A Syndicated Conservation Easement Deal With Substance

Judge Robert Goeke of the United States Tax Court approved a $17.5 million 2012 charitable deduction disallowance in the case of Glade Creek Limited Partnership. He went a little easier on the penalties than the IRS had proposed. Rather than a 40% penalty on the deficiency attributable to the whole $17.5 million disallowance, there will be a 20% penalty on roughly half. He also allowed a $35,077 cash contribution to Atlantic Coast Conservancy.

The Usual Suspects

Glade Creek was a syndicated conservation easement deal. The land is in Bledsoe County Tennessee, but the brain power behind the tax deduction was in Rome Georgia, which along with Atlanta is the intellectual center of the industry. If you have been following the scandal surrounding the syndications you will recognize Atlantic Coast Conservancy, Timothy Pollock and Morris, Manning & Martin from class action litigation. Matthew Campbell and Claud Clark III show up in the Senate Finance Committee investigation. Claud Clark III also appears in the DOJ complaint filed in December 2018.

Glade Creek is a bit different from other syndications in that it involved a development with quite a bit of substance, rather than something purely hypothetical. That accounts for the break on penalties that Judge Goeke allowed.

The Original Deal

The story begins in 2006 when International Land Co purchased nearly 2,000 acres in Bledsoe County with $9 million in seller financing. There was a three-phase development contemplated that would have created over 800 lots. The development required significant infrastructure improvements – roads, water, electricity. A small group of out-of-state developers owned ILC. Local businessman James Vincent pitched in to help them with permits and the like. Vincent became more involved as time went on investing his own funds in the infrastructure and guaranteeing ILC bank loans.

Lots in the first phase were ready in 2007. They sold 75 lots in 2007, 46 in 2008 and only 9 in 2009 as they stopped marketing because they ran out of money. The name of the development was Hawk’s Bluff.  Another Hawks Bluff that Mr. Vincent had promoted in nearby Van Buren County had sold out before the recession. The marketing must have been quite expensive. It involved advertising in Florida offering expense-paid trips (including airfare) to visit the property.

There is something ironic about advertising in Florida to sell lots elsewhere, if you know anything about the history of real estate promotion.

The Workout

In April 2010 Mr. Vincent and two of the ILC owners formed Hawks Bluff Investment Group, Inc., an S corporation. HBIG purchased the unsold land from ILC in exchange for assuming the liabilities. The owners needed to fund the company to the tune of $33,000 per month to cover debt service. One of them dropped out leaving James Vincent and James Tague as equal owners. It was a struggle. With no marketing they only sold two lots in 2010 and 2011.

They worked something out with the seller to get the debt down to a total of $5.1 million. Mr. Vincent was concerned that Tague might drop out and he did not think he could carry the property on his own for very long. He considered logging. He did not want to sell to a developer who would use it for a “mobile home community, recreational vehicle park, or other environmentally insensitive development”. As a dedicated RVer, I find that comment hurtful, but that is neither here nor there.

Then the president of the bank suggested that Mr. Vincent talk to Matthew Campbell about donating a conservation easement to raise money to pay off the debt. The easement would be on the second two phases and unlike other solutions would not have a negative affect on the remaining lots in the first phase.

Two New Entities

Mr. Campbell now had the reins. Glade Creek LP would hold the the property and Sequatchie Holdings LLC would raise money from investors. Sesquatchie would use the investor money to purchase a majority ownership interest in Glade Creek. Mr. Campbell set the price in order to raise enough money to pay off some of the debt on the property. Evergreen Capital Administration LLC, founded by Mr. Campbell, was Sesquatchie’s managing member and its tax matters partner. Tim Pollock of Morris, Manning & Martin LLP provided the tax advice on the easement deduction. Mr. Campbell engaged Claud Clark III and James Clower to appraise the properties.

According to the decision, Mr. Vincent believed the the land was worth more than the amount being raised. Of course, in order for the deal to work, that has to be at least arguably true, since the investors are expecting a deduction that is a multiple of their investment. According to the decision, Mr. Vincent was proud of the easement, but did not understand the specifics. HBIG continued to own the first phase. They sold 24 lots in 2015.

Based on the Clark appraisal of $17.7 million Sequatchie raised $3,224,400. $1,776,000 went to pay down Hawks Bluff debt, $504,954 went to redeem members interests, $300,000 went to Evrgreen’s management fees, $77,400 for legal and escrow fees, $290,196 to the brokers, $24,750 in miscellaneous expenses and $251,000 in capital reserves. I know you are probably trying to figure out what happened to the remaining hundred bucks, but I don’t know.

The Escrow

The IRS disallowed $35,077 paid to Atlantic Conservancy because it did not get to them until January 2013. The taxpayer argued for the deduction in 2012 because it went into escrow with the easement transfer closing on December 29, 2012. Judge Groeke found for the taxpayer on that point:

The chance that the settlement agent would not pay the escrowed funds to the Conservancy was so remote as to be negligible. Once the funds were deposited into escrow, they were not under Glade Creek’s control. Glade Creek had directed their payment to the Conservancy and could no longer use or redirect the funds. We find that Glade Creek is entitled to deduct the $35,077 donation for 2012.

Perpetuity

A key requirement of 170(h) is that the easement be perpetual, but the regulations note that things might change and an easement might be judicially extinguished. In that event the agreement should be that proceeds from the sale of the property should be allocated between the fee owner and the easement owner in proportion to the values established at the time of the donation.

The Hawks Bluff easement provided that any post easement improvements should be reimbursed off the top before the split. The deed read:

[T]his Easement shall have at the time of Extinguishment a fair market value determined by multiplying the then fair market value of the Easement Area unencumbered by the Easement (minus any increase in value after the date of this grant attributable to improvements) by the ratio of the value of the Easement at the time of this grant to the value of the Easement Area, without deduction for the value of the Easement, at the time of this grant. The Conservation Values at the time of this grant shall be those Conservation Values used to calculate the deduction for federal income tax purposes allowable by reason of this grant, * * * [and] the ratio * * * shall remain constant. (Emphasis added)

That “minus any increase in value” was fatal to the deduction.

The deed improperly subtracts any value attributable to posteasement improvements from the extinguishment proceeds before determining the Conservancy’s share. It does not properly allocate extinguishment proceeds to the Conservancy in accordance with the proceeds regulation. The proceeds regulation is not satisfied, and the easement’s conservation purposes are not protected in perpetuity. Glade Creek is not entitled to the easement deduction

This sort of attack on conservation easements is not that unusual. When it works it is a lot easier for the IRS than attacking them on valuation abuse. Valuation is something IRS has trouble with as we will see.

Valuation For Penalties

The ruling disallows the deduction based on easement language, making valuation irrelevant for purposes of the deduction. But not for penalties.

A taxpayer makes a gross valuation misstatement when it claims a value for the donated property that is 200% or more of the correct amount. Sec. 6662(h). On its 2012 return Glade Creek claimed an easement deduction of $17,504,000. If we find that the easement’s fair market value is $8,752,000 or less, there is a gross valuation misstatement as the claimed deduction is more than 200% of the correct amount. Reasonable cause is not available as a defense to the gross valuation misstatement penalty for the deduction of donated property but is a defense to the alternative penalties respondent asserts.

Judge Goeke shredded the IRS appraisal which held residential development was totally infeasible, making the easement essentially worthless. There was a real project there and many lots were sold. The recession and turmoil among the owners caused it to stall. Judge Goeke did not think that the IRS appraiser had done his homework.

Mr. Broome did not speak to anyone involved in the ILC project. He did not know that ILC had stopped marketing the tract I lots by 2010 and was unaware of the factors that contributed to the decline in sales of tract I lots that were unrelated to the land’s development potential.

Mr. Broome’s before value, $1.5 million, severely undervalues the easement property when compared to the $9 million ILC paid for all three tracts in 2006.

Judge Goeke showed a little more respect for Mr. Clark’s appraisal.

We are presented with limited options to determine the before value as there are no comparable sales of the easement property and the sales identified were not close to the easement date. Respondent did not present any evidence of the easement property’s value to a developer but raises valid concerns with Mr. Clark’s assumptions.

There were some serious problems with Clark’s appraisal. There was ” a degree of uncertainty and risk to a hypothetical development that Mr. Clark did not properly account for in his discounted cash flow analysis” and Judge Goeke thought his projected sales prices were too high. Judge Goeke found Clark’s discount rate of 11.25% too low. He used 26.25% which applied to lower revenue arrived at a before value of $9.3 million. This is supported by the original purchase price for all three phases in 2006 of $9 million along with $6 million in infrastructure.

That value put the overstatment in “substantial” but not “gross” territory. That means a penalty of 20% and also the possilbility of arguning that they had been acting in good faith. All they got from that was the lower penalty.

“Petitioner argues that Mr. Campbell relied on the advice of two appraisers, Mr. Clark and Mr. Clover, to value the easement. We find that the appraisers determined the before value to achieve the tax savings goals of the easement transaction and did not attempt to accurately ascertain the easement’s fair market value Glade Creek did not make a good faith investigation of the easement’s fair market value and the reasonable cause defense is not available.“

The 20% penalty was not assessed on the portion of the deduction that was denied solely from the defective language.

A Little Different

This case is a little different from the run of the mill syndicated conservation easement. It is somewhat reminiscent of Kiva Dunes, the Claud Clark appraised property that gave the impetus for the industry. 

James Vincent and his partners had acquired, held and improved the property. There likely was development potential, although there is debate about that from one of my sources. Everything else being equal, if the raise had been in the two million dollar range rather than three million dollars plus, the deal might have worked absent the technical flaw in the easement language.

A critical component was the presumption of a conservation purpose on the part of James Vincent. That allowed Judge Groeke to not use the $3.2 million raised as being indicative of the value. Absent that there is no way for a conservation easement syndication to work.

Comments 

Nancy McLaughlin, a law professor at the University of Utah, wrote me:

 I think this nicely captures the abusive nature of syndicated transactions.

The opinion explains that the taxpayer, looking for a financing solution for a failed real estate development transaction, hired a Mr. Campbell to structure a conservation easement transaction to raise sufficient funds to pay the outstanding debt. The opinion further provides:

“Mr. Campbell’s tax scheme primarily relies on the overvaluation of the easement, and he knew the easement was overvalued…..In fact, overvaluing the easement was part of the easement transaction he devised. Neither Mr. Campbell nor the appraisers he selected actually sought to determine the easement’s fair market value. Rather, Mr. Campbell wanted an appraisal that accomplished his tax objectives for the easement transaction. The appraised value was determined on the basis of the need to attract investors by providing a sufficient tax benefit to raise enough money to repay the…debt and to pay the fees of the professionals involved. It was not a good faith valuation of the easement property.”

“Factual Freddie”, one of my anonymous sources had more for me than I can easily share. I found one of his observations particularly apt.

I have no clue about what the IRS process is with their different legal teams nor their understanding of who a competent expert is. And it’s really simple. It’s the value between a willing BUYER and seller plus the HBU must be more than hypothetical to accomplish by an objective assessment including nearness in time.  

Many IRS lawyers have no practical business view or experience. There have not focused an experienced team for a proper court presentation on a single DCF valuation.Frediie tells me that new abusive deals are still being done, despite the IRS crackdown, but that they tend to be one-offs rather than things put together by major players.

Other Sources

Jeffrey Leon has something behind the Bloomberg Tax paywall.

Lew Taishoff has So It’s Not Perpetual. Mr. Taishoff sums up the appraisal situation masterfully with his usual literary panache.

IRS nixes the whole, but the IRS appraiser gets shredded on the stand.

His appraisal “was nothin’ much before, an’ rather less than ’arf o’ that be’ind,” as a much finer writer than I put it. IRS’ appraiser’s “after” value uses a 10-yr old CA article. His “before” used a couple logging sites (hi, Judge Holmes), not homes, such as the predecessors to the Glade Creek crew were building before The Black ’08.

The Glade Creek crew had two (count ’em, two) appraisers, who both did a much better job, but still came in north of $16 million. Judge Goeke decides that residential development is the highest and best use. So he does a cost-benefit analysis that shows if he retires from Tax Court, he has a great future as cost estimator for a national homebuilder. He does an analysis of builder’s profit margin worth reading, 2020 T. C. Memo. 148, at pp. 49-52.

You and I both know the reference is to Gunga Din by Rudyard Kipling, but you have to consider the other readers.