Tax Advantages of Conservation Easements

By Kathleen J. Masterton

(excerpted from a two part article published in 2005 in the Baltimore County Bar Association journal  The Advocate.)

            Many tax benefits are available to landowners by placing real property under conservation easements of various kinds.  Such easements have the added advantage of being available for first use on a post-mortem basis, adding another tool to the estate planner's tax-avoidance arsenal. 

           Private landowners in Baltimore County voluntarily have placed more than 40,000 acres of additional land in easements.  The easements typically keep the subject properties from being developed, thereby preserving habitat for flora and fauna, conserving the Chesapeake Bay watershed, and preserving the visual beauty that characterizes so much our County.  Property owners may have conservation as their primary motive, but the tax advantages attending easement donation are an attractive incentive for their use.  Estate tax benefits can insure that lands remain in family hands, while income tax benefits and property tax savings can add to the cost effectiveness of land conservation.   Conservation easements are useful tools which deserve to be better publicized.

            A conservation easement is a voluntary land preservation agreement negotiated between a landowner and an easement holder in which the landowner gives up in perpetuity one right in the landowner's bundle of rights.  The easement may be sold (to a government or to a private conservation organization) at its full fair market value (FMV) or at a fraction of its FMV (a bargain sale), and/or may be donated.  While each easement is the subject of individual negotiations between the landowner donor and the conservation donee, the most commonly encountered terms include strict limits or outright bans on subdivision of the property; new residential structures; dumping of household garbage; billboards or large signs; surface mining or material alteration of the topography; and industrial and commercial activity except for agriculture, silviculture, horticulture, viticulture, aquaculture, equine activities, and businesses that can be conducted in permitted buildings (e.g., B&B; home office).

            Agricultural structures usually are allowed, but may be subject to size or other restrictions.  There normally are specific protections for natural or scenic resources and provisions for inspection of the property by the easement holder to ensure that the agreement is honored.  There may be provisions for management of forest resources (commercial harvest is allowed) or other natural resources.

            People often have misconceptions about easements.  For example, many believe that once an easement is conveyed, the general public must have access to the property, that the landowner cannot farm, hunt, fish, or cut timber on the land, that the landowner cannot sell the land or pass it onto his heirs, that more structures or subdivisions are permitted on the property, or that the "Government" will take the land away.  There is no truth to these myths (although a landowner certainly is free to include any of these provisions in the easement agreement, if the landowner so desires).

            Potential tax benefits associated with donated conservation easements include federal and state income tax deductions, estate tax benefits, and property tax benefits.  The federal income tax deduction is limited to the value of the cost basis in the property, is equal to the easement value, and is subject to an annual limit of 30% of AGI per year if the property is a "long-term" capital asset (>1 year), or 50% of AGI per year if the property is a "short-term" capital asset (<1 year).  After 1 year the donor may elect to use the 50% rate.  Excess contribution may be carried forward for 5 additional years (allowing a maximum of 6 years).

            State law provides a tax credit of up to $5,000 per year against State income taxes when an easement is donated.  To qualify, the easement must be perpetual, must be conveyed to the Maryland Environmental Trust or the Maryland Agricultural Land Preservation Foundation, and must be approved by the State Board of Public Works.  The total credit may not exceed the appraised value of the easement, reduced by any payment received for the easement.  The maximum credit an individual may take per year is the smaller of $5,000 or the amount of State income taxes owed for that year.  An individual may take the credit for the year  the conservation easement is conveyed, and continue, at a maximum of $5,000 per year, for 15 more years, for a total of up to $80,000.  A taxpayer may not claim a State income tax deduction and a State income tax credit for the same conservation easement donation.

            When multiple individuals (owners) jointly donate an easement, each  is separately entitled to the tax credit of up to $5,000 per year.  For example, a husband and wife, even if filing jointly, may take up to $10,000 credit per year.  To calculate the total credit which an individual may take, multiply the appraised easement value by the individual's percentage of ownership of the property.  Easements donated before July 1, 2001 do not qualify for this credit.  However, a second easement, or amendment, that materially strengthens the conservation restrictions of the original easement may create a tax credit.

            Land subject to a conservation easement may qualify for two specific estate tax benefits: as much as 40% of the value of the land (up to a $500,000 cap) may be excluded from the estate, and the land use restriction will reduce the value of the remaining taxable estate.  At the time of donation, the easement must reduce the value of the land by at least 30% to qualify for the full 40% exclusion: for every 1% by which the easement has not reduced the value of the property by 30%, the exclusion is reduced by 2%.  Of tremendous benefit, the estate may make a post mortem election to donate the easement.  Thus, where a decedent either has not planned to avoid the impact of the federal and state estate taxes, or where a plan has gone awry for some reason (such as subsequent changes to tax laws, a situation often encountered since Maryland decoupled its estate tax in 2004), a conservation easement offers a real opportunity for heirs to reduce the value of the taxable estate.  Whenever an estate is facing substantial estate tax, the prudent attorney will determine whether the estate contains any real property that may be appropriate for an easement and will discuss with the Personal Representative the advantages and disadvantages of an easement as a post mortem planning tool.

            A final tax benefit is that if a landowner chooses to donate a conservation easement to the Maryland Environmental Trust, the landowner is not liable for property tax on the unimproved portions of the property for 15 years from the date of the donation. 

            The process of donating a conservation easement is similar no matter which land trust is involved, but may vary slightly according to the specific land trust's procedures.  After locating an appropriate land trust and determining that the organization has interest in the subject parcel, a site visit is scheduled to determine if the  property has sufficient conservation potential.  If so, the organization's staff presents the proposed project to the governing body for approval or rejection.  In accordance with IRS regulations and with land trust monitoring guidelines, the current condition of the property must be established through a report consisting of maps, pictures and a narrative description of the parcel.  This baseline document is reviewed regularly by the easement holder to ensure that the terms of the easement are enforced. The landowner verifies that he/she has clear title to his/her property and that any liens or mortgages are subordinated to the easement.

            Once these steps are complete, a draft conservation easement is prepared by land trust staff or the landowner's attorney.  The  landowner should consult an attorney regardless of who drafts the easement.  Once the easement is in draft stage, the landowner and the land trust staff review the document to insure that the easement achieves the preservation of the conservation resources on the property.  Once a final agreement is reached by the landowner's attorney and the land trust attorney, the value of the easement is appraised.  It is wise to have the value of the entire property, subject to the easement, appraised as well (the difference in a property's value without a conservation easement and the same parcel with the easement  may be the difference that bumps an estate below the level at which State or federal estate taxes are due, or may significantly reduce the amount of such taxes for which an estate is liable).  Finally, the easement is signed, notarized, and recorded in the County Land Records. 

            Ordinarily, for a real property-related donation to constitute a charitable donation warranting an income tax deduction, the owner's entire interest in the gifted property must be donated.  But when a landowner donates a conservation easement to an appropriate land trust, the easement constitutes a charitable gift.  According to Internal Revenue Code 170(h), an easement qualifies as a deductible charitable gift if it meets the following criteria: (1) a "qualified" real property interest is given to (2) a "qualified" organization, which is (3) exclusively for a "conservation purpose."  A property interest is "qualified" if the restriction on the use of the real property is in perpetuity, is a remainder interest, or is the entire interest of the donor other than a qualified mineral interest.  An organization is "qualified" if it has both a commitment to protect the conservation purposes of the donation and the resources to enforce the restrictions. 

            Qualified organizations serving Baltimore County include local, state, and federal governmental agencies (Maryland Agricultural Land Preservation Foundation, Baltimore County) and charitable organizations (Maryland Environmental Trust, local land trusts, The Nature Conservancy).

            Some restrictions worth noting are that a deduction is disallowed if, even though the contribution would accomplish one of the enumerated conservation purposes, it would permit destruction of other significant conservation interests. 1.170A-14(e)(2).  Likewise, density reduction alone does qualify an easement donation for the income tax deduction.  The following example illustrates this point: H owns Greenacre, a 100-acre parcel of woodland, pasture, and orchards atop a mountain.  All of Greenacre is clearly visible from a nearby national park.  Under the strict enforcement of an applicable zoning plan, the highest and best use of Greenacre is as a subdivision of 25-acre tracts.  H wishes to donate a scenic easement on Greenacre to a qualifying conservation organization, but wants to reserve the right to subdivide Greenacre into 25-acre parcels with just one single-family house allowed on each parcel.  Random building on the property, even as little as one home for each 25 acres, would destroy the scenic character of the view.  Hence, no deduction would be allowed under this section. 1.170A-14(f).

            Other examples of "easement abuse" include an easement that merely reduces the density of development permitted under local subdivision/zoning rules; an easement protecting a small tract of open space in the midst of larger residential development where the conservation benefits are minimal and/or enjoyed only by the homeowners in the development; an easement on a private golf course that is an intensively altered landscape; an easement that does not contain appropriate riparian buffers, building envelopes, house size/siting restrictions, etc.  Land conservation organizations do not guarantee that the easements they accept will qualify for a federal charitable income tax deduction under 170(h).  Therefore, prudent easement donors should consult with a qualified tax advisor to determine the tax effect for each particular financial situation.

            A taxpayer who claims a value in excess of $5,000 for a charitable gift must have a "qualified appraisal" conducted by a "qualified appraiser" to support the claimed value.  The appraisal must be completed not more than 60 days prior to the donation and prior to the due date of the tax return in the year in which the charitable donation is claimed.  The value of a conservation easement equals the property's FMV with development rights minus its FMV without the donated development right (CE = FMV w/ DEV FMV w/o DEV).  The IRS prefers the "sales comparison" valuation approach and, if there are enough comparable easement sales, requires that this approach be used.  The "before and after" valuation approach is used in the great majority of cases, and compares the property values "before" and "after" the easement donation. 

            The amount of the deduction when the easement covers a portion of the property owned by the donor and the donors family is the difference between the FMV of the entire contiguous parcel before and after the granting of the easement 1.170A-14(h)(3)(I).  If the easement increases the value of any other property (contiguous or non-contiguous) owned by the donor or a related person, the value of the contribution shall be reduced by the amount of the increase in value 1.170A-14(h)(3)(I).