Henderson & Caverly LLP

(1)        Gift of the Donor’s Entire Property Interest Other than a Qualified Mineral Interest. A gift of the donor’s entire interest in real property other than a “qualified mineral interest” is a gift of a qualified real property interest. [1] A “qualified mineral interest” is the right to the sub-surface oil, gas and other minerals, including the right to access those mineral interests. [2]

In addition to minerals that are clearly “subsurface” in nature, a qualified mineral interest can also include the right to extract surface minerals, such as gravel. [3] However, a gift of a donor’s interest in real property subject to a retained mineral interest will not qualify as a QCC unless the terms of the gift specifically prohibit surface mining. [4] The gift will also fail if any other method of mineral extraction is permitted that would be inconsistent with the conservation purposes of the gift, unless such extraction is localized in nature and the destructive impact is limited, can be remedied, and would not have a significant adverse impact upon the conservation purposes of the gift. [5]

The Treasury Regulations provide that a donor cannot, in anticipation of making a conservation gift of this type, separate interests in the subject property beyond those contemplated by the definition of a qualified mineral interest and then later take the position that a gift has been made of the donor’s entire interest in the property. [6] A special rule applies to mineral interests that have been separated from the property other than in anticipation of the donation. Specifically, if such interests were separated from the property after June 12, 1976 and remained separated up until the time of the gift, and if the owner or owners of such interests are neither the donor nor persons related to the donor within the meaning of I.R.C. §267(b) or I.R.C. §707(b), such separate interests should not disqualify the gift so long as surface mining on the property is completely prohibited. [7] For separations that occurred on before June 12, 1976, surface mining need not be completely prohibited, but the likelihood of its occurrence must be so remote as to be negligible. [8] The Regulations provide factors to take into consideration for this purpose, including, for example, the presence of data indicating the absence of mineral reserves on the property as well as the lack of commercial feasibility of a surface mining operation. [9] In making this determination, the opinion of a qualified geologist can be very valuable. [10]

(2)        Gift of a Remainder Interest in Real Property. Another form of qualified real property interest is a gift of a remainder interest in real property for conservation purposes. [11] The donor’s retained interest can be for life (or joint lives) or for a period of years. However, tenants for life or a term of years cannot be permitted to use the subject property in a manner that diminishes the conservation purposes of the gift. [12]

Where the subject of the remainder interest gift is a farm or personal residence, it will usually be more desirable for the donor to claim an income tax deduction under I.R.C. §170(f)(3)(B)(i) rather than a deduction under I.R.C §170(h). First, to obtain a deduction under I.R.C. §170(f)(3)(B)(i), the donee need not satisfy the substantially more restrictive tests for a “qualified organization” under I.R.C. §170(h). Further, the donation need not be exclusively for conservation purposes. [13] Regardless of whether a deduction is secured under I.R.C. §170(h) or I.R.C. §170(f)(3)(B)(i), however, the value of the remainder interest will be computed in the manner described in I.R.C. §170(f)(4), including the requirement that the value of the donee’s remainder interest in any structures or other depreciable property be computed separately from the remainder interest in the land. [14]

(3)        A Gift of a Perpetual Conservation Restriction. The third form of qualified real property interest for purposes of I.R.C. §170(h), and the primary focus of this article, is a restriction granted in perpetuity with regard to the use of the donor’s real property. [15] These restrictions can take the form of equitable servitudes, restrictive covenants, easements, and other restrictions on the use of real property as provided under applicable state law. For purposes of the balance of this article, all such restrictions are referred to collectively as “easements” or “QCEs.”

QCEs are particularly attractive to donors because, in many instances, the donor’s current use of the property can remain unchanged. In some cases, the donor can even continue to develop the property. [16]    However, no deduction will be permitted if the use of the property retained by donor is either inconsistent with the conservation purposes of the gift or would have a detrimental effect upon other significant conservation interests. For example, a gift of an easement restricting a property to agriculture use for flood control purposes will not be a QCC if such use will involve the application of pesticides that are harmful to a significant natural ecosystem. [17] On the other hand, a QCC will not fail simply because the advancement of the intended conservation interests of the gift will by necessity have a detrimental impact upon other important conservation interests. For example, the excavation of a historically important archaeological site in accordance with established archaeological practices could have a negative impact upon the scenic beauty of the property without disqualifying the gift as a QCC. [18]

B. Qualified Organizations. The second requirement for a QCC is that the donee organization must be a “qualified organization.” Qualified organizations are a narrow subset of the organizations that otherwise benefit from tax deductible charitable contributions. Qualified organizations are limited to governmental units, public charities described in either I.R.C. §170(b)(1)(A)(vi) [19] or I.R.C. §509(a)(2), [20] and I.R.C. §509(a)(3) supporting organization controlled by one or more of public charities described in I.R.C. §170(b)(1)(A)(vi) or I.R.C. §509(a)(2). A private foundation, including a private operating foundation, can never be the donee of a QCC.

In order to be a qualified organization, the donee of a QCC must also be committed to protecting the conservation purposes of the donation. A donee will be deemed to satisfy this requirement if its tax exempt purposes are consistent with the conservation purposes contemplated by I.R.C. §170(h). Even if the donee is so committed, the donee must also have the actual resources to enforce the restrictions imposed under the donative instrument to meet the requirements of a qualified organization. [21] The donee need not have an actual reserve for such enforcement actions, however. [22]

In addition to the requirement that the initial donee of a QCC be a qualified organization, the instrument of conveyance must address the possibility of a subsequent transfer of the easement. Specifically, as a condition of the gift, the relevant documentation must specify that any subsequent transferee of the easement must, at the time of the subsequent transfer, satisfy all of the requirements for a qualified organization, and the transferee must be required to carry out the original conservation purposes of the gift. [23]

C. Exclusively Conservation Purposes. To be a QCC, a gift of a qualified real property interest must be made exclusively for conservation purposes. Exclusivity for this purpose does not prohibit incidental benefits to the donor, which will be disregarded. [24] Qualifying conservation purposes include the following:

(1) preserving land areas for outdoor recreation by, or the education of, the general public;

(2) protecting a relatively natural habitat for fish, wildlife, plants or a similar ecosystem;

(3) preserving open space (including farmland and forest land) where such preservation is for the scenic enjoyment of the general public and will yield a significant public benefit; [25]

(4) preserving open space (including farmland and forest land) pursuant to a clearly delineated federal, state, or local government conservation policy that will yield a significant public benefit; and

(5) preserving a historically important land area or certified historic structure.

(1)        Preserving Land Areas for Public Recreation or Education.   The preservation of land areas for the outdoor recreation by, or the education of, the general public are qualifying conservation purposes. [26] Examples of such purposes include the preservation of a lake for public boating and fishing, or the preservation of a public hiking trail. [27]

An important characteristic of this particular conservation purpose is that, by definition and by Regulation, it demands regular and substantial public access to the subject property. [28] Consequently, this conservation purpose may not be appropriate or desirable for a donor who maintains a home on the property unless the donor’s protection and privacy can be maintained with use reservations that are not inconsistent with the intended charitable purposes of the easement. Further, regular and substantial public access to the property gives rise to issues of liability that need to be addressed between the donor and the donee organization. This purpose is therefore more often appropriate for a gift of a remainder interest or a gift of the donor’s entire interest other than certain mineral rights, rather than a QCE, where the donor maintains substantial ownership rights (and the incumbent liability to the public) with regard to the subject property.

(2)        Protecting a Relatively Natural Habitat or Similar Ecosystem. The protection of a relatively natural habitat for fish, wildlife, plants or other similar ecosystem is a qualifying conservation purpose. Properties that are suitable for this purpose are typically inhabited by rare or endangered species. While the property might be large and notable, such as an undeveloped island or other remote habitat, it is not the size of the parcel but its importance as a natural habitat, or in relation to a natural habitat, that should be considered. For example, where a private lakefront property was found to have at least two threatened plant species and served as a roosting spot for bald eagles, the protection of its shoreline from development was determined to protect a natural habitat. [29] In addition, a property that itself lacks significant habitat can qualify for this conservation purpose if it provides a buffer between developed land and a protected habitat.

An important aspect of this conservation purpose is the concept of relativity. In this regard, the habitat or ecosystem to be protected by a QCC need not be in its pristine natural state, unaffected by human activity. Rather, the property could have been altered or otherwise impacted by human activity, even substantially, so long as wildlife or plants continue to inhabit the property in a relatively natural state. [30] For example, timberland that has been significantly affected by logging can be protected if wildlife continues to inhabit the property in a relatively natural state. [31]

One significant advantage of this particular conservation purpose is that public access can be restricted. The donor and the donor’s invitees may nevertheless be allowed use of or access to the property, including residential use, so long as that use does not interfere with the intended conservation purposes of the QCC. [32]

(3)       Preserving Open Space for Scenic Enjoyment by the Public. Preservation of open space for scenic enjoyment by the public is appropriate only for land that is visible to the public, such as from the edge of a national park, a highway, a hiking trail, or a waterway. [33] An important characteristic of this particular conservation purpose is that, while scenic access over the subject property must be provided to the public, the public need not have physical access to the property. [34]

The appropriateness of a property for this particular conservation purpose is driven by the particular facts and circumstances. As noted, a primary requirement is that the property must, by definition, be visible to the public. Examples of such properties are woodland along a highway or open land between the highway and the ocean as a view corridor. [35] Additional factors used to determine the suitability of property for an open space scenic easement include the compatibility of the proposed use of the property with other land in vicinity and the degree of contrast and variety provided by the visual scene offered by the property. With regard to property located in an urban or densely populated area, factors include the openness of the property, whether the property would provide relief from urban closeness as well as a harmonious variety of shapes and textures, and the degree to which the property maintains the scale and character of the urban landscape to preserve open space, visual enjoyment and sunlight to surrounding area. [36] Characteristics of the property that are consistent with a state or regional scenic identification program or landscape inventory that was part of a rigorous review process are also helpful, as is an endorsement of the donation by a state or local government agency. [37]

Merely limiting the amount of houses that can be built or other development that can take place on a property that might otherwise qualify for a scenic preservation easement is not sufficient if the donor’s retention of development rights could interfere with the scenic quality of the land. [38] For example, the reservation of the right to build one home on lots of not less than 90 acres each on a 900 acre parcel consisting of rolling pastures and woodland visible from a national park would be inconsistent with the preservation of those 900 acres by a scenic easement. [39] On the other hand, a donor may continue an existing use, or even retain the right to limited future development of the property, so long as the use or development would not destroy the scenic character of the land. [40] Thus, under the same facts surrounding the 900 acre parcel just described, the donor’s reservation of the right for cluster development on five (5) nine acre parcels, none of which are visible from the national park, could qualify for a scenic easement. [41]

While the preservation of open space for the scenic benefit of the public must, by definition render a public benefit, the Regulations further require that the public benefit be significant. [42]    If the donation involves multiple parcels, the public benefit test must be applied independently to each parcel. [43] The factors that will determine whether this criteria is met include the uniqueness of property to the area; the foreseeability of intense development and the likelihood that development would degrade the scenic or natural character of the area; the consistency of the proposed use of the property with any governmental conservation programs in the region; the opportunity of the public to use and appreciate the property; the importance of the property to the preservation of a landscape that attracts tourism or commerce; the likelihood that the donee could acquire substitute property of equivalent conservation value; the cost to enforce the restrictions that will be imposed upon the property; the density of the surrounding population; and the consistency of the purpose of the contribution with a legislative mandate to preserve particular parcels as open space. [44]

(4)        Preserving Open Space Pursuant to a Government Policy. Open space donated pursuant to a government policy qualifies for QCC treatment. Rather than public scenic enjoyment, the purpose of such open space could be, for example, flood control or water conservation, [45] the preservation of agricultural land, [46] or the preservation of a corridor for wildlife migration. [47] Consequently, visibility to the public is not required unless it is necessary to accomplish the stated government policy.

An issue that arises is how strongly stated and formulated the government policy must be to qualify a conservation easement as being made pursuant to such policy. The mere statements of a public official supporting a proposed policy or a specific conservation gift is clearly insufficient for these purposes. Rather, there must be some significant degree of governmental commitment to a conservation project. In this regard, it is helpful if there is some form of governmental review of a proposed contribution before it is accepted by the donee. [48]

While it is necessary to show that a conservation contribution pursuant to a government policy provides an important public benefit, this requirement should be automatically satisfied if the donation is clearly tied to a specific governmental conservation policy. [49]

(5)        Preserving a Historically Important Land Area or Certified Historic Structure. A QCC can be made in furtherance of the preservation of a historically important land area or a certified historic structure. [50]

(a)        Preserving a Historically Important Land Area. Land areas are historically important if they fall into certain categories defined in the Treasury Regulations. The first category of historically important land areas is those which are independently significant and which meet the National Register Criteria for Evaluation. [51] Such criteria looks to, for example, whether the land area is associated with events that have made a significant contribution to the broad patterns of our history, is associated with the lives of persons significant in our past, or has yielded, or may be likely to yield, important information in prehistory or history. Structures on the property, such as homes, bridges, cannons, or markers, might embody distinctive characteristics of a type, period, or method of construction, might represent the work of a master, or might possess high artistic values. [52] Typical examples of such land areas include battlefields and archaeological sites. Conversely, the National Register Criteria for Evaluation would typically exclude from consideration ordinary cemeteries, birthplaces or graves of historical figures, properties owned by religious institutions or used for religious purposes, structures that have been moved from their original locations, reconstructed historic buildings, properties primarily commemorative in nature, and properties that have achieved significance only within the past 50 years. [53]

Two other categories of historically important land areas can qualify for QCC treatment. The first such category is land located within a registered historic district, including any buildings on the land that contribute to the significance of the district. [54] The other category involves property adjacent to a property listed on the National Register of Historic Places but which is not itself within a registered historic district. Such property must have physical and environmental features that contribute to the historic or cultural integrity of property in the National Register of Historic Places. [55]

(b)        Preserving a Certified Historic Structure. A certified historic structure is either a building, structure or land area that is listed on the National Register of Historic Places or a building located in a registered historic district and certified by the Secretary of the Interior as being of historic significance. [56] Certification of a structure need not be obtained prior to the donation, but it must be obtained before the due date of the donor’s income tax return (including extensions). [57] For this purpose, the term “structure” could have the common meaning, or it might be simply an easement on a private residence, [58] such as, for example, an easement with regard to the preservation of an architectural façade and building interior. [59]

Prior to the enactment of the Pension Protection Act of 2006 (Public Law 109-280, referred to in the balance of this article as “PPA 2006”), it was possible to donate an easement protecting only the façade of a building located in an historic district but not listed in the National Register of Historic Places. Now the easement must protect the entire exterior of any such building, including the front, sides, rear and height. [60] Further, changes may not be made to the exterior of the building if they are historically inconsistent. [61] In addition, if a restriction is to preserve a land area or building within a registered historic district, and if that restriction does not prohibit future development, any such development must conform to appropriate government construction or rehabilitation standards within the district. [62]

(c)        Public Access Requirements. In order for the public to benefit from a QCC involving the preservation of historic land areas and structures, public access is required. The nature and magnitude of such public access depends upon the circumstances surrounding the particular property. Whether sufficient public access has been provided will be determined from the language of the donative documents, not from the actions of the donee organization. [63]

Assume, for example, that a conservation easement has been provided to a qualified organization for purposes of preserving the exterior and portions of the interior of a historic property that is used as the donor’s principal residence. Assume further that this residence is generally hidden from public view behind a high wall or tall and dense shrubbery. The requisite amount and nature of public access to this property might be met by providing actual public access several times each year, by permitting scheduled educational visits for scholars and others to study the property, and by allowing pictures of the property to be taken by the donee to be published in magazines and other written materials. [64] On the other hand, if, for example, a donation is made to preserve a historic structure adjoining a Civil War battlefield, if that structure is not generally visible to the public and is only accessible by a private road, and if that structure is in safe condition, permitting public access only four weekends each year from 8:30 a.m. to 4:00 p.m. will not provide the requisite amount of public access. [65] Under the same facts, however, public access provided every other weekend would likely be sufficient. [66]

D. Enforcement in Perpetuity. A gift of a conservation easement or other donation of rights or interests in real property will not be deemed exclusively for conservation purposes unless it is enforceable in perpetuity under the terms of the donation and applicable state law. [67] Any restrictions placed upon the use or development of property that is the subject of a QCC must be binding not only upon the donor, but also upon the donor’s successors. If the instrument restricting the use or development of property must be recorded to be legally enforceable, whether upon the donor or the donor’s successors in interest, then it is critical that the instrument creating such restrictions be so recorded. [68]

Where the restrictions upon the use of the property are established solely by a state law that expires at a date in the future, then the restrictions are not perpetual restrictions. [69] If, however, state law requires the donee organization to renew the restrictions on a periodic basis without the donor’s consent, the restrictions will not fail on that basis alone. [70]

Another factor in the perpetuity of a restriction upon the use or development of property is the commitment and ability of the donee organization to enforce the restriction. As noted earlier in this article, in order for a donee to be a qualified organization for purposes of I.R.C. §170(h), the donee must have a purpose of historic or open space preservation, land conservation or environmental protection, the commitment to enforce the restrictions imposed on the use of development of land that is the subject of a QCC, and the resources to back up that commitment. [71] Further, if the donor retains any rights to use or develop the property, the donor must provide the donee the documentation necessary for the donee to establish the condition of the property at the time of the gift. The required documentation might include survey maps as well as land based and aerial photography. The documentation must be accompanied by a statement from the donor verifying its accuracy, and the donor must agree to notify the donee of any use or development of the property that could impair the conservation purpose of the QCC. [72] Further, the donee must be granted sufficient access to the property to allow the donee to confirm that the donor’s use or development of the property has not impaired the conservation purposes of the QCC. If the donee ascertains the donor has made any inconsistent use of the property, the donee must have the legal right to require the donor to restore the property. [73]

Finally, to insure that a restriction on property will exist in perpetuity, special care must be paid to property that is, or subsequently becomes, encumbered by debt. To qualify as a QCC, only the donor’s retained rights and interests may secure the debt, and the lender must agree to subordinate its rights to those of the donee. [74]

E. Purchases of QCEs. Land trusts and other qualified charitable organizations are sometimes willing to purchase a QCE. This can be an attractive option for a property owner who either cannot afford to part with the value of the QCE or who wishes to benefit other charities with the proceeds of the sale of a QCE. In such cases, the seller will recognize taxable gain to the extent that the consideration received for the QCE exceeds the donor’s basis in the property. Importantly, despite the general rule that the basis of property is allocated between partial interests when only a portion of a property is sold, the seller’s entire basis in the property (excluding basis appropriately allocated to improvements in the case of a QCE restricting the use of land) is available to offset the gain that would otherwise be recognized on the sale of a QCE. [75] Further, QCEs are real property interests that are of “like kind” to other real property interests for purposes of I.R.C. §1031. [76] Consequently, the proceeds of a sale of a QCE over property held by the seller for investment or for use in a trade or business can be sheltered from immediate taxation by reinvesting the proceeds in, for example, a tenancy in common interest in an income-producing investment property. Finally, if the QCE is over land that is also used by the seller as a principal residence, and if the residence is sold within two (2) years before or after the sale of the QCE, it is possible that the $250,000 exclusion provided under I.R.C. §121 can be applied to reduce or eliminate the taxable gain on the sale of the QCE.

F. Deductibility, Valuation and Filing Requirements

(1)        General Rules for Deductibility of QCCs. If all of the requirements for a QCC described above have been satisfied, then the donor of a QCC is entitled to a current income tax deduction. So long as the donor has held the property for at least one (1) year and the property is not considered the donor’s stock in trade, the property will likely constitute long-term capital gain property to the donor. Because the donee organization must, by definition, be a governmental entity or a public charity, the amount of the deduction therefore will, in most cases, be the fair market value of the QCC. Assuming the donor elects to deduct the fair market value of the QCC, the donor will be able to use that deduction to offset up to 30% of the donor’s contribution base (which, for most donors, will be the donor’s adjusted gross income). If the deduction generated exceeds the 30% ceiling in the year of the donation, the deduction can be carried forward for as many as five (5) successive tax years.

In order to secure a deduction for a gift of a QCC, the donation must be substantiated in the same manner as any other charitable gift. Specifically, the donor must have a receipt for the contribution from the donee organization on or before the due date (with extensions) of the donor’s income tax return for the year of the contribution. In addition, if the value of the gift exceeds $5,000, a qualified appraisal will be required.

Under PPA 2006, certain additional filing requirements have been imposed upon donors of easements protecting the exterior of a historic structure. This includes the requirement that the donor submit photographs of the entire exterior of the building with the return and a description of all restrictions on the development of the building, [77] as well as a $500 filing fee if the amount of the deduction claimed on the return exceeds $10,000. [78]

PPA 2006 also addressed an issue of “double dipping” by taxpayers with regard to deductions for QCCs and rehabilitation credits on the same property under I.R.C. §47. Now the deduction for a QCC will be reduced by an amount which bears the same ratio to the fair market value of the contribution as the sum of the rehabilitation tax credits claimed by the donor for the preceding five (5) tax years bears to the fair market value of the property on the date of the contribution. [79]

(2)       Expanded Deductibility of QCCs through December 31, 2007. PPA 2006 also enhanced the deductibility of QCCs made between July 26, 2006 and December 31, 2007. The ceiling for the deductibility of the value of such a QCC has been raised from 30% of the donor’s contribution base to 50%. [80] Further, if a donor’s income from the trade or business of farming, as defined in I.R.C. §2032A(e)(5), [81] represents at least 50% of the donor’s gross income in the year of the contribution, if the QCC applies to land used in agriculture or livestock production, and if the restrictions on the use of the subject property require that it remain available for such agricultural use or livestock production, then the resulting deduction can offset the donor’s income by as much as 100% of the donor’s contribution base. [82] In either case, the unused deduction can be carried forward as many as 15 successive tax years. [83]

The expanded deductibility for QCCs provided by PPA 2006 only applies to the partial interests described in I.R.C. §170(h). The normal rules for deductibility of charitable contributions continue to apply to gifts of fee interests in real property. Therefore, if a taxpayer wishes to make a gift of his or her entire property interest for conservation purposes but lacks the income to make full use of the deduction in the current year and the five (5) succeeding years under the 30% limitation, that taxpayer might be better advised to donate a QCC in 2007, such as a remainder interest in the property, take advantage of the higher deduction limitation and longer carry-over period, and gift the balance of the donor’s interest in the property in a future year.

(3)        Valuation of QCEs. Certainly the most litigated issue in the context of QCCs is the value of a QCE. Where there is a record of comparable sales of conservation easements, that data should be used to establish the value of a QCE for purposes of establishing the donor’s income tax deduction. [84] However, a substantial record of comparable QCE sales is not typically available. Therefore, the method most commonly used to establish the value of a QCE is the “before and after” method of valuation. Applying this method, the value of the QCE is the difference between the value of the subject property at its highest and best use without the QCE and the value of the property at its highest and best use with the QCE. [85]

In apply the “before and after” method of valuation, consideration must be given to a number of factors. First, the pre-QCE value of the property must take into consideration the current and the realistic potential future use of the property, the cost to develop the property to its highest and best use, and the effect of existing zoning and other restrictions upon the use and development of the property. [86] Further, if the donor or the donor’s family owns other parcels that are contiguous to the property that is the subject of the QCE, then the before and after test must be applied to the value of all such parcels collectively. [87] Finally, the deduction for the value of the QCE must be reduced by any increase in the value of any non-contiguous parcels owned by the donor or a related person resulting from the QCE, [88] as well as any “quid pro quo” obtained from the donation, such as zoning changes to other property owned by the donor. In applying all of these factors, it is possible that even substantial QCEs could produce income tax deductions that are, in fact, very small or even zero.

G. Modifying and Terminating QCEs. While QCEs are restrictions upon the use of property that exist in perpetuity, the Regulations acknowledge that changed circumstances can make continued use of the property for the intended conservation purpose impossible or impractical. Under such circumstances, the donee organization can modify the restrictions. [89] If the restrictions are to be terminated altogether, however, a judicial proceeding will be required. [90] A qualified organization seeking to modify a QCE needs to be mindful, however, that QCEs are not simply private agreements that can be amended upon the mutual consent of the current property owner and the holder of the QCE. Rather, a QCE is a charitable trust and as such can only be modified or terminated in accordance with applicable state laws and common law concerning the modification of charitable trusts (including the cy pres doctrine and the doctrine of administrative deviation). [91] In some cases, notifying the state Attorney General’s office of a proposed change to a QCE, as well as the original donor or the donor’s family, will be advisable, if not legally required.

A QCE can also be involuntarily terminated by governmental condemnation (imminent domain). In the event of a condemnation sale of property subject to a QCE, the sale proceeds must be allocated between the property owner and the holder of the QCE in the same proportions as the value of the unencumbered property bore to the value of the QCE at the time of the donation. [92] If the property owner is the donor of the QCE, then the property owner’s basis for computing gain on the condemnation proceeds will be a fraction of the donor’s basis at the time of the grant of the QCE, the numerator of which is the value of the easement at the time of the gift and the denominator of which is the value of the property unencumbered by the easement at the time of the gift. [93]

II. ESTATE TAXATION AND QCCs

Intervivos QCCs can substantially reduce the estate tax value of the subject property at the donor’s death. Even if a decedent was reluctant to encumber a family property with an easement during his or her lifetime, however, the decedent’s heirs and personal representatives might nevertheless choose to do so in order to secure a reduction in the estate taxes imposed upon that property.

The Internal Revenue Code provides both an estate tax deduction under I.R.C. §2055(f) of the Code and an estate tax exclusion under I.R.C. §2031(c) of the Code for property subject to a QCC. Each of these provisions is discussed below.

A.        I.R.C. §2055(f) Estate Tax Deduction. Under I.R.C. §2055(f), an estate tax charitable deduction is available for intervivos, testamentary and post mortem grants of QCEs. [94]    To qualify for an I.R.C. §2055(f) deduction, the grant must be completed by the due date of the decedent’s estate tax return, including normal extensions. The deduction under I.R.C. §2055(f) will not be permitted with regard to a post morten QCE, however, if an income tax deduction is also claimed for the same grant under I.R.C. §170(h). [95]

The amount of the deduction under I.R.C. §2055(f) is determined using the same principles applicable to determine the amount of a charitable income tax deduction for an intervivos QCE, except that there is no ceiling on the amount of the deduction. For federal estate tax purposes, the net estate tax value of the property subject to a QCE granted upon or after the decedent’s death will therefore be the same as if the decedent had created the QCE during life. However, as with most charitable transfers that take effect at death, it is usually more tax efficient to make the transfer during life due to the additional income tax savings.

B.        I.R.C. §2031(c) Estate Tax Exclusion. In addition to the I.R.C. §2055(f) estate tax deduction, I.R.C. §2031(c) provides that, under certain circumstances, as much as 40% of the value of land that is subject to a QCE may be excluded from estate taxation. [96] The QCE exclusion is available regardless of whether the QCE was granted by the decedent during his or her lifetime or upon or after the decedent’s death.

For the exclusion under I.R.C. §2031(c) to apply, the property must be located within the United States or a U.S. possession; [97] it must have been owned either by the decedent or by a member of the decedent’s family for at least three (3) years before the decedent’s death; [98] the terms of the QCE must prohibit more than de minimis use of the property for commercial recreational purposes; [99] and an election to apply the exclusion must be made on a timely filed federal estate tax return. [100] In order to qualify for the exclusion, the donor must be either the decedent, the executor of the decedent’s estate, the trustee of a trust that owns the property, or a member of the decedent’s family. For these purposes, the decedent’s family members include the decedent’s spouse and ancestors, the lineal descendants of the decedent, the decedent’s spouse, or the decedent’s parent, and the spouses of such lineal descendants. [101]

The exclusion does not apply to any “development rights” retained with regard to the property. “Development rights” for this purpose means the right to use the property for a commercial purpose which is not subordinate to and directly supportive of the use of the property for farming purposes within the meaning of I.R.C. §2032A(e)(5). [102] It is nevertheless possible to preserve the full benefit of the exclusion by extinguishing any retained development rights so long as every living person who has an interest in the property executes an agreement to do so on or before the date for filing the estate tax return, and if that agreement is filed with the return. [103]

The I.R.C. §2031(c) exclusion does not apply to the extent that the property is encumbered by “acquisition indebtedness.” “Acquisition indebtedness” for this purposes means debt incurred to acquire the property, as well as debt incurred before or after the acquisition of the property if that debt would not have been incurred but for the acquisition, provided that a debt incurred after the acquisition must have been reasonably foreseeable at the time of the acquisition. [104] Any renewal, extension or refinancing of a debt that would have been acquisition indebtedness is also acquisition indebtedness. [105] 2031(c)(4)(B)(ii)

If all of the requirements of I.R.C. §2031(c) are met, then the estate tax exclusion is the lesser of the “applicable percentage” of the value of the property (reduced by the value of the QCE, any deduction claimed under I.R.C. §2055(f), and the value of any structures on the property) and the “exclusion limitation,” which, for estates of decedents dying after December 31, 2001 is $500,000. [106] The applicable percentage can be as high as 40%. However, the applicable percentage is reduced if the value of the QCE on the date of the contribution is not at least 30% of the value of the land on that date. This reduction is 2% for each 1% that the reduction in value was less than 30% but more than 10%. [107] If a QCE reduces the value of the land by 10% or less, no exclusion will be available under I.R.C. §2031(c). Importantly, to the extent that an exclusion is elected under I.R.C. §2031(c), the decedent’s heirs will receive the property with a carry-over basis. [108]

C.        QCCs and I.R.C. §2032A Special Valuation. I.R.C. §2032A, commonly referred to as the special use valuation rule, permits certain real property used in farming or in a trade or business to be valued for estate tax purposes with regard to its actual use rather than its highest and best use. Property subject to QCCs can also qualify for special use valuation. [109] However, certain issues are presented in this context.

First, special use valuation is only available if the real property used in farming or in a trade or business constitutes at least 25% of the value of the estate. [110] Therefore, if placing a QCE on the property would reduce the value of the property below the 25% threshold, a calculation must be run to insure that the loss of the I.R.C. §2032A exclusion is at least offset by the estate tax or other benefits of the QCE. Conversely, if I.R.C. §2032A is applied to a property, it will reduce the amount of the deduction under I.R.C. §2055(f) and the exclusion under I.R.C. §2031(c) that are available to the estate.

An additional issue with regard to I.R.C. §2032A is whether the grant of a QCC made within 10 years of the decedent’s death is a disqualifying disposition that would give rise to a recapture tax under I.R.C. §2032A(c). I.R.C. §2032A(c)(8) provides specifically that the grant of a conservation easement by gift or otherwise is not such a disqualifying disposition. Despite the apparent broad scope of I.R.C. §2032A(c)(8), however, there remains some uncertainty as to whether the sale of a QCC (as opposed to a gratuitous transfer) is a disqualifying disposition. [111] Consequently, a family that has secured the benefits of an I.R.C. § 2032A special use valuation would be well advised to either avoid a sale of a QCC during the recapture period or to seek a private letter ruling confirming that the sale would not give rise to the recapture tax.

D.        Fiduciary Considerations with Regard to Post Mortem Grants of QCCs. In the context of post mortem grants of QCCs, it is important to recognize that a QCC is not simply a tax election. It is a transfer of rights to property that effects an actual and potentially significant reduction in estate value to the beneficiaries. In most circumstances, that reduction in value will exceed the tax savings achieved by the QCC.

If the donor of a QCC will be acting as an executor or trustee, or in some other fiduciary capacity, consideration must be given to whether applicable state law or the terms of the will, trust or other instrument authorize the fiduciary to grant the QCE. While a few states have given fiduciaries discretionary powers to grant QCEs, in most cases it will be necessary for the fiduciary to seek the consent of the beneficiaries and/or court approval of the grant both to protect the fiduciary from surcharge and also to insure that the grant cannot be set aside by a beneficiary, causing the grant to be deemed revocable and therefore, an incomplete or otherwise non-perpetual transfer. Where post mortem QCEs are contemplated during the estate planning process, the drafting attorney should incorporate provisions in a client’s will, trust or family holding company agreement to facilitate that result. This might include, for example, a provision requiring only the class of adult living beneficiaries with a current interest in the property to approve a QCE, thereby avoiding the need to appoint a guardian ad litem to represent the interests of minor, unborn or contingent beneficiaries, particularly as it could be difficult to show that the granting of the easement is economically in the best interests of those beneficiaries. Language absolving the Trustee or other fiduciary from liability for granting a QCE would also be well advised.

III. USING QCCs WITH OTHER ESTATE PLANNING TECHNIQUES

A.        QCCs and Family Holding Companies

(1)        Intervivos QCCs by Partnerships, LLCs Taxed as Partnerships, and Subchapter S Corporations. For income tax purposes, charitable contributions by partnerships, Subchapter S corporations and other pass-through entities are taken into account by the entity’s individual partners, members or shareholders (for purposes of this discussion, the “members”). Each member must take into account separately the member’s pro rata share of charitable contributions made by the entity within the entity’s taxable year. [112] The limitations on the deductibility of these contributions will apply at the member level as though the member was the donor. For example, for purposes of determining whether a member can take advantage of the enhanced deductions available under PPA 2006 for QCC donations on agricultural land, that member must be able to show that at least 50% of his or her income in the year of the donation is attributable to farming.

(2)        Intervivos QCCs by Subchapter C Corporations. The income tax deduction for charitable contributions by “C” corporations is generally limited to 10% of the taxable income of the corporation in the year of the donation. [113] However, for contributions made before December 31, 2007 (unless extended), corporations (other than publicly traded corporations) qualify for the 100% deduction ceiling and the 15-year carry-over of unused deductions applicable to QCCs involving property used in agriculture or livestock production, subject to the same requirements for individual donations of this type, discussed earlier in this article.

(3)        Estate Tax Consequences of QCCs on Property Held by Partnerships, LLCs and Corporations. The exclusion under I.R.C. §2031(c) applies to property held in a partnership, LLC, corporation or other entity so long as the decedent owned, directly or indirectly, at least 30% of the entity, with ownership being determined by applying the principles of I.R.C. §2057(e)(3). [114] If the decedent owned less than 100% of the entity, then the exclusion is reduced proportionately by the percentage interest in the entity owned by someone other than the decedent. As a result, the estate tax value of the decedent’s interest in the entity should likely be computed by first determining the value of a pro rata share of the entire net asset value of the entity, reducing that value by the permitted exclusion, and then applying the appropriate discounts for lack of control and marketability.

B.        QCCs and Qualified Personal Residence Trusts. Since the enactment of Chapter 14 of the Internal Revenue Code, qualified personal residence trusts (or QPRTs) have been a mainstay in estate planning to preserve family residences and vacation homes. Combining QPRTs with QCEs can have powerful results. First, the QCE granted before the creation of the QPRT will reduce the base value from which the remainder interest is computed for federal gift tax purposes. In some cases, this will permit the donor to create a QPRT for a shorter term, thereby increasing the chances that the donor will survive to the end of the term and the QPRT will be successful. Second, where property being transferred to the QPRT is surrounded by more land than will be deemed reasonably appropriate for residential purposes within the meaning of I.R.C. §2702 and the applicable Treasury Regulations, the transfer tax value of the portion of the land that cannot be included in the QPRT might be reduced for gift or estate tax purposes with a QCE.

C.       QCCs and Life Insurance Trusts. The granting of a lifetime QCE can provide the donor significant income tax savings and can further reduce the estate tax value of the property, improving the likelihood that the property can be preserved for the use and benefit of successive generations. However, restricting the use and development of property in perpetuity can result in a true loss in value for the donor’s family. This can be a family political issue, as well as a financial issue, if some family members, possibly including the donor, are inspired by the concept of preserving family land in a natural or historic state, whereas other family members favor preserving their options for as long as possible. To address this issue, the donor could couple the grant of the QCE with the acquisition of “wealth replacement” life insurance, either on the donor’s life, the lives of the donor and his or her spouse, or even on the lives of members of the next generation, as it may be the donor’s grandchildren and more remote descendants who feel less connection to the land than do the donor and the donor’s children.

IV. STATE TAX BENEFITS OF QCEs

A.        Property Tax Reduction. In addition to federal income, gift and estate tax benefits from QCCs, donors and their heirs can often secure significant property tax savings if the QCC has had the effect of reducing the market value of the donor’s property. That savings may not be as dramatic, however, with regard to farming properties, which in many parts of the country already benefit from a form of special use valuation for property tax purposes.

B.        State Income Tax Credits. Approximately a dozen states provide donors of QCCs substantial state income tax credits. For some donors, the state tax credit can represent a more significant financial benefit than does the federal income tax deduction. So substantial are certain state tax credits that the office of the Chief Counsel has indicated the IRS is examining whether state tax credits, particularly transferable credits, should be treated as a form of “quid pro quo” that reduces the federal income tax deduction available for a QCC. [115]

To provide a flavor for how favorable state tax laws can be in the context of QCCs, examples of four (4) such state tax credits (those applicable in Colorado, Virginia, Maryland, and North Carolina) are outlined below. The reader is, of course, encouraged to research the state tax credits for QCEs applicable to his or her clients in other states.

(1)        Colorado. Colorado provides perhaps the most generous tax incentives for QCEs. So long as a Colorado QCE qualifies for a federal income tax deduction under I.R.C. §170(h), and if the donee organization has been in existence for at least two (2) years, Colorado provides an income tax credit equal to the lesser of $375,000 or 50% of the fair market value of the QCE. [116] This limitation applies to married couples and to all members of a pass-through entity, such as a partnership or Subchapter S corporation, collectively.

The Colorado tax credit is available to Colorado resident individuals, C corporations, trusts, estates, and members of pass-through entities who receive the credit from the entity. Members of pass-entities (other than single member LLCs) need not be Colorado residents to benefit from the credit. The credit is partially refundable, but only if the state has a certain level of surplus funds. Any unused credit can be carried forward for 20 years. Perhaps most important, the credit is transferable and can therefore be sold to another individual or corporate entity (but not to a pass-through entity). The credit is never refundable by a transferee, but the transferee does enjoy all other benefits of the credit.

(2)        Virginia. Until January 1, 2007, Virginia offered an income tax credit to Virginia taxpayers for the lesser of $100,000 or 50% of the value of a Virginia QCE. The credit could either be applied against the donor’s Virginia income tax liability or it could be sold, and a five-year carry over period was available for unused credits. As of January 1, 2007, the amount of the credit was reduced from 50% to 40% of the value of the QCE, but the carry-over period was extended to 10 years. Virginia also offers an exclusion from taxable income of gain derived from the sale or exchange of a conservation easement for open space for a term of at least 30 years. [117]

(3)        Maryland. Maryland also offers an income tax credit based upon the value of QCEs on land located in that state. The amount of the credit cannot exceed $5,000 per year per donor ($10,000 per married couple), and any unused credit can be carried forward for up to 15 years subject to the same annual maximum, provided that the total credit claimed cannot exceed $80,000. [118]

(4)        North Carolina. North Carolina offers a tax credit of up to 25% of the value of donated conservation land or a QCE provided that the total credit cannot exceed $250,000 for individuals and $500,000 for corporations. Any unused portion of the credit may be carried forward for five (5) succeeding years. To qualify for the credit, the donation must be certified by the North Carolina Department of Environment and Natural Resources and a letter of certification must be attached to the donor’s North Carolina state income tax return. [119]

V. ABUSES OF QCCs AND THEIR FUTURE IN INCOME AND ESTATE TAX PLANNING

A.        The “Darker Side” of Conservation Contributions. The growth in land trusts and the use of QCCs to accomplish property owners’ charitable and tax objectives has been accelerating. Over 1500 land trusts now exist, whereas, when the first federal income tax incentives for QCCs were introduced in the early 1980s, there were barely more than 500 such entities. [120] More strikingly, during the five-year period from 1998 to 2003, the number of conservation easements in this country grew from just 7,400 covering 1,400,000 acres to over 18,000 covering more than 5,000,000 acres. [121] In the state of Colorado alone, which, as discussed above, offers perhaps the most aggressive state income tax incentives for QCCs, the number of acres protected by QCEs grew from 350,000 acres in 2000 to over 1,000,000 acres in 2005. [122]

With so many tax incentives offered to donors of QCCs, it should not be surprising that QCCs are sometimes the subject of tax evasion schemes and fraudulent tax avoidance transactions; what Steven T. Miller, Commissioner of Tax Exempt and Government Entities for the IRS, has referred to as the “darker side” of charitable tax planning. [123] The potential for abuse of QCCs was brought to the public’s attention in an October of 2003 Washington Post article by reporters Joe Stephens and David Ottaway. The article accused land trusts, and the Nature Conservancy in particular, of paying far too much attention to the tax benefits to their donors and the needs of real estate developers and not enough to carrying out their tax exempt purposes. Stephens and Ottoway highlighted instances of gross overvaluations of QCEs for tax deduction purposes as well as the failure of land trusts to enforce the use and development restrictions that generated those tax deductions. Naturally, the article did not go unnoticed by the IRS and Congress.

B.        Notice 2004-41 and Other “Shots Across the Bow”. Less than a year following the Washington Post article, the IRS issued Notice 2004-41, [124] two pages of which are devoted to the perceived abuses of QCCs and other charitable contributions. The Notice takes particular aim at “two-step conservation buyer programs,” in which a land trust buys property for its fair market value, places a restrictive easement on that property, and resells it to a buyer at a substantially discounted price, purportedly to reflect the negative effect of the easement on the property’s value. The buyer of the property then makes two payments to the qualified organization: one that is for the discounted value of the property and the other as a purported tax deductible charitable donation. The Notice warns that the IRS will apply a substance over form analysis to such two-step transactions and will deny a deduction for the second payment.

Even for transactions that lack the abusive taint of two-step conservation buyer programs, the Notice warns taxpayers that a tax deduction will be disallowed for conservation easements that do not have a material detrimental impact upon the value of the subject property. Further, in computing their deductions for QCEs, donors are strongly reminded that they must take into account any benefits they obtain from the easement, including the enhancement in the value of other properties of the donor. In situations where the benefits of the easement to the donor are greater than the public benefits of the gift, no deduction will be allowed.

Notice 2004-41 was only the first of several IRS “shots across the bow” with regard to conservation easements. In every year since 2005, the IRS has included abusive tax avoidance schemes involving tax exempt organizations generally, and conservation easements in particular, in its annual “dirty dozen most notorious tax scams.” IRS Commissioner Mark Everson has warned that taxpayers who attempt to “game the system” with conservation contributions, and the charities that assist them, “will be called to account,” [125] and an IRS task force has been formed to examine returns claiming large deductions for QCCs. As of a few months prior to the finalization of this article, a reported 250 IRS audits of conservation contributions were in process in Colorado alone. [126]

C.        PPA 2006 and the Future of Tax Deductible Conservation Contributions. Congress also took aim at conservation contributions in PPA 2006. Congress focused in particular on the potential abuses of architectural façade easements, adding new restrictions on these donations in certain circumstances, increasing the reporting requirements, and imposing additional filing fees where larger deductions are claimed. More dramatic, however, are the changes in the law applicable to appraisals, appraisers and the penalties upon taxpayers for understating their income tax liabilities due to overvaluations of QCCs.

A full discussion of the provisions of PPA 2006 applicable to appraisers and appraisals is outside of the scope of this article. [127] In general, however, only “qualified appraisers” with designations awarded on the basis of “demonstrated competency” in valuing real property interests of the type being donated may now fill out the declaration on the Form 8283 necessary to substantiate a charitable income tax deduction. [128] Further, if an appraisal represents a substantial or gross overstatement of the value of a donated property interest, the appraiser can be subject to civil penalties. Appraisers who support a substantial or gross overstatement of value can also be suspended or disbarred entirely from practicing before the IRS in the future. Importantly, both for appraisers subject to the new rules and taxpayers seeking to avoid the risk of penalties, the threshold of what represents “substantial” or “gross” misstatements of value have been significantly decreased by PPA 2006, and taxpayers can no longer rely upon the “reasonable cause” exception to avoid penalties for gross misstatements of value. [129]

Fortunately, however, the news with regard to conservation contributions is not all bad. While PPA 2006 resulted in more stringent rules on façade easements and increased risks to donors and appraisers who engage in overly aggressive valuations of conservation contributions, PPA 2006 arguably represents a renewed vote of confidence by Congress for the proper use of tax deductible conservation contributions. As discussed earlier in this article, for conservation contributions made on or before December 31, 2007, PPA 2006 has lifted the deduction ceiling from 30% to 50% of the donor’s contribution base, and, with regard to agricultural property, the deduction ceiling can be as high as 100%. Further, for contributions that qualify for these higher deduction ceilings, the carry-over period for unused deductions has been extended from five years to 15 years.

Congress’s apparent schizophrenic approach to conservation gifts should not be surprising. Despite their potential for abuse, conservation contributions are favored by politicians (and voters) of most political persuasions. Those on the right of the political spectrum tend to favor QCCs for promoting the rights and interests of property owners, saving family farms and reducing taxes. Those on the left find QCCs attractive because they encourage the protection of natural habitat and open space from future development. [130] Therefore, while Congress should be expected to continue to enact laws intended to close down loopholes and targets for tax abuse, and the IRS should be expected, to the extent of its available resources, to vigorously enforce those laws, the federal tax benefits of conservation contributions should remain available for their intended purposes for the foreseeable future.