Tax Implications of Conservation Easements

Estate & Income Tax Considerations

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

Qualifying for a Tax Deduction

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

Qualifying for a Conservation Easement Appraisal

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

 

INCOME TAX

Contribution Value

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

To quantify the value of the charitable contribution generated by the donation of the easement, you must obtain a “qualified appraisal” by a “qualified appraiser.” As recipient of the donated conservation easement, MLR needs to be detached from the appraisal process. In this example, the appraisal sets the fair market value of the ranch at $2 million. This is the value of the property before the conservation easement.

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

Before conservation easement property value	=	$2,100,000
After conservation easement property value	=	$1,400,000
Value of charitable contribution	=	$700,000

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

The 50% Limitation New in 2006

Federal tax law generally allows a maximum deduction of 50 percent of your Adjusted Gross Income (AGI) in any given year through the donation of a conservation easement on a property. However, you can use the 50 percent deduction for up to 16 years until the value of the charitable contribution is used up. In our example, the value of the charitable contribution generated through the donation of the conservation easement is $700,000. Let’s assume that the landowner’s annual AGI is $140,000, which remains constant. The deduction resulting from the easement is as follows: (50 percent of $140,000 = $70,000).

Easement Deduction

Year 1	$70,000	The actual tax reduction is a function of your income tax bracket. In this case, in Year 1 the landowner would apply his or her tax rate to a $70,000 AGI instead of $140,000 AGI.
Year 2	$70,000
Year 3	$70,000
Year 4	$70,000
Year 5	$70,000
Year 6	$70,000
Year 7	$70,000
Year 8	$70,000
Year 9	$70,000
Year 10	$70,000
Year 11	$0
Total	$700,000

100% Deductibilty For Qualified Farmers & Ranchers New In 2006

The second important change provided by the new federal tax provision entitles a landowner who meets the tests for “qualified farmers and ranchers” is allowed to take the deduction up to 100% of AGI (for individuals), or up to 100% of taxable income (for corporations), also with a 15-year carryforward.

According to the new statute, “qualified farmer or rancher” means a taxpayer whose “gross income” from the business of farming (as defined under Section 2032A(e)(5) of the tax code) is greater than 50% of the taxpayer’s gross income for the taxable year in which the conservation easement is donated. This definition applies to individuals, partnerships, and to corporations. For purposes of this incentive, farming, ranching, other kinds of agricultural activities, and forestry use will satisfy the requirements of the statute.

Deductibility of Easement Costs

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

 

Estate Tax — Succession Planning

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

Generally the first $2,000,000 in assets (including land) that an individual gives during his or her lifetime, or holds at the time of their death, is not subject to estate tax. Married couples may pass on $4,000,000 of property tax-free to their heirs through their estate. The estate tax exclusion increases from $2,000,000 in 2008 to $3,500,000 in 2009. The federal estate tax rate levied on the amounts that exceed these exemptions is 46% in 2006 and 45% for years 2007–2009. Conservation easements reduce the fair market value of the property by restricting the amount and kind of development that may occur. This reduction in fair market value also reduces the value of the estate.

Changes In Individual Estate
And Gift Tax Exclusions

Year of Death	Estate Tax Exclusion*
2006	$2,000,000
2007	$2,000,000
2008	$2,000,000
2009	$3,500,000
*Exclusion amount is per individual

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

Let’s assume that the ranch has appreciated to a current fair market value of $8,000,000 as determined by appraisal. The owners donate a conservation easement to MLR which generally limits development of the property but enables the continuation of agriculture. A “qualified” appraiser determines the value of the conservation easement to be 40 percent of $8,000,000, or $3,200,000.

Each parent has an applicable exclusion amount of $2,000,000 for a total of $4,000,000. This allows the parents to pass on $4,000,000 of property to heirs through their estate free of tax.

Without a conservation easement in place, this would leave $4,000,000 ($8,000,000 minus $4,000,000) resulting in a $1,800,000 estate tax liability ($4,000,000 x 45%). With the conservation easement in place, the value of the ranch for estate tax purposes would be $4,800,000 ($8,000,000 minus the $3,200,000 value of the conservation easement). Utilizing Mr. and Mrs. Jones’ individual $2,000,000 estate tax exclusions, the estate taxable value of the ranch would be reduced to $800,000 ($4,800,000 minus $4,000,000) resulting in $360,000 in estate tax ($800,000 x 45%).

Additional Estate Tax Exclusion

The tax law also allows beneficiaries to exclude from the taxable estate up to 40 percent of the value of the land subject to qualifying conservation easements (this is in addition to the reduction in value as demonstrated in the example on the previous page). The exclusion is $500,000. This exclusion saves an additional $235,000 in estate taxes. Applying this provision to the Jones family example, the estate tax liability could be reduced to $135,000 ($800,000 - $500,000 = $300,000 x 45%).

Post-mortem Election

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

Estate Planning

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