The Tax Treatment Of Conservation Easements: A Traditionalist’s View

In the second part of a two-episode series, Tax Notes legal reporter Kristen Parillo interviews Steve Small, one of the authors of the federal income tax regulations on conservation easements who is now in private practice, about the controversy surrounding the tax treatment of conservation easements.

This post has been edited for clarity.

Kristen Parillo: Welcome to the podcast, Steve. Thanks for joining us.

Steve Small: Happy to be here, Kristen. Thank you for having me.

Kristen Parillo: As you know, the tax treatment of conservation easements has been getting a lot of attention in the last few years. Let me start by asking if you agree that there should be tax incentives for donating a conservation easement?

Steve Small: Absolutely. This provision deduction for conservation easement was first added to the tax code in 1976. It was modified and extended in 1980. The idea was very simple then and it’s the same idea now. If someone has land that has an important conservation value, they might be tempted to sell out for development and just consider that payment. There should be a federal tax incentive for people who want to protect that land instead of develop it. That’s really what a conservation easement is.

One of the things I found that’s very unusual about this particular field is that it cuts across social, economic, geographic, and even political lines. I remember having dinner more than 20 years ago in southern Arizona with a rancher who thought that Barry Goldwater was a communist. But by God, he didn’t want any condominium or real estate development in his valley.

This is a provision that really can work for anyone who has land they love.

Kristen Parillo: The IRS and Congress have been focusing specifically on syndicated easements. You wrote an article for Tax Notes back in 2004, where you said you were seeing syndicated deals involving golf course easements. Can you walk us through how the syndicated partnerships became so pervasive in the conservation easement area?

Steve Small: I started to notice transactions in 2004. Leaving golf course easements aside for a moment, the thing that really concerned me was inflated appraisals. This is where an appraiser would say about a piece of rural land, “This could be zoned for a 3,500-unit planned unit development (PUD) commercial golf course hotel and it’s worth $40 million.” Instead of doing that, they would put a conservation easement on it and take a $39 million deduction.

It may well have been that the land could have been zoned for a PUD, but no one would have built it because the market simply did not exist. The value for IRS purposes and for deduction purposes was grossly inflated. 

At the end of a long Tax Notes article I had published in 2004, I asked these key questions: Has the taxpayer owned the property for less than 24 months? If the answer to question number one is yes, then is the claim deduction greater than two and one half times the cost basis? I thought that was a pretty good filter for realistic or unrealistic appraisals.

I think that this was not a busy time for syndications and most of these were not true syndications in the sense we see today. But the IRS wasn’t paying much attention to this field.

As a colleague of mine once said years ago, “If there’s a provision in the tax code long enough, people will find a way to abuse it.” That’s what subsequently happened. People said, “My goodness, this is an easy way to make money because nobody’s paying attention.”

Kristen Parillo: Those who support these syndicated deals argue that the IRS is unfairly targeting partnerships. They say that syndication is a good thing because it lets people who may not be able to buy land on their own, to invest in a partnership, and still participate in conservation efforts. Why do you disagree with that view?

Steve Small: First of all, that’s all a red herring. To put it another way, it’s all smoke and mirrors. There’s really nothing wrong with a syndicated transaction. It happens all the time in the commercial world.

The issue here isn’t whether it’s syndicated. The issue isn’t in whether there’s offering material or whether the conservation easement really accomplishes some conservation purpose. The sole issue here is that these deals rely on grossly inflated appraisals to come up with a grossly inflated income tax deduction.

I know that there was an article by Robert Ramsay in Tax Notes stuff last month. One of the things he said, one of his myths as he put it about conservation easements was, “Sponsors of conservation easement transactions should be fearful of the IRS.”

I look at that and I say, “Sponsors of conservation easement transactions? Sponsors of charitable contribution transactions?” To me, that’s a giveaway right there. In a true charitable contribution, one gives away value. It’s philanthropy. There’s a tax incentive that provides a benefit and encourages people who want to do that sort of thing. Whether it’s writing a check to your alma mater, or donating a painting to a museum, or donating a conservation easement.

Once again, the people who are fighting the attempts to clamp down on these abusive transactions throw smoke out there. This has nothing to do with land conservation.

A colleague said to me, “You know, you could clarify this for a lot of people and instead of saying syndicated conservation easements, you said ‘abusive syndicated conservation easement tax shelter transactions.'”

That’s all we’re talking about. We’re not talking about partnerships, limited liability companies, or even conservation. We’re talking about inflated appraisals.

Kristen Parillo: How can the IRS curb this valuation abuse? Do you think their stepped-up enforcement efforts in the last six months can get at the root of the problem?

Steve Small: I’ve been concerned about these transactions for years. I know the Land Trust Alliance, which is the umbrella organization for the land conservation groups around the country, has also been very concerned. I know they’ve made attempts and I’ve made attempts over the years to convince the IRS, “Listen, we know you have to audit transactions. OK? Nobody ever says, ‘Oh good. Come audit me.’ People complain about that, but there are some really bad transactions out there that you need to start auditing.”

I know for a fact that the IRS was provided names of appraisers, promoters, syndicators, and so forth. Apparently, nothing happened. Whether that was a lack of sufficient personnel or a lack of willpower isn’t really the issue. The IRS simply wasn’t paying attention. I don’t mean that as a critical observation.

The tax code is massive and there are only so many things the IRS can pay attention to. But there’s a part two to that also, and that is enforcement.

Let’s say the IRS really stepped up enforcement and oversight of syndicated conservation easement tax deduction tax shelters. There was a case that interestingly enough just came down yesterday: Brannen Sand & Gravel. It’s not a conservation easement case, but I’ll get to my point.

The partnership return Tax Court opinion notes the partnership return was filed on September 19, 2011, for U.S. return of partnership income for 2010. That was a 2010 transaction that was at some point subsequent to that audited. A Tax Court decision finally closed this case and rendered a verdict against the taxpayer on June 4, 2020. That’s not including appeals.

Even in an enforcement case, even when the IRS is paying attention and wins, it takes so long for justice to be done. IRS enforcement efforts alone simply aren’t going to do it.

One of the things that we’ve noticed with significant interest in these syndicated abusive conservation easement tax shelter transactions is that so many of them today also have in the offering materials a request for funds to set up a legal defense fund. It can be $200,000 or $300,000. I think I’ve seen one for $750,000. What that means to me is that if one of these transactions gets audited, it may not be resolved for a decade. There are hundreds and hundreds of these transactions going on right now.

That tells me that enforcement, even the best possible enforcement, isn’t going to stop it. It’s a situation where I think we need a change in the law to stop it.

What I’ve said for a long time is if the IRS went after eight to 10 of the appraisers who are the key participants in many of these transactions, they would really shut down a lot of these abusive transactions.

Someone said to me a year ago, “No, that’s not true. There’s so much money to be made here that if the IRS shuts down eight to 10 people, there are at least 25 people in line right behind them ready to step up and do the work and get paid for it.”

Again, enforcement it just not the way to stop this, and I say that intending no disrespect or criticism of the IRS.

Kristen Parillo: Now there’s legislation pending in the House and Senate that would cap the size of the deduction that can be claimed by these syndicated transactions. Groups like the Partnership for Conservation don’t like this bill. They say it would hinder conservation and retroactively increase taxes on taxpayers since the effective date is tied to December 2016, when the IRS issued the notice flagging these deals as a listed transaction.

Do you think limiting the size of the deductions that can be claimed in these syndicated deals is fair?

Steve Small: Years ago, a fellow from the IRS said to me about the related matter, “You know, we don’t need any new rules. We need people to follow the existing rules.”

The fact of the matter is the regulations already limit the size of the income tax deductions for any charitable contribution. They limit it to the fair market value of the asset that’s being contributed to charity. The whole key here with the syndicated transactions is appraisers either don’t understand that that’s the rule, or they think there’s a different way to deal with it.

Let me just give you one example. I’m changing a couple of the details, but this is all available in the public records, so I’m not giving away any secrets. Promoters purchased 3,500 acres of relatively rural land for $13.5 million. That works out to about $4,000 an acre.

The IRS rules state that you get a charitable deduction for the fair market value of the asset that you contribute to charity. Fair market value is defined as the price at which the property would change hands between a willing buyer and a willing seller. There’s more to it than that. But what that means is fair market value is what you would get if you put the property on the market and sold it.

In this case, promoters bought 3,500 acres for $13.5 million at roughly $4,000 an acre. The promoters then sliced and diced that 3,500 acres into a number of smaller parcels, syndicated it out in a more than a dozen separate LLCs, and more than a dozen separate deals.

In the end, the total deductions generated for the investors who bought into these abusive tax shelter transactions was $1.4 billion. That means that an appraiser, or more than one appraiser, said, “This property may have changed hands for $13.5 million, but it’s really worth $1.4 billion.”

I say to clients a lot that people love their land and often tend to think it’s worth more than it really is worth. I’ll say, “Tell me, if you didn’t own this piece of property, what would you pay for it? If it was on the open market?” That’s really the issue here.

There is no way that these appraisals that come up with these numbers resemble what a willing buyer would pay a willing seller. Nobody in any of these transactions would pay $400,000 an acre for land that would reasonably change hands for $4,000 an acre.

If people followed the rules and paid attention to the definition of fair market value, we wouldn’t need any new rules. But those rules have been abused, so I think people aren’t going to stop voluntarily. I think we need legislation to fix it.

The Land Trust Alliance, with a number of sponsors on Capitol Hill, has introduced the Conservation Easement Program Integrity Act, to limit to the size of the deduction that can be taken in certain of these abusive transactions. This legislation is not designed to shut down conservation or landowners aggravated. It’s designed to stop these abusive syndicated transactions. 

Kristen Parillo: Where do we go from here?

Steve Small: Well, I think it has become, unfortunately, a legislative issue. Intending no offense to this session of Congress or any other, the chances of getting legislation passed are always slim.

I think there’s a flip side to that. I wrote an article on syndicated transactions that was published in Tax Notes in 2016. In that article, I suggested legislation that would limit the deduction, if the claimed deduction was greater than 250 percent of the investment. 

Two of my colleagues in Washington, who know their way around the Hill, said, “You know, you have to watch out. Whenever you introduce legislation, that’s not a secret anymore. It’s not in your pocket anymore. The interest groups will form that want to oppose it, and they’ll be out there spending money opposing it. You could introduce legislation, but there’s never a guarantee that it will become law.”

They were absolutely right. This legislation has been introduced to curb abuse. It’s costing taxpayers hundreds of millions of dollars a year. It’s making people rich. There are a lot of lobbyists out there saying, “Oh no. This is going to shut down a land conservation.” Well, in fact, if this isn’t shut down, land conservation may be threatened.

I hope that common sense prevails, and that we can get a legislative solution to this problem. I’m sorry that we need one, but that’s where I come out.

Kristen Parillo: Thanks so much for talking with us, Steve. I’m sure this is not the last word on this issue.

Steve Small: Thank you for having me. Again, I appreciate your interest in this subject, because I think it’s a very narrow niche as far as the tax code is concerned, but it’s causing a lot of problems. If these problems can be stopped and we can return to whatever normal is, then would be a good time.