Other Property and Non-Proximate Other Property
And then there are the more complicated cases. A few situations I have been involved in have had these facts. Landowner (either an individual, or an entity like a limited liability company) donates a conservation easement on Property. Landowner owns other parcels of property in the area of (within the sphere of influence of) Property. Some of those parcels increase in value because of the easement; some do not. Landowner also owns other property, and related persons own other property, further away, that is, not within the sphere of influence, and there is clearly no enhancement to such other further away property.
The first point here is that to reach a point of knowing all of the facts in the above paragraph took a lot of work, with respect to gathering the ownership facts in the first place, and with respect to making the enhancement-no enhancement determinations for the various properties. And then, even with all of this information in hand, writing this up in the appraisal report in an organized and readable fashion was a challenge.
One suggestion for framing the discussion in the appraisal report is to divide all these other properties into “Proximate Other Property” and “Non-Proximate Other Property.” In the appraisal report, the appraiser first discusses each of the Proximate Other Properties, all of which were within the sphere of influence of the easement property but only some of which had their values increased or enhanced by the conservation easement. In the next section, Non-Proximate Other Properties, the appraiser first makes the statement that these were all too far away for the easement to have any impact on value but then the appraiser lists all of them anyway!
Overkill? I don’t think so. I would call this excellent due diligence AND I would call this taking an argument or question away from the IRS in the case of an audit. For example, instead of allowing an agent to ask, “Well, we know about this other property the donor (the IRS would call her ‘the taxpayer’) owns, and why didn’t you cover it in the appraisal report? We believe there is some enhancement, and you didn’t cover it, so we are denying your deduction.” As far-fetched as this argument might sound, I have been in audit situations where claims like this, at this level of absurdity, are made regularly. So head this off at the pass, so to speak. Trust me.
Some language for the appraisal report
This is just an example, but it is the sort of thing I referred to a few times earlier in this Note, and I also included some suggested language for the appraisal report in Note #9. As I said there, after the appraiser includes, verbatim, the rules from the regulation (near the beginning of this Note), the appraiser should then include a brief discussion that goes something like this. Obviously, the particulars will depend on the particulars of each appraisal situation, but you get the point:
“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.”
Sometimes, the application and explanation of Rule #4 can get more complicated. Here is language with respect to Rule #4, slightly modified, from one appraisal report:
“Pursuant to the Treasury Regulations, we have determined that a related party (as defined by Treasury Regulations) owns an apartment complex, known as Woodmere Commons, abutting the subject encumbered property. The design of Woodmere Commons is such that windows and patios are directed to a central courtyard (away from the encumbered area), and do not have a view of the encumbered property, and residents of Woodmere Commons do not have a right to use the encumbered property. Further, we have also determined that there is no enhancement to Woodmere Commons attributable to the conservation easement because no new construction permitted by local zoning rules on the encumbered property (in the absence of the easement) would have any adverse impact on the value of Woodmere Commons.
“In addition, a related party owns another small property (a 3.5-acre vacant lot) in the vicinity of (but not visible from) the encumbered property, but there is no enhancement to that lot attributable to the easement because of the distance and already existing apartment and condominium construction between it and the encumbered property.
“Accordingly, because there is no enhancement attributable to the conservation easement to any other property owned by a family member of or a related person to the donor of the easement, no further adjustment is necessary to the conclusion of value.”
And, almost in conclusion
Know the rules and how they work.
Do the due diligence: know who owns what and, when it is necessary, the relationship, if any, of the owners of the various parcels in the area to the easement donor. Create a map if necessary to help work through the Rule #4 issues.
The appraiser should make it clear, near the beginning of the appraisal report, that the appraiser knows the rules in the regulation and is following them. I also recommend that at the end of the report the appraiser state (actually, restate) any conclusions with respect to Rule #4.
Finally, as I said in Note #8 and Note #9, the purpose of these three Notes is primarily to go over the appraisal methodology rules in the conservation easement regulations. There are all sorts of other issues that can come up in a conservation easement appraisal, but those are beyond the scope of these three Notes.
Bonus: A Quiz!!!
When I wrote the first Preserving Family Lands book, way back in 1988, all donors who made gifts of conservation easements (in fact, all donors who made gifts to charity of property that had gone up in value) needed to pay careful attention to the alternative minimum tax (“AMT”) rules. Since that time, Congress has repealed the particular tax code rule that brought the AMT into play for gifts of appreciated property to charity. But in 1988 it was a potentially significant issue for donors, and I thought it would be good to include a chapter in the original Preserving Family Lands on how the AMT worked. I planned to self-publish the book when it was done.
When I had completed the first draft of my book, I think the chapter on the AMT was something like Chapter 6 out of a total of ten chapters. I shared the draft of the book with my senior partner at the law firm where I worked at that time. He was a smart guy and had an excellent entrepreneurial sense.
He read the manuscript overnight, showed up in my office the next morning, and dropped the manuscript on my desk.
“I think this is great,” he said, “and I think you should go ahead and have it printed up. But you really should take the chapter on the AMT out of the middle of the book and move it to an Appendix. Some nice little old lady will be reading the book, and she’ll be learning a lot, because it’s easy to read, and she’ll come to the chapter on the AMT and she’ll sigh ‘oh my’ and she’ll put the book down and never finish it. If you put it in an ‘Appendix’ at the end of the book, she’ll finish what you want her to read, she’ll come to the Appendix and she’ll say, ‘I’m so glad I don’t have to read that!’ and she’ll put the book down. But the people who really want to understand the AMT will keep reading.”
I took his excellent advice.
Consider the following “Quiz” an Appendix to this Note #10. It has to do with the application of the “related person” rule in the regulation, and it is highly technical. If you want to stop reading right now, you can, or you can stop reading at any point in the quiz.
“Related Person” Quiz
For each scenario below, discuss how the appraiser determines the value of the conservation easement that is donated.
- Aunt Sally owns Parcel A, and Aunt Sally’s mother owns Parcel B. Aunt Sally donates a conservation easement on Parcel A.
- Aunt Sally owns Parcel A. A single-member limited liability company that is treated as a disregarded entity for federal income tax purposes (an “SMLLC”) owns contiguous Parcel B (I told you you could stop reading at any point in the quiz). Aunt Sally is the single member of the SMLLC. Aunt Sally donates a conservation easement on Parcel A.
- Aunt Sally owns Parcel A. An SMLLC owns contiguous Parcel B. Aunt Sally’s daughter is the single member of the SMLLC. Aunt Sally donates a conservation easement on Parcel A.
- Aunt Sally owns Parcel A. A limited liability company (“LLC”) owns contiguous Parcel B. Aunt Sally owns 48% of the LLC, her husband Bob owns 30% of the LLC, and their son Rand owns 22% of the LLC. Aunt Sally donates a conservation easement on Parcel A.
- Aunt Sally owns Parcel A. A limited liability company (“LLC”) owns contiguous Parcel B. Aunt Sally’s husband Bob owns 60% of the LLC interests, and two of Bob’s golfing buddies, not related to Bob or Sally, each own 20% of the LLC. Aunt Sally donates a conservation easement on Parcel A.
For those of you who have made it this far, and are actually trying to answer the questions, rather than just read them, this must be the sort of thing you like. And for you I have a prize. The questions above are taken more or less directly from CCA No. 201334039, which appeared earlier in this Note (as did question #5, above), and the answers are all in the CCA. Question #1 above is Scenario 1(b) in the CCA, question #2 is Scenario 3(a), question #3 is Scenario 3(b), question #4 is Scenario 4(b), and question #5 is Scenario 4(c). If this is the sort of thing you like, you will find the CCA very instructive, indeed.