Note #15: Using an Option to Help Save Land
In Note #14, we discussed some of the structures that people have been using to complete “conservation buyer” transactions.
As a refresher, the situation we considered is when an owner (whether the owner is a conservation group or a private landowner) wants to sell property for its full, unrestricted fair market value, but wants an enforceable commitment from a “conservation buyer” that the property will be protected, in perpetuity, with a conservation easement. As we discussed in Note #14, one of the goals of these conservation buyer projects is to be sure the buyer is entitled to an income tax deduction for protecting the property with a conservation easement. And, as we discussed in Note #14, if the buyer makes an enforceable commitment ahead of time to protect the property, the conveyance of a conservation easement is likely to be NOT deductible. The IRS would argue, and I would agree, that if the only way the buyer is going to be allowed to purchase the property is to make an enforceable commitment to protect it, the conveyance of the easement is part of the business deal, it is not a charitable contribution, and therefore it is not deductible.
The “holding period” rule
Before we turn to a slight variation on these transactions, we need to discuss the “holding period” rule. Very very simply put, the tax rules say that if you purchase an asset (any asset), and you donate that asset to charity before you have owned it for more than a year, your deduction is limited to your “basis” in the asset. “Basis” is a tax concept; it often means what you paid for something (although it doesn’t always mean that, but a longer discussion of “basis” is beyond the scope of this Note). For purposes of this Note, let’s just assume that cost and basis are the same. So, if Aunt Sally buys a farm for $1,000,000, and turns around and donates that farm to the land trust before she has owned it for a year, Aunt Sally’s deduction for that donation is limited to $1,000,000. Even if Aunt Sally claims that the farm is really worth more than that, and that she bought it at a great price, in a distress sale from the seller, who had to get rid of it and dumped it, and even if Aunt Sally’s appraiser can deliver a bulletproof qualified appraisal that concludes the fair market value of the farm on the date Sally gave it to the land trust was $1,300,000, Aunt Sally’s deduction is limited to her $1,000,000 cost or basis.
If Aunt Sally donates a conservation easement on the farm (before she has owned the farm for a year), rather than donating the farm outright, her deduction will be limited to the cost or basis of that easement. The discussion of how you calculate the basis of an easement is beyond the scope of this Note; see Note #1 for a discussion of those issues.
Where are we going with this? Some “conservation buyers” are familiar with this “holding period” rule, and would like to wait more than a year, sometimes longer than that, before they donate the conservation easement, even though they agree ahead of time that they will in fact donate the conservation easement. How does the land trust deal with this situation? One common way is for the land trust to acquire an option to bargain purchase (see Note #2) a conservation easement from the buyer/owner. The terms of the option would state that it cannot be exercised until a period beginning say thirteen months after the buyer has purchased the property, with the option period running for say one year, or even two years, or even more. (There is more to the discussion of the use of an option in this way than this brief description; see that all in this Note, below.)
Once again, even though there can be legitimate ways to use an option to secure the protection of property, the same rule applies here as in the less-complicated traditional conservation buyer structure, discussed above and in Note #14. If the enforceable commitment to convey a conservation easement is the price a buyer has to pay to get into the deal, that is, to be able to buy the property, the conveyance of the easement is not charitable and therefore is not deductible. It doesn’t make any difference whether the easement is donated at or shortly after closing, or a year or two later, pursuant to an option.
But this sets up the real purpose of this Note #15, which is to discuss the proper use, and the tax and other complexities, of using an option to secure a conservation commitment.
Ok, so when can an option work?
Here are a few different situations in which an option can work.
Aunt Sally approaches the land trust.
“I’m going to buy another farm next to mine. Old Farmer Brown died, and his kids just want to sell the property, ‘get rid of it quick,’ they told the executor, and I think I’m getting a very good deal. I have been getting Notes from Steve Small, so I know the ‘conservation buyer’ rules and the ‘holding period’ rules, and I’m going to donate a conservation easement on the farm but I want to wait at least a year. So I’m going to buy the farm. But I don’t want you to worry, and I don’t want any of the neighbors to worry, so maybe two or three months after I buy the farm you can come over for some hot coffee and fresh pie and we can discuss the option I’m going to give you to buy a conservation easement on the farm at some point in the future.”
(We need a short digression. In the early days, that is, the late 1980s and into the 1990s, the Montana Land Reliance established a tremendous track record securing significant conservation easements from ranchers on thousands of acres in Montana. Some time around then, I asked the then-director of the Land Reliance, Jan Konigsberg, the secret of his success in dealing with Montana ranchers about conservation easements.
“I drink a lot of hot coffee and eat a lot of fresh pie,” he said.)
Here is a second situation.
Uncle Bob approaches the land trust.
“I think the real estate market is good again, and I think the country property I own is going to go up in value, a significant amount, over the next few years. But I like your work and I want to make a commitment now to donate a conservation easement to your land trust in two or three years. I’m going to give you an option that would allow that to happen.”
Here is a third situation. The fact pattern here is from a matter I worked on more than a decade ago.
Businessman owns two 10-acre house lots on the hillside overlooking town. His business is growing and expanding, and he has made some very good investments. Businessman is a capitalist and a conservationist. He approaches the town with this proposal.
“I love it here and I want to give something back. I have also been consulting with my tax advisor. I would like to give the town both of the lots I own up on Overlook Hill. I know the market here and they are worth a lot of money. But if I give you both of them this year, I won’t be able to use up all of the income tax deduction from the gifts. What I would like to do is give you one lot this year and then the other lot in four or five years. That way, I can spread out my deductions and get the most tax savings out of my donations.”
“That is very generous and thoughtful,” says the Director of Open Space for the Town. “We have been eying those lots for years; we think that area would make a beautiful public park. And we trust you and believe you. However, we don’t want to take the first lot this year without an absolute guarantee that we will own the second lot at some point in the near future, because for our planning we need all 20 acres. So we’ll take the first lot this year, and we want an option to acquire the second lot no sooner than four years out.”
As it turned out, the deal went through and both the landowner and the Town were very happy. The Town now owns the 20 acres on Overlook Hill.
Revenue Ruling 82-197 – an Oldie but Goodie
Most readers of Notes probably know this already, but a revenue ruling is guidance issued by the Internal Revenue Service. Revenue rulings usually involve a set of facts and questions of law that apply to any situation that matches those facts, and a revenue ruling can be relied on by any “taxpayer” as the official position of the IRS with respect to tax questions raised in the revenue ruling. A letter ruling, also referred to as a private letter ruling, is made available to one taxpayer in one particular situation, and even though a letter ruling clearly illustrates what the IRS is thinking about certain tax questions, the IRS always makes it clear that a letter ruling cannot be relied on by other taxpayers and cannot be used as precedent.
Here are the facts of this 30+-year old revenue ruling (which you can also see by following this link).
In the revenue ruling, an individual owned real estate valued at $500,000. The individual granted to a charitable organization an option to purchase the real estate for $475,000, at any time within the next two years. Within the two-year time period, the charitable organization exercised the option and purchased the property from the individual for $475,000 (again, see Note #2 for a discussion of bargain sales).
The specific tax question that was addressed in the ruling was whether the taxpayer was entitled to an income tax deduction for the bargain sale in the year the option was signed, or in the year the option was exercised. And the answer, of course, was that the deduction was available in the year the option was exercised.
Of course, this is substantially the same as a charitable pledge. If I pledge to make a donation to my favorite charity, I don’t get a deduction when I make the pledge, I get the deduction when I write the check. Certainly, to tax professionals, this is not a complicated question.
When I was working for Chief Counsel’s Office at IRS (from 1978-1982), I took a course offered to IRS employees, taught by the late Professor Martin Ginsburg. (He passed away in 2010; his surviving spouse is Supreme Court Justice Ruth Bader Ginsburg.) Professor Ginsburg was so smart he could tell tax jokes about reverse triangular corporate reorganizations, and they were funny.
I don’t remember the jokes, but I do remember one very interesting planning point he shared with us. Remember, he said, on the right set of facts, every single tax code rule that was designed to work against the taxpayer can be turned around and used to your advantage.
Of course, it is safe to assume that the question in the revenue ruling (that is, when can the taxpayer take the deduction?) arose either because one or more taxpayers were asking the IRS for guidance on this issue, or, for whatever reason, the IRS thought that guidance on this issue was necessary. In other words, at least someone out there might have thought that in these option situations the deduction was available when the potential donor gave the charity the option. To that extent, then, the ruling was not favorable to such a taxpayer.
But the fact is that in any number of planning situations, this ruling gives us some very helpful planning guidance and can be used to our advantage: we know that a bargain-sale option transaction can work to “secure” a property, or an easement, for the future, and we know the income tax consequences of a “delayed” bargain-sale option transaction and when those tax consequences are determined.
What have we learned from the revenue ruling?
First, it is clear from the revenue ruling that if a land trust signs an option agreement with Aunt Sally, or with Uncle Bob, to bargain-purchase an easement at some point in the future, Aunt Sally and Uncle Bob can’t take an income tax deduction when they sign the option agreement, but can take an income tax deduction when the option agreement is exercised. Of course, in the scenarios I described above, this is exactly what Aunt Sally and Uncle Bob want.
Next, and this is not an analytical leap either, but it is very nice to have it confirmed: because the income tax deduction is available only in the year in which the option is exercised, the value of the income tax deduction is also determined as of the date when the option is exercised.
And we are not done yet with what we have learned from the revenue ruling.
Here is one tricky and highly technical point. Note that the revenue ruling says, in the Holding: “A is entitled to a charitable contribution deduction. . .in the year in which (the charity) exercised the option. The amount of the contribution is the excess of the fair market value of the property on the date the option was exercised over the exercise price….” (emphasis added) Note that the revenue ruling does not tie the deduction to the date the asset was bargain-sold to the charity; the revenue ruling states specifically the deduction is available in the year in which the option is exercised, and the deduction is based on the difference between the purchase price and the fair market value of the asset on the date the option was exercised, not on the date on which the purchase actually occurred.
This is very simplified, but…. An option is exercised when the holder of the option notifies the owner of the asset that is the subject of the option that the holder is going to exercise the option and acquire the asset. There can be a time period between the notice of exercise and the actual closing, or acquisition. More on this point below.
Here is another tricky and technical point. Because the deduction is determined on the date the option is exercised, the deduction is based on the fair market value of the asset on that date. This might seem obvious, but (1) the revenue ruling does not completely close the loop on this question, and (2) without more guidance, there might be some lingering doubt about this valuation issue. But there is more guidance; see IRS Publication 561, “Determining the Value of Donated Property.” On page 2 of Publication 561, in the middle column, we see the following Example: “You grant an option to a local university, which is a qualified organization, to purchase real property. Under the option, the university could purchase the property at any time during a 2-year period for $40,000. The FMV [fair market value] of the property on the date the option is granted is $50,000.
“In the following tax year, the university exercises the option. The FMV of the property on the date the option is exercised is $55,000. Therefore, you have made a charitable contribution of $15,000 ($55,000, the FMV, minus $40,000, the exercise price) in the tax year the option is exercised.”
Note, of course, that the asset increased in value between the date the option was granted and the date the option was exercised, but the charitable contribution was made when the option was exercised and the charitable deduction component of the bargain sale is determined as of the date the option is exercised. It is also worth noting that the IRS clearly takes the position that the existence of the option itself has no impact on the fair market value of the asset; that is, the asset is valued without regard to the existence of the option. This could develop into a much longer discussion, but that will not happen in this Note.
(It is not clear whether the IRS actually intentionally used the “exercise” date as the date that controls the valuation, regardless of when the purchase/acquisition occurs, or whether the IRS language is a bit loose here. But because the revenue ruling says what it says, to avoid any confusion with the IRS, I have recommended to clients, and will continue to recommend to clients, first, that exercise and the actual sale occur in the same year, and, second, that the appraiser follow the language of the ruling and value the asset as of the date of exercise.)
Here is another tricky and technical point. And, remember, as I say throughout these Notes, readers are of course free to disagree. I have heard it said that some conservation organizations that have used an option to secure the acquisition of property, or of an easement, have used an option price of $1, or $10, or some other “nominal” number, simply to make it easy on their finances if and when they exercise the option. I did hear the following argument many years ago (and I have not heard it since). Since the option price is so nominal, there is no reason whatsoever why the holder of the option would not in fact exercise it; it is a foregone economic conclusion that the option will be exercised. Therefore, someone could argue, the transaction might be treated as if the option were in fact exercised when it is first written, which means the deduction occurs when the option is first written, which analysis would bring with it a shorter holding period and just possibly (if the holding period under this analysis is less than a year) a deduction that is limited to basis. And if we go back to the Aunt Sally and Uncle Bob option examples earlier in this Note, that might not be what Aunt Sally or Uncle Bob want at all.
I have not looked for any authority to back up this sort of recharacterization of this transaction, and this analysis might be wrong. But I have advised clients not to take a chance with this, and to have an option price that at least creates some pain on the part of the party writing the check. Whether that amount is $5,000, or $10,000, or $25,000, or whatever that number is, depends on the circumstances of each particular transaction. And, of course, that having been said, the option price can be $25,000 but the landowner can choose to forego any payment at the time the donation is made.
In addition, the option should not be open-ended, that is, it can’t say “we can exercise the option any time after 13 months from the date it is signed.” The date can be more than a few years out, but the option should by its own terms expire after a date certain.
And in conclusion….
I hope this Note #15 gives readers more options when it comes to saving land.