ESTATE, CONSERVATION AND PRESERVATION EASEMENTS
Conservation and Preservation Easements
The 6th Edition of the Dictionary of Real Estate Appraisal defines a conservation easement as: “an interest in real estate restricting future land use to preservation, conservation, wildlife habitat, or some combination of those uses. A conservation easement may permit farming, timber harvesting, or other uses of a rural nature as well as some types of conservation-oriented development to continue, subject to the easement. (Page 47).” There are of course many types of the easements including but not limited to affirmative easement, easement by prescription, easement in gross, negative easements, appurtenant easement, reciprocal Easement, conservation easements or historic preservation easements to mention a few.
Most are self explanatory such as a negative easement that is described as an easement preventing a property owner from certain, otherwise permitted, uses of his or her land.
The 6th Edition defines an Historic Preservation Easement as a “type of easement in gross that protects historically or architecturally significant properties by prohibiting or requiring review of future alterations or additions to protected features. When only some or all of the exterior surfaces and not the interior are protected, such an easement is often called a facade easement. The Internal Revenue Code allows a charitable gift deduction for the voluntary grant of qualifying historic preservation easements on some types of historic buildings (Page 110).
A conservation easement and even a preservation easement are legal agreements voluntarily entered between the owner of real estate and land trust (those being a qualified organizations to accept such an easement – such as the Landmarks Preservation Council of Illinois) or a government agency that will permanently limit the use and future development in order to protect the conservation of a property or historic value of a structure. By that I mean a preservation easement is there to protect architecturally or historically significant structures such as the Palmolive Building in Chicago.
Easements can be tricky and mistakes can be made. As a general rule they are straight forward and even when an error is made it can be rectified. Such as in the event the donor fails to attach the appraisal summary required under paragraph (c)(2)(i)(B) the IRS may request the donor submit the appraisal summary within 90 days.
However the Palmolive Building above was chosen as an example since the façade easement that they had applied for during their renovation of the property that one’s whole house the playboy Corporation am was converted to residential use, turned out to be a spectacular failure. A technical error relating to the property’s mortgages cost the taxpayers over $33 million in a conservation easement deductions.
Not alone did the IRS disallow or deny the conservation easement but the IRS also attached valuation penalties. The case boiled down to who had superior rights in the subordination of the mortgage (there were actually two) to the Preservation Council. The preservation council was not guaranteed to receive any share of the proceeds resulting from potential extinguishment of the easement. The court stated that the conservation easement did not satisfy the ‘perpetuity requirement’ because the mortgages were not fully subordinate to preservation easement.
If there are two issues that are highlighted in this case…Is that the IRS can be a stickler for rules and the idea of perpetuity is not a notion in some theoretical sense, but perpetuity means perpetuity – forever. The IRS also pressed home the fact that the requirements for the charitable contribution must be (completely) satisfied “at the time of the gift” and that any defects in the agreement are not cured in their eyes by amendment provisions that purports to retroactively amend the deed. This should not be confused with providing additional paperwork significantly smaller donations.
Appraising or valuing property that is going to be used as part of an easement, a tax shelter, etc., can attract significant penalties if careful attention is not paid to the appraised value or the Estimated Market Value for charitable taxation purposes.
Basically we are referring to a substantial valuation misstatement. Penalties increase as the error in the valuation increases. A 200% valuation misstatement (over where the valuation should be – that estimated market value where the majority of peers would concur was a reasonable estimate) can attract a 40% penalty. The IRS at its discretion may solicit the opinion a subject matter specialists for the purpose of assisting the department in determining the fair market value at the time of the donation. This is never good.
From a valuation point of view the donated easement can develop a tax deduction equal to the before and after values due to the grant of the easement. So for example a parcel of land that is perpetually donated for “View,” will lose all of its future development potential. While the donor may retain ownership rights including the ability to sell or bequeath property, any buyer or inheritor of the property has the same lack of development potential rights.
Therefore the property’s value is not the same as say a similar neighboring parcel of land that, for all intent and purpose, is the same as that parcel which is now encumbered with the donation. In reality this is where the competency rule (USPAP) comes into play.
According to the Competency Rule on page 11 of the Uniform Standards of Professional Appraisal Practice (2020-21) being confident means that “an appraiser must determine, prior to agreeing to perform an assignment, that he or she can perform the assignment competently. Competency requires:
The ability to identify the problem to be addressed;
The knowledge and experience to complete the assignment competently; and
Recognition of, and compliance with, laws and regulations that apply to the appraiser or to the assignment.
Being familiar with the specific type of property, type of appraisal required or analytical methods etc., are all important in developing true competency.
This all appears to be straightforward but like everything else there are checks and balances along the way. It is up to the appraisal firm to closely work with and to advise the donor from valuation point of view. Significantly over-valuing any property can cause issues down the road and is always ill advised. On the other hand the donor is entitled to capture the highest possible deduction available due to the donation. This is where slapping together any old appraisal is simply not sufficient and is not in the best interest of the donor and possibly falls afoul of the competency rule.
There are hurdles to overcome, and there is a need to understand what is demanded of an appraisal of a donation of real estate. In talking with several ‘bean counters,’ on receipt of a donation of property their first inclination is to sell. Frankly that possibly should be their last inclination, but there is typically a complete lack of understanding and knowledge base, therefore selling is the easiest answer. Hence many properties are sold within a three-year period of donation. This should be remembered.
Without completely getting into the weeds, below are some of the areas that an appraiser should be aware of in the valuation of these assets.
There is a requirement to file a form 8283 with any tax return for non-cash gift donations valued at more than $500 is donated. From an appraisal point of view, property valued in excess of $5,000, the tax prayer for certain gifts is required to attach an appraisal summary.
In the case of art valued at more than $20,000 or other property valued at more than $500,000 a qualified appraisal is required to be attached to the tax return on which the deduction is to be claimed. IRC Section 170(f)(11)(E)(i) directed the treasury secretary to determine the specific requirements for a qualified appraisal. These directions we’re subsequently set out in Treasury Regulations Section 1.170A-13(c)(3)(i).
The appraisal (regardless of its format) must be comply fully with the Uniform Standards of Professional Appraisal Practice (USPAP.) It also, in certain circumstances needs to conform to the Uniform Appraisal Standards for Federal Land Acquisitions often referred to as the “Yellow Book.”
IRS form 8283 must be signed by the appraiser and by the taxpayers. But to ensure there is no “appraisal value inflation,” or in other words the property is not substantially overvalued charitable Donees are further required to submit form 8282 and provide a copy to the donor. Form 8282 is come referred to as the “tattletale form,” since the IRS can compare the amount reported form 8283 with the appraised value claimed with the original filing which included form 8283. This process is an attempt to “deter” overvaluing and the gift to ensure that there are not significant differences claim by the donor vis-à-vis the subsequent cash value obtained by the charity.
(Critically jumping back to the word ‘deter,’ one has to be very careful here. In essence we are talking about a three-year period in which gift maybe sold by the receiving organization. If the pandemic driven by COVID-19 is anything to go by, valuations have been rocked left, right and center. If the donation was an office building in the central business district of the major City in 2019, it may be fair to assume that there is potential for a significant decrease in value. This could never have been anticipated at the time of the original donation in 2019. If the donation was a small say 10-unit shopping center, again it is theoretically correct to assume that the value stated on the form 8283 maybe substantially different (and higher) when the property was finally sold and reported on the tattletale form, Form 8282.
This may mean that the qualified appraiser (which is an individual who either holds himself or herself out to the public as an appraiser or performs appraisals on a regular basis) may have to get involved again to underline the changing economic circumstances has occurred. As we clearly understand there are fines both for the donor and the appraiser, it’s in everyone’s interest to square this away. As a word of caution from a professional appraiser, searching for the lowest appraisal fee is guaranteed that the delivered appraisal may be lacking.
For example, if the original appraiser just concluded the total revenue over the past three years prior to the donation, but omitted the rent roll, there is really little to substantiate the value change. Sure the original rent-roll can be re-attached, but based on the Palmolive case in Chicago (Palmolive Building Investors, LLC v. Commissioner,) the court held that requirements for the charitable contribution must be satisfied “at the time of the gift.” Stressing I am not a lawyer, but I see a cloudy area here. So as a fair warning, choosing the right firm to handle the valuation work that advises carefully and from a valuation point of view, develops the soundest course of action is paramount to a successful donation. JSO never like to see a file twice!
The date of valuation in the appraisal can be no more than 60 days prior to the date of the contribution in conveying the conservation easement (1.170A-13(c)(3)(iv)(B)).
The IRS imposes severe penalties for over-valued appraisals. Both the donor and the appraiser are subject to these penalties.