This fall has been fairly quiet when it comes to court rulings relating to conservation easements. Let me take advantage of this lull to go over a case that was decided in the U.S. Tax Court over the summer: Bosque Canyon Ranch, L.P. v. Commissioner, T.C. Memo 2015-130. (Read the full court opinion here.) The case dealt with two important issues that affect conservation easements, specifically boundary-line modifications and the baseline documentation requirement. Let’s go through these issues one by one.
The facts in Bosque Canyon Ranch are a bit convoluted. Basically, a limited partnership owned a property that it partially subdivided into 5-acre lots. The subdivided 5-acre lots were acquired by the partners of the limited partnership. (The method by which the partners acquired those parcels of land was also in dispute in the court case, but I won’t go into that part of the case here.) The remainder of the property was not subdivided; instead, most of it was placed under a conservation easement. Thus, the 5-acre lots adjoined the easement property but were not subject to the terms of the easement. The court opinion does not make this clear, but it seems that the easement property was designed to look something like Swiss cheese, with the 5-acre lots forming “holes” in the easement property. The terms of the easement prohibited residential development on the easement property itself.
This happened twice, once in 2005 and again in 2007. In other words, Bosque Canyon Ranch actually dealt with two conservation easements, each donated by related entities on adjoining tracts of land. The terms of each conservation easement were substantially identical.
Ignoring a few potential issues with that arrangement that were not raised by the IRS, all that was fine and good. However, the deed for each conservation easement also stated that the land trust holding the conservation easement and the owners of the 5-acre lots could agree to modify the boundaries of the easement property with the 5-acre lots, provided that:
- The boundary-line modification could not, “in the [Land] Trust’s reasonable judgment, directly or indirectly result in any material adverse effect on any of the Conservation Purposes,” which included protecting the habitat of a certain endangered bird nesting on the easement property; and
- The area of each adjoining parcel could not be increased. In other words, the 5-acre lots could not be made any larger than 5 acres. By extension, the overall acreage of the easement property could not be reduced.
The IRS subsequently denied the charitable deductions for these two easements on the grounds that this language did not suffice to protect the easement property in perpetuity. Federal tax law requires that donations of conservation easements be made “in perpetuity” pursuant to Section 170(h)(2)(C) of the Internal Revenue Code. In other words, a conservation easement must be permanent and unchangeable, with very limited exceptions. This is called the “perpetuity requirement.”
The landowners appealed the IRS’s decision to the U.S. Tax Court, where the landowners argued that, because the terms of the easements prohibited any boundary-line modification that would result in a “material adverse effect” on any of the conservation purposes of the easements, and because the terms of the easements prohibited the addition of more land to the 5-acre lots, each easement property was sufficiently protected in perpetuity.
However, the Tax Court bluntly disagreed with the landowners, succinctly stating:
As a result of the boundary modifications, property protected by the 2005 and 2007 easements, at the time they were granted, could subsequently lose this protection. Thus, the restrictions on the use of the property were not granted in perpetuity.
In other words, because the terms of each easement allowed for property to be swapped in and out of the easement, portions of each respective easement property could lose the protections provided by the terms of the easement and were not protected in perpetuity. (These are often called “floating” parcels because their boundaries can be moved.) Therefore, the perpetuity requirement was violated, and the deduction for each easement was properly disallowed. (More on that below.)
Baseline Documentation Report
I have previously written about the need for a thorough baseline documentation report (BDR) to be prepared in the process of donating a conservation easement. The purpose of a BDR is to document the condition of the easement property at the time of the donation of the easement. The BDR must be completed before the easement is actually donated. This is called the “baseline documentation requirement.”
Sometimes landowners do not treat the BDR seriously. Such was the case in Bosque Canyon Ranch. Although the first easement was donated on December 29, 2005, the dates of the materials used in the BDR ranged from early 2004 to early 2007. Importantly, the easement property was actively being developed during this time; the condition of the property continued changing. The second easement was donated on September 14, 2007, but the BDR included materials from as early as 2004 and as late as November 2008. Additionally, the landowner never signed that BDR to acknowledge its accuracy.
The Tax Court was not impressed with this “slipshod preparation of the baseline documentation.” The Tax Court straightforwardly held that the two BDRs were “unreliable, incomplete, and insufficient to establish the condition of the relevant property on the date the respective easements were granted.” Because the baseline documentation requirement was not met, the deduction for each easement was properly disallowed.
Why Violating Either the Perpetuity Requirement or the Baseline Documentation Requirement Is a Bad Thing
In learning about cases like Bosque Canyon Ranch, it is important to remember that a dispute over the perpetuity requirement is something entirely different than a valuation dispute. In a valuation dispute—a “battle of the appraisals”—the judge will review the landowner’s appraisal and the IRS’s appraisal, and oftentimes the judge will assign an intermediate value to the easement. In other words, the landowner might be entitled to a smaller tax deduction, but the landowner will still be entitled to a tax deduction.
However, if a judge finds that the terms of the easement do not satisfy the perpetuity requirement, the landowner’s tax deduction is entirely disallowed. The landowner receives no tax deduction at all. In addition to not receiving the benefit of a tax deduction, the landowner will have to pay penalties and interest to the IRS (as the landowners in Bosque Canyon Ranch had to do).
The same is true for a violation of the baseline documentation requirement. This makes sense because the purpose of the baseline documentation requirement, as Treas. Reg. § 1.170A–14(g)(5)(i) points out, is “to protect the conservation interests associated with the property, which although protected in perpetuity by the easement, could be adversely affected by the exercise of the reserved rights”—in other words, the purpose of the baseline documentation requirement is to enforce the perpetuity requirement. “Reserved rights” mainly include the landowner’s retained development rights, such as the right to place so many dwellings and other buildings on the easement property.
And this is where it is important to underscore the difference between federal tax law and state property law. Even if a conservation easement is not valid under federal tax law, oftentimes the easement will still be valid under state property law; the landowner will have already given away many development rights and cannot get them back even though no tax benefits result from the donation. Donations of conservation easements cannot be made contingent on approval by the IRS. (That also violates the perpetuity requirement!)
Bosque Canyon Ranch reminds us just how harsh the consequences can be for donating a conservation easement that is either not properly drafted or not properly documented. If you wish to donate a conservation easement, please make sure that you hire competent advisers who can ensure that the various tax requirements are met. The cost of these advisers might seem expensive in the short run—but this cost will quickly pale in comparison to the cost of receiving no tax benefits at all.