Taxpayer Wins on Conservation Easement Valuation
In Schmidt, 1 the IRS challenged a taxpayer's valuation of a conservation easement. In determining the value of the easement, the tax court applied a version of the discounted cash flow method, referred to as the subdivision development method, to value the subject property prior to the conveyance of the easement.
Mr. Schmidt purchased a 40-acre parcel of vacant land for $525,000 with the intention of subdividing and developing the parcel. He retained a consultant to provide land planning and consulting services in order to develop the property into a 13-lot subdivision. Before obtaining all final construction permits and zoning approvals, however, Mr. Schmidt decided not to develop the property. Instead, he decided to construct a single residence on the property and to grant a conservation easement that restricted development on the property to a single residence.
The appraiser hired by Mr. Schmidt valued the conservation easement at $1.6 million. The appraiser reached this conclusion by valuing the property both before and after the conveyance of the conservation easement. The appraiser determined that the highest and best use of the property before the granting of the conservation easement was as a residential subdivision, and he used the subdivision development method to determine the value of the property before the conveyance of the easement. The appraiser opined that the value of the property before the conveyance of the easement was $2 million. The appraiser determined that the highest and best use of the subject property after the granting of the conservation easement was as a single 40-acre home site, and he used the market method to determine the value of the property after the conveyance of the easement. The appraiser opined that the value of the property after the conveyance of the easement was $400,000. He therefore concluded that the value of the conservation easement was $1.6 million.
Mr. Schmidt claimed a charitable contribution on his income tax return, and on audit the IRS issued a notice of deficiency on account of valuing the conservation easement at $195,000. The IRS's appraiser used the market method and determined that the value of the property before the conveyance of the easement was $750,000, and the value of the property after the conveyance of the easement was $270,000. The IRS's appraiser therefore concluded that the value of the easement was $480,000.
Generally, a taxpayer may not deduct the value of a contribution of property that consists of less than the taxpayer's entire interest in that property.2 However, a taxpayer is allowed a charitable contribution deduction for a qualified conservation contribution.3 "A qualified conservation contribution is the contribution of a qualified real property interest to a qualified organization exclusively for conservation purposes."4 "A perpetual conservation restriction is a qualified real property interest" that is defined as "a restriction granted in perpetuity on the use which may be made of real property-including, an easement or other interest in real property that under State law has attributes similar to an easement (e.g., a restrictive covenant or equitable servitude)." 5
Reg. 1.170A-14(h)(3)(I) states in relevant part:
The value of the contribution under Section 170 in the case of a charitable contribution of a perpetual conservation restriction is the fair market value of the perpetual conservation restriction at the time of the contribution. See Section 1.170A-7(c). If there is a substantial record of sales of easements comparable to the donated easement (such as purchases pursuant to a governmental program), the fair market value of the donated easement is based on the sales prices of such comparable easements. If no substantial record of marketplace sales is available to use as a meaningful or valid comparison, as a general rule (but not necessarily in all cases) the fair market value of a perpetual conservation restriction is equal to the difference between the fair market value of the property it encumbers before the granting of the restriction and the fair market value of the encumbered property after the granting of the restriction.
The court recognized that since a market for the purchase and sale of conservation easements rarely exists, a conservation easement's value is ordinarily determined by measuring the diminution in value of the affected property resulting from the creation of the easement ("before and after method"). The court also recognized that generally, the fair market value of property is determined by taking into account the highest and best use of that property on the relevant valuation date. Finally, the court recognized that three methods are generally employed to measure the fair market value of property:
1. Replacement cost method.
2. Market method.
3. Income method.
The replacement cost method values a property by determining the cost to reproduce it less applicable depreciation or amortization. The parties agreed that the replacement cost method was not a reliable method for determining the fair market value of the property.
The market method values a property by comparing the property to similar properties sold in arm's-length transactions in or about the same period. The prices of comparable properties are adjusted to create parity between those properties and the property being valued for comparative purposes. The reliability of the market method depends on the comparability of the property selected and the reasonableness of the adjustments made to establish comparability. The court rejected the application of the market method to the valuation of the property either before or after the conveyance easement since the court found that appropriate comparable sales did not exist.
The income method values a property by capitalizing or discounting expected cash flow from the property. Property value is determined under this method by adding the sum of the present value of the expected cash flow and the present value of the residual value of the property. The subdivision development method is a variation of the income method. The subdivision development method values undeveloped land by treating the property as if it were subdivided, developed, and sold. The court held that the subdivision method was the appropriate method to value the property before the conveyance of the easement.
The court set forth the following factors that would be considered using the subdivision method to determine the value of the property before the conveyance of the easement:
1. Number of lots.
2. Retail lot selling price.
3. Retail lot selling price appreciation rate.
4. Time required to obtain entitlements to develop the property.
5. Absorption rate of the lots (i.e., the amount of time it would take for the market to absorb all of the lots).
6. Development costs.
7. Marketing and administrative costs.
8. Discount rate.
The parties agreed that before the conveyance of the easement, the property could have been divided into 13 lots. The parties also agreed that the selling price for the lots would have appreciated at six percent per annum and that the appropriate discount rate was 22 percent. The parties also agreed on the costs to develop the lots. The parties disagreed with respect to the selling price for the lots on how long it would take to obtain the necessary entitlements to develop the property, the absorption rate, and the amount of the marketing and administrative costs.
The court conducted a detailed review of each expert's appraisal report and found neither appraisal to be entirely convincing. Therefore, the court drew its own conclusions based on the evidence submitted with respect to those issues upon which the parties disagreed and determined, using a discounted cash flow analysis, that the value of the property before the conveyance of the easement was $1,422,445.
The court next turned to an analysis of the property after the conveyance of the easement. The parties agreed that the value of the property after the conveyance of the easement should be based on sales of other comparable properties with restrictions similar to those imposed by the conservation easement at issue. The court accepted the conclusion of the IRS's appraiser finding that his method seemed to more accurately value the subject property after the granting of the conservation easement because the sales of the lots selected by the taxpayer's appraisal were still subject to possible rezoning and development as a multi-lot subdivision. Therefore, the court accepted the IRS's determination of the value of the property of $270,000 after the conveyance of the easement. Accordingly, the court concluded that the value of Mr. Schmidt's conservation easement was $1,152,445 ($1,422,445 minus $270,000).
Over the past few years there have been a number of decisions from the tax court and courts of appeal addressing issues regarding conservation easements and the valuation of conservation easements. Charitable contributions for conservation easements appear to be an area of particular scrutiny for the IRS. The opinion in this case sets forth a helpful summary of the factors to be considered when the subdivision development method is used to value an easement, and can serve as a blueprint as to how those factors will be applied by the court. Because of the likelihood of challenge by the IRS, this case once again highlights the crucial importance of obtaining a well-prepared appraisal report in order to support the valuation being sought by the taxpayer.
Frank Baldino is an estate planning attorney who co-chairs Lerch, Early & Brewer’s Estate Planning & Probate group in Bethesda, Maryland. His focus is on protecting the assets of high net worth individuals to minimize federal and state tax liability. For more on conservation easements, contact Frank at (301) 657-0175 email@example.com.
This article originally appeared in the December 2014 edition of Estate Planning, a monthly periodical directed to estate planning professionals that offers readers the newest and most innovative strategies for saving taxes, building wealth, and managing assets.