Note #14: How to Do, and Not to Do, a “Conservation Buyer” Transaction
Now it is time for a series of Notes dealing with tax rules that can make it harder to do a land conservation transaction, and some planning steps you can take to have a shot at getting these transactions done. I will also cover at least one tax rule that may make it easier to do some transactions.
The material in this “series” is taken from work I have done for clients, and, in some cases, from memos I have done for clients. In those cases, names and some facts have been changed to protect client confidentiality.
At this point, I’m thinking about five Notes in this series, but I’m not going to summarize any of those future Notes here, because I might change my mind (and something else particularly timely might come up). But let’s start with this Note #14, which addresses a decades-old planning problem in the land conservation business: how to do a “conservation buyer” transaction that meets the goals of all of the parties. If you think this is easy, think again. Or, better, read on.
Most of this Note #14 is adapted from work and a memo I did for a client.
Here are the facts as you have shared them with me.
The Local Land Trust (“LLT”) owns an 800-acre tract of land LLT has been managing and improving for wildlife habitat for many years. They now desire to sell the land, and they have a potential conservation-minded buyer, but they want to be certain the property is protected in perpetuity with a conservation easement. They would like another land trust in good standing, most likely the State Habitat Center, to hold the easement. The question you have asked is (1) how can LLT sell the land to the prospective purchaser and be certain that the conservation easement will actually be granted, while (2) still allowing the purchaser to take an income tax deduction for the donation of the conservation easement?
We can call this a typical “conservation buyer” project, in which the seller of the property wants to sell it for full fair market value to a buyer who has agreed, ahead of time, as part of the deal, to some sort of enforceable commitment to put a conservation easement on the property. In some cases, the seller is a land trust or other conservation organization; in many cases, the seller is a private landowner who loves the land but is reluctant to put a conservation easement on her land herself because she needs the cash from a full market-value sale. Over the years, we have seen a number of different suggestions on how to structure this transaction to achieve that result.
In order to make this memo more complete, let me share some of the ways I think do NOT work, then get to my suggestion of how to make this work. The fundamental tax questions, of course, are the ones you have asked: how can the seller can get full fair market value for the property and the assurance that the property will be restricted, while at the same time giving the conservation buyer the opportunity to take a charitable contribution deduction for the protection of the property with a conservation easement.
Let’s go back and visit with Aunt Sally so we can see what works and what doesn’t work.
Aunt Sally owns a farm. The fair market value of Sally’s farm is $1,000,000, unrestricted. Subject to a conservation easement, reserving the right to continue agricultural activities and reserving the right to construct two more house lots but otherwise prohibiting any new residential construction, the farm is worth $400,000. Therefore, a conservation easement on the farm is valued at $600,000.
(The structure I will recommend, below, works whether Aunt Sally is the owner or whether a land trust or other conservation group is the owner.)
A “typical” structure we have seen over the years is for the purchaser to agree, in the Purchase Agreement, that at the time of closing the purchaser will donate a conservation easement on the property. A variation of this, either before being allowed to sign a Purchase Agreement or before closing, is that the purchaser is required to sign an option agreement giving the land trust the option to acquire a conservation easement, usually at a price well below the fair market value of the easement, at some point after closing (sometimes more than a year after closing). See Note #15, in which I discuss in greater detail the use of an option to “secure” the conservation of property. In the “option” situation, the conveyance of the conservation easement is in effect “assured,” because even though the option agreement does not have to be exercised, the parties intend that the option will in fact be exercised.
At a workshop attended by hundreds of people some years ago, in discussing “conservation buyer” transactions, an attorney in the IRS Office of Chief Counsel said this: if you can’t buy the property unless you make an enforceable commitment to put a conservation easement on it, the commitment to donate the easement is part of the “consideration” for the purchase (“consideration” in this legal context means part of what you are paying for the property) and therefore is not a charitable contribution and therefore is not deductible. The tax and legal analysis is the same with respect to the option arrangement: if the only way the buyer will be permitted to buy the property is to sign the option, the easement is not a charitable contribution and is not deductible. Signing the option is part of the “price” for getting into the deal. Without going into a longer discussion, this is not an unreasonable position, it makes sense, and it might be the correct answer to the question. While the comment in that workshop was not “official” IRS policy, it is in fact a reasonable and supportable interpretation of the law.
Others have suggested a different result. Why shouldn’t a conservation-minded landowner, a philanthropic purchaser, be able to pay full market value for an important property, with the intention, fully charitable, and the commitment, in writing, to donate a conservation easement on that property after purchasing it, and take a deduction for the value given up? This position is also defensible. But as a tax law matter, I don’t think it works. Readers are free to disagree. (Of course, readers are free to disagree with any or all of my Notes.)
Even before the IRS attorney’s comments, I had been uneasy about transactions in which the buyer was required to make a commitment ahead of time to protect the property as part of the cost of getting into the transaction. While I understand the “philanthropic purchaser” line of thinking, I have told people that I believe the IRS could successfully deny the deduction if the commitment to convey an easement is part of the deal and the purchaser makes such an irrevocable commitment, in writing, as part of the purchase documents. I believe the issue is the same with the option agreement.
In the face of these sorts of proposed structures (and you will note that below I propose a different structure), to be certain that it the contribution of the easement is deductible, I believe the buyer must own the property free and clear of any enforceable commitment to donate a conservation easement for some undetermined period of time, say at least 30-60 days and longer if possible, before the donation, or before making an enforceable commitment (for example, with a pledge, or with an option) to donate a conservation easement. In other words, there must be a period of time during which the buyer/owner must be free to sell the property, unrestricted, to anyone. If the owner subsequently decides not to do that but instead decides to put a conservation easement on the property, that easement should be deductible.
In other words, the “trust me” situation could work. That is, assume the prospective purchaser says, “It is my current thinking, and my current intention, to put a conservation easement on the property at some point after I buy it. But based on the advice of my attorney, I simply can’t say any more than that and I can’t make any other commitment.” Of course, in this situation, there is a risk that the buyer will not donate the easement, and most land trusts with whom I have spoken are not willing to take such a risk, even if the buyer is known to them and trusted by them.
This is where the “what if the buyer is hit by a truck” discussion comes up. The buyer may have the best intentions, and may be telling the truth, but if the buyer purchases the property, and then gets hit by a truck, the person who steps into the buyer’s shoes (a fiduciary, a spouse, etc.) may say, “I understand the conversations you had, but I have a fiduciary duty to maximize the value of his estate and I can’t put a conservation easement on the property,” or, simply, “No.”
There is one more common variation of the conservation buyer structure, although less common more recently, that has been on the table from time to time in the past. This has been a structure that has been discussed when a conservation group (“Land Trust”) owns the property. The suggestion is that Land Trust put a conservation easement on the property and then sell the property to the buyer, restricted, for the “reduced” value, and that the buyer also makes a cash contribution to Land Trust for the difference between the reduced value and the unrestricted appraised value. Using the numbers from the Aunt Sally example, the farm is valued at $1,000,000 unrestricted. Land Trust puts a conservation easement on the farm, and that lowers the value of the farm to $400,000. Land Trust agrees to sell the property, restricted, to a buyer who also, as part of the deal, must agree to write a check to Land Trust for $600,000, the value that Land Trust “gave up” with the donation of the conservation easement.
The IRS does not like these transactions. There is authority for the proposition that if you buy an asset from a charity (or a government agency), and pay more than fair market value, the excess payment is deductible as a charitable contribution. But there are at least two problems with the use of that concept in the above example. First, to repeat myself, the IRS does not like these transactions. Second, while it might be correct that the voluntary payment of an additional amount is deductible, the required payment of that additional amount does not appear to be “charitable” at all, but rather appears to be a non-deductible “fee” to get into the transaction, or perhaps even non-deductible as part of the purchase price.
A complete analysis of all of the above tax issues is beyond the scope of this Note. The bottom line is this: I would recommend that any conservation buyer to whom the income tax deduction for the easement donation is important not agree to any of the above structures or proposals.
That leads me to this important observation. In today’s climate I believe there is no certain way to structure this transaction in any of the (above) “traditional” ways that will both ensure that the property is protected and preserve an income tax deduction for a conservation buyer who makes an enforceable commitment to convey a conservation easement.
But I have a different structure that, bottom line again, I think works. There is really no authority addressing this structure, but I have been talking about it, recommending it, and suggesting it for years, and I have not heard anyone suggest a “fatal flaw” in this plan. I offer it for your consideration.
In the transaction you asked about, here are the steps. Recall that LLT owns the property and wants to sell it. First, the party that is going to be acquiring the easement must have an appraisal to determine the value of the conservation easement. Then, the conservation buyer makes a cash (by check) contribution to the party that is going to be acquiring the easement, assume that is the State Habitat Center, of an amount that is at least somewhat higher than the value of the easement. Then the State Habitat Center signs a contract with LLT to purchase the conservation easement. Then the conservation buyer signs a contract with LLT to purchase the restricted fee. I am skipping over a lot of the lawyer details.
At closing, the State Habitat Center purchases a conservation easement from LLT; the conservation easement should be complete and correct, and should meet all of the requirements of section 170(h) of the tax code for deductibility (more on this below). Then the conservation buyer purchases the restricted fee from LLT.
The result? LLT ends up with the full unrestricted fair market value purchase price. The State Habitat Center ends up with a conservation easement. The conservation buyer ends up owning the restricted fee. The conservation buyer has made a deductible cash contribution to the State Habitat Center.
Here are a few further important observations.
First, it is important that the land trust that is buying the conservation easement have an accurate appraisal of the value of the easement. If the landowner wants to sell the land trust the easement for less than its fair market value, that’s fine, that’s a bargain sale, that works (see Note #2). However, if the seller is a private landowner, the land trust cannot “overpay” a private landowner for the easement – that would create private benefit (a discussion that is beyond the scope of this Note).
Next, it is important that the purchased conservation easement meet all of the requirements of Section 170(h) of the tax code for deductibility. Again, informally, an IRS attorney has said that one potential problem with this proposed structure could be if the cash contribution to the land trust easement buyer, and the subsequent purchase of the easement, turns out to be a way for the buyer to avoid meeting all of the requirements of the tax code rules for easement deductibility. So the purchased easement should be in every respect identical to what a donated easement would look like if the transaction were in fact the traditional donation of a conservation easement. (This does not mean the IRS “blessed” the rest of the structure; it was solely a comment addressed at a potential tax issue.)
Third, there are a number of other potentially tricky legal and “deal” issues that can come up with this structure, so participants should be careful to get good legal advice from experienced counsel on all aspects of the proposed transaction. Those legal and deal issues are beyond the scope of this Note. As lawyers say, there is no authority strictly on point about this. I think it works, but this is not legal advice. If you want to do a transaction like this, get good legal advice.
I concluded the memo to the client with this: This is not intended to be an opinion letter; it is my good-faith attempt to discuss some of the issues surrounding “conservation buyer” transactions in general and this transaction specifically.