Tax Implications of Conservation Easements

Introduction

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Tax incentives help many landowners take advantage of conservation opportunities. The potential tax benefits of a donated conservation easement are twofold. First, income tax benefits may accrue at the federal level and, depending on the landowner's residence, the state level as well. Second, the conservation easement works as an estate planning tool to reduce estate tax liability, there by allowing family ranches and farms to be passed from generation to generation with the potential of a substantially lower tax burden. Conservation easements by law do not affect Montana property tax levels.

Qualifying for a Tax Deduction

To qualify for a tax deduction, your donation must be considered a charitable gift by the Internal Revenue Service. To determine whether your gift meets IRS requirements, it is best to review the proposed gift with an experienced attorney or accountant. A deductible, charitable donation can be made only to an IRS-qualified, tax-exempt organization. It must be considered a true gift motivated by a charitable intent and not granted as a requirement for getting something in return. For example, a conservation easement donated by a developer, in exchange for government approval of a subdivision, is not considered a gift. A gift must also be complete and irrevocable, without strings or contingencies.

Quantifying the Tax Deduction

For tax deductions on gifts worth more than $5,000 (other than cash and publicly traded securities), landowners must obtain a "qualified appraisal" by a "qualified appraiser." (These terms are defined by the IRS; check with your attorney or accountant for details.) You should consult with a professional appraiser who has direct experience with charitable gifts or easements. The Montana Land Reliance can refer you to appraisers with experience in this field, but cannot provide the appraisal. The appraisal cost is a necessary expense if you wish to pursue a charitable tax deduction.

 

INCOME TAX

Contribution Value

For illustrative purposes, let's assume you are the owner of a riverside ranch and you would like to donate a conservation easement on the property. Working with MLR staff, you negotiate the terms of the easement, which continues agricultural use, protects wetlands and important wildlife habitat, allows for potential construction of an additional residence, precludes commercial development, subdivision and surface mining, and prevents any commercial waste dumping.

To quantify the value of the charitable contribution generated by the donation of the easement, you must obtain a "qualified appraisal" by a "qualified appraiser." As recipient of the donated conservation easement, MLR needs to be detached from the appraisal process. In this example, the appraisal sets the fair market value of the ranch at $1 million. This is the value of the property before the conservation easement.

The appraisal also consists of data on sales of comparable properties already under conservation easement, data on the sale of developed and undeveloped comparable properties, information on appraised values of other conservation easements and the specific terms of this conservation easement. All of this information is used to arrive at the market value of the property after the conservation easement is in place. The difference between the before and after values becomes the amount of charitable contribution.

For this example, let's assume that the appraisal determined that the after value is $600,000. Thus, the before value of $1 million minus the after value of $600,000 generates a charitable contribution of $400,000. In other words, the value of the conservation easement as a charitable contribution is 40 percent of the before market value.

Before conservation easement property value	=	$1,000,000
After conservation easement property value	=	$600,000
Value of charitable contribution	=	$400,000

NOTE: The before value of a conservation easement donated within the first 12 months of purchasing a property must be your basis, or what you paid for the property.

The 30% limitation

Federal tax law generally allows a maximum deduction of 30 percent of your Adjusted Gross Income (AGI) in any given year through the donation of a conservation easement on a property owned for more than one year. However, you can use the 30 percent deduction for up to six years until the value of the charitable contribution is used up. In our example, the value of the charitable contribution generated through the donation of the conservation easement is $400,000. Let's assume that the landowner's annual AGI is $330,000, which remains constant. The deduction resulting from the easement is as follows: (30 percent of $330,000 = $99,000).

Easement Deduction

Year 1	$99,000	Year 4	$99,000
Year 2	$99,000	Year 5	$4,000
Year 3	$99,000	Year 6	$-0-
		Total	$400,000

The actual tax reduction is a function of your income tax bracket. In this case, in Year 1 the landowner would apply his or her tax rate to a $231,000 AGI instead of $330,000 AGI. (If the landowner's tax bracket is 33 percent, the actual tax savings in Year 1 would be $32,670.)

The 50% election

As an alternative, the landowner may elect to use the property's basis (usually the original purchase price or its inherited value) instead of the appraised fair market value as the "before" conservation easement value. If this election is chosen, an annual deduction of up to 50 percent of adjusted gross income is allowed for a period of six years or until the charitable contribution is used up, whichever occurs first.

Where property has appreciated in value, the 30 percent option may be more advantageous. The 50 percent election is most appropriate for taxpayers whose property has appreciated little, who anticipate a large drop in income, who recently purchased or inherited land or who do not expect to live to take advantage of the full five-year carry-forward period.

Corporate Income Tax

The income tax benefits of a conservation easement to a corporation are identical to those of the individual taxpayer, except a corporation can deduct only up to 10 percent of the net income before the contribution deduction, per year, over six years through the donation of a conservation easement.

Deductibility of Easement Costs

Some of the costs incurred in making a charitable contribution are themselves deductible. Legal and appraisal fees and costs associated with compilation of the "Resource Documentation Report" can generally be deducted as business expenses if, in combination with other miscellaneous deductions, they exceed 2 percent of your adjusted gross income. Any cash or securities given to endow stewardship of a conserved property are considered charitable contributions.

 

Estate Tax — Succession Planning

State and federal estate taxes are based on the fair market value of the property at the time of the landowner’s death, not the original purchase price or current use value. This can be a significant and potentially debilitating tax burden for farm and ranch families whose land values have appreciated over time, particularly if the appreciated value is due largely to increased development value. Sometimes caught unaware and without the benefit of estate planning, ranch families may have to subdivide and sell some of their land just to meet the estate tax obligations. Conservation easements can be a useful estate planning tool to reduce estate tax liability and allow ranches to remain in the family.

Reflecting changes that take effect in 2002, generally the first $1,000,000 in assets (including land) that an individual gives during his or her lifetime, or holds at the time of their death, is not subject to gift or estate taxes. Married couples may pass on $2,000,000 of property tax-free to their heirs either by gift or through their estate. The estate tax exclusion increases to $2,000,000 in 2006 and to $3,500,000 in 2009. The gift tax exclusion remains at $1,000,000. If the ranch qualifies as a family-owned business, as provided/defined in the tax law, each individual owner may be eligible for an exclusion of $600,000 in addition to the applicable exclusion amount ($1,000,000). The family-owned business exclusion is eliminated after 2003. The federal estate and/or gift tax levied on amounts that exceed these exemptions is between 37 and 50 percent (due within nine months of the death). Conservation easements reduce the fair market value of the property by restricting the amount and kind of development that may occur. This reduction in fair market value also reduces the value of the estate.

Changes In Individual Estate
And Gift Tax Exclusions

Year of Death	Estate Tax Exclusion*	Gift Tax Exclusion*
2001	$675,000	$675,000
2002	$1,000,000	$1,000,000
2003	$1,000,000	$1,000,000
2004	$1,500,000	$1,000,000
2005	$1,500,000	$1,000,000
2006	$2,000,000	$1,000,000
2007	$2,000,000	$1,000,000
2008	$2,000,000	$1,000,000
2009	$3,500,000	$1,000,000
*Exclusion amount is per individual

For example: The Jones family has owned a ranch in the Madison Valley for three generations. The parents are in their mid-60s and want to pass the ranch on to their children. One child has moved away and is living on the East Coast. Another has stayed on the ranch and worked it with the parents over the years. Both children want to see the property remain whole and a working ranch, as do the parents. They are concerned that the value of the ranch has appreciated significantly over time and they will not be able to keep the ranch because of a potentially large estate tax liability.

Let’s assume that the ranch has appreciated to a current fair market value of $4,000,000 as determined by appraisal. The owners donate a conservation easement to MLR which generally limits development of the property but enables the continuation of agriculture. A “qualified” appraiser determines the value of the conservation easement to be 36 percent of $4,000,000, or $1,440,000.

Each parent has an applicable exclusion amount of $1,000,000*, for a total of $2,000,000. This allows the parents to pass on $2,000,000 of property to heirs either by gift or through their estate free of tax. Without a conservation easement in place, this would leave $2,000,000 ($4,000,000 minus $2,000,000) resulting in a $780,000 estate tax liability. With the conservation easement in place, the value of the ranch for estate tax purposes would be $2,560,000 ($4,000,000 minus the $1,440,000 value of the conservation easement). Utilizing Mr. and Mrs. Jones’ individual $1,000,000 estate tax exclusions, the estate taxable value of the ranch would be reduced to $560,000 ($2,560,000 minus $2,000,000) resulting in $178,000 in estate tax. By placing a conservation easement on the property, the family has not only kept the ranch whole, protected fish and wildlife habitat and open space, but also saved $602,000 in estate taxes in 2002.

Additional Estate Tax Exclusion

Beginning January 1, 1998, the tax law allows beneficiaries to exclude from the taxable estate up to 40 percent of the value of the land subject to qualifying conservation easements (this is in addition to the reduction in value of the land as demonstrated in the example on the previous page). The exclusion is $400,000 in 2001, and $500,000 in 2002 and thereafter. Assuming a 50 percent estate tax rate, this exclusion saves an additional $250,000 in estate taxes. Applying this provision to the Jones family example, the estate tax liability could be reduced to zero.

Post-mortem Election

The new federal tax law allows estate beneficiaries and/or the executor to elect to place the land under conservation easement after death, but before filing an estate tax return.

Estate Planning

Conservation easements are only one component of several estate planning options available to effectively pass on a ranch or farm, as well as other assets, to the next generation. Proper planning with a qualified estate planning team is essential to maximize the benefits of available estate tax exclusions.