Originally published on Forbes.com.
Professor Nancy McLaughlin is something of an idealistic attorney, which really is not an oxymoron. She told me that she practiced law early in her career in Virginia and dealt a bit with conservation easements. She noticed a lot of problems and hoped that by writing about them she might have some influence on policy. Time for writing is what influenced her to move into the academic realm, where she thought she might be better positioned to influence policy.
Professor McLaughlin has done a great service by summing up litigation concerning valuation easements in her article Conservation Easements and the Valuation Conundrum. She notes that over the last decade, there have been over 75 court decisions concerning charitable contributions for easements. She divides them into two categories facade easements, which are all the rage in the big cities for purposes of historic preservation and their country cousins conservation easements which are for the scenery and the critters.
Conservation Easements
If you own property that you would like to have preserved from future development, the contribution of a qualified easement is about as close as you can come to a free lunch in the tax arena. You get a tax deduction for not doing something that you did not want to do anyway and you may also save on property taxes and estate taxes. Presumably, some people who are on the borderline of whether to restrict their property might be pushed over the edge by the tax incentive, which, I suppose, is the point of having tax incentives.
Normally when you donate property your deduction is limited to 30% of your adjusted gross income with a five-year carryover. Contributions of easements have a 50% limit with a 15-year carryover, which is better than giving money. For ranchers, who meet certain qualifications, the limit is 100%.
Abuse
Easements are valued by valuing what the property could be at its “highest and best use”, which is appraiser speak for what can bring the most money, and subtracting from that the value of the property as encumbered by the easement. It’s that highest and best use that can provide the entertainment. Since it is not something you are going to actually execute the plan to bring the property to its highest and best use can have fantastic elements and obstacles to it success can be “assumed” away. It is as if the property that is being protected was Fantasy Island before those restrictions went into place.
Facade Easements
Facade easements generate a lot of cases in which the courts determine that the easement has no value at all. That’s because the buildings in historic districts are already subject to substantial restrictions. I have several times remarked that easements on buildings like that are like me renouncing my superpowers. Professor McLaughlin told me that she really appreciated that line giving her strong credentials to become my new BFF.
The case law reflected in Appendix A suggests that overstatement of values has been a persistent problem in the facade easement donation context. In addition, the fact that the taxpayers in the recent cases asserted values for their easements that were, on average, more than four times the court-determined values, and in seven of the cases claimed sizable deductions for easements that were determined to have no value, suggests that the problem of overstatements has worsened over time.
Development Is Easy When It Stays Hypothetical
The technique that comes in for the most criticism – it would have been scorn if I had been writing it – is “subdevelopment analysis”. If you have a couple of thousand acres of land somewhere and decide that you are tired of dog ranching or whatever it is you are doing for long hours and low profit and decide to turn into five hundred units of housing, you may well find that you have entered into an enterprise that is one GD thing after another – zoning, financing, construction, marketing – through an economic cycle or two, each of them fraught with peril. A sanguine appraiser can assume all those uncertainties away allowing a highest and best use valuation based on a piece of cake development project.
…..in many cases the has been applied under the wrong circumstances or in the wrong way. If all of the land that has been appraised by the development approach were actually subdivided, there would be enough subdivision lots on the market to last hundreds of years and little, if any, farmland left in the United States. ……
In determining the before-easement highest and best use of the subject property,conservation easement donors (or, more accurately, their appraisers) often assert that the property could be rezoned (or upzoned) to allow for more development than is permitted
under existing law. This can dramatically increase the estimated before-value of the property. The author of a treatise on valuation in the eminent domain context cautions that “the probability of rezoning is fertile ground for the unscrupulous, the naïve, and the
dreamer……few appraisers adequately support their conclusion on this matter in their appraisal reports.…” Accordingly, assertions of a “reasonable probability” of rezoning in the “reasonably near future” call for particularly careful scrutiny.
What Number Did You Have In Mind?
Professor McLaughlin indicates that there is something of a race to the bottom in terms of appraisal quality in the “easement industry”.
Confidential conversations with land trust personnel, attorneys, and appraisers lead this author to believe that appraisers who consider it a point of professional pride to write only fully-supported easement appraisals currently lose business to appraisers willing to assert abusive values and to charge less to do so.
Can It Be Fixed?
Professor McLaughlin has some suggestions for reform that go beyond Treasury proposals, which she also discusses. One would be a six-year statute for easement deductions.
Given the extent of the abuses in the easement donation context and the generosity of the enhanced incentives, it seems a fair trade to extend the period within which the IRS could challenge the claimed deductions from the current three years to six years. Doubling the window of vulnerability would make playing the audit lottery a less attractive option for those engaged in abusive transactions.
She suggests improvements in Form 8283 and at least for a while an Easement Advisory Panel similar to the Art Advisory Panel. She also thinks that automatic review of some appraisals might lessen the temptation to play the audit lottery along with increased appraiser penalties.
Given that the incentives for taxpayers, donees, and appraisers generally align toward aggressive valuations and the risk of audit is low, the current modest monetary penalties to which appraisers are subject are unlikely to deter overvaluations.
Maybe Not
The more I study this issue, the more discouraged and cynical I become about it. I think this is another instance of what Joe Kristan calls using the Tax Code as the Swiss Utility Knife of public policy. There is going to be a natural inclination for people to view the easement donations as “free money”. I had one practitioner talk to me about developers not being able to get their projects off the ground and seeking to monetize through conservation easements. I even heard from one group that was planning to raise money to buy property and to get return to the investors through the granting of conservation easements. In order for that to work they have to be buying property from really stupid people or, you know, fibbing on the valuation.
On the other hand I don’t doubt that many people who work in the field and many landowners are sincere and the program does a lot of good. You can read the reaction to some of my negative coverage by a conservation officer here.
Other Coverage
Paul Streckfus included an abstract of Professor McLaughlin’s article in EO Tax Journal 2015-247. Professor McLaughlin posted a brief summary on the Nonprofit Law Blog.
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