On August 23, 2018, the IRS released new proposed tax regulations that penalize Virginia conservation easement donors for receiving the land preservation tax credit. This new rule significantly reduces the tax benefits that Virginia landowners will receive for donating a conservation easement.
What Was the Old Rule?
Previously, a landowner who donated a conservation easement received both federal and state tax benefits in their full amounts. For the sake of providing an example with easy math, this meant that, if the easement were appraised at $100,000, the landowner would have received $100,000 in federal tax deductions and $40,000 in Virginia tax credits. If the landowner chose to apply the Virginia tax credits to his or her own taxes, the landowner was not required to pay tax on the Virginia tax credits. However, if the landowner sold the Virginia tax credits, the landowner was required to pay federal capital gains tax on the sales proceeds.
What Is the New Rule?
Under the new rule, the federal tax deductions are reduced by the amount of the Virginia tax credits, or 40%. For an easement valued at $100,000, this means that a landowner will receive $60,000 in federal tax deductions and $40,000 in Virginia tax credits. This reduction happens even if the landowner does not sell the Virginia tax credits.
The Virginia tax credits themselves remain unchanged and can still be sold. However, the IRS has not yet clarified how to treat the sale of Virginia tax credits under the new rule. It is entirely possible that the landowner will still be required to pay federal capital gains tax on the sales proceeds, even though the federal tax deductions have already been reduced.
When Did the New Rule Take Effect?
All conservation easements that are donated after Monday, August 27, 2018 are affected by the new rule. Conservation easements that were donated on or before August 27 are not affected.
This new rule came as a surprise. The IRS provided virtually no advance notice, as it did not publicly announce the new rule until Thursday, August 23, 2018.
Why Did the IRS Write This New Rule?
The IRS wrote this new rule in response to a problem that has nothing to do with conservation easements. The new tax law that Congress enacted in December of last year (the Tax Cuts and Jobs Act) limited the amount of state and local tax (“SALT”) that an individual may deduct on his or her federal tax return; previously, there had been no limitation. In response to this change, several states with high income tax rates, such as New York and California, implemented new tax credit programs to try to get around these new limitations on deducting state and local taxes. The purpose of these new tax credit programs was to allow residents of those states to take what they had previously been deducting as tax payments (which were limited by the Tax Cuts and Jobs Act) and deduct them as charitable donations instead (which were not limited by the Tax Cuts and Jobs Act), while still funding various state and local programs, such as schools.
The effect of this workaround would have been to reduce federal tax revenue, thus making the federal budget even more imbalanced than usual. The IRS wrote this new rule to prevent that from happening. Rather than targeting only these new tax credit programs, however, the IRS has responded by targeting all state tax credit programs, including Virginia’s longstanding land preservation tax credit.
Is the New Rule Inevitable?
This new rule is only a proposed rule and can still be changed. However, the final version of the new rule will not be released until mid-November at the very earliest. This means that we will not know whether or not there will be changes to the new rule until well after the November 1 deadline set by the Virginia Department of Taxation to be able to receive Virginia tax credits in time to be able to sell them before the end of the year.
If you are interested in submitting a public comment on the new rule, you may do so at https://federalregister.gov/d/2018-18377 until October 11, 2018. The IRS will also hold a public hearing on the new rule in Washington, D.C. on November 5, 2018; you may register to speak at the public hearing by visiting the same website.
It is deeply frustrating that the IRS has suddenly published this new rule at this time of the year—just when many landowners, relying on receiving certain tax benefits and rushing to meet the Virginia Department of Taxation’s November 1 deadline, have spent months going through the process of donating their conservation easement and have already incurred significant costs in doing so.
It is also regrettable that the IRS has chosen to attack tax deductions for conservation easements so soon after Congress made the enhanced conservation contribution permanent. Congress has clearly stated its intent to provide special tax treatment to conservation easements. The IRS, in its zeal to counteract other states’ tax credit abuses, is now undermining Congress’s clear intent. This should not be allowed to stand.
Nevertheless, while the tax benefits for conservation easements have been reduced, they are still significant. Again, only the federal tax benefits have been reduced; the Virginia tax credits remain unchanged. I anticipate that the Virginia tax credits will remain a significant motivation for many landowners who wish to donate a conservation easement in Virginia.
I will be closely watching this story for further developments. Stay tuned here or follow me on Twitter (@dpfellows) for developments as they happen.