Judge David Gustafson injected a good dose of common sense into the ongoing struggle between the IRS and the syndicators of conservation easements. His opinion in Mill Road 36 Henry LLC lays bare the nonsense that has created the syndicated conservation easement industry.
The story starts with undeveloped suburban land acquired by real estate professionals for $10,700 per acre in December 2014. In September 2016 an investment fund acquired a 97% interest at $25,800 per acre. In December 2016 the investment fund donated an easement on the property and claimed a charitable contributions of $270,800 per acre. That deduction represents a tax subsidy of over $100,000 per acre. It doesn’t make sense. It doesn’t even make good nonsense. And Judge Gustafson makes that clear.
This is a really long piece. If you want the executive summary, Richard Rubin masterfully provides it in this tweet sequence.
The Transaction
Mill Road 36(MR36) is a Georgia LLC formed on December 10, 2015. It’s sole asset was a 40 acre tract (Mill Road Tract) in Henry County GA. The tract was carved out of a larger purchase. I’ll spare you the details on that. The business plan was to hold the tract for sale to a developer. There were various studies done with a view towards development for single family, multi-family or assisted-living units. On July 8, 2016 MR36 filed an application to develop an assisted living facility. It received conditional zoning approval. It withdrew the application after receiving the conditional approval. It could have paid $300 to have the application tabled, which would have let it pick up from that point if it decided to go through with development.
Jeff Grant, one of the MR36 owners had a similar application done for ten other entities. From this Judge Gustafson concludes that the Mill Road Tract was plainly not a unique parcel. A buyer actually interested in building an assisted living facility would have plenty of choices of suitable tracts within the neighborhood selling for less than $11,000 per acre. Judge Gustafson’s opinion provides the details in an appendix which I have reproduced, with some notes here.
In June 2016 Daniel Carbonara, who had been working with Grant since 2014, entered the picture. He formed a Delaware LLC called MR36 Investments (MRI). MRI would purchase up to a 97.99% interest in MR36. It would raise money by issuing up to 410 units at $5,000 each. The investment options for MRI would be to sit on the property for capital appreciation, pull the trigger on the development plan or donate a conservation easement. A majority vote of the partners would determine the choice. On September 20, 2016 MRI bought a 97% interest in MR36 for $1,000,000 (about $25,800 per acre). The exiting partners had roughly doubled their money.
On December 28, 2018 MR36 conveyed a conservation easement deed on 33 of the acres in the tract to Southern Conservation Trust Inc.(SCT). MR36 claimed a charitable deduction of $8,935.000 for the easement donated to SCT. On Form 8283 where the deduction is reported, they noted that the basis in the property was $416,563. That number represents what the original partners paid for the property.
What They Got Right
The IRS has taken to “throwing the book” at syndicated easement deals so there were a number of things that Judge Gustafson ruled the promoters had done right. The IRS argued that MR36 lacked donative intent and was purely motivated by tax avoidance. MRI had promised the investors a tax benefit ratio of 4.25. There was noting charitable going on. Judge Gustafson did not buy that argument. There was a real easement donated and Congress long ago decided to incentivize conservation easements.
“It would be perverse indeed to deny a deduction to a donor simply because he had responded to the incentive. The Government may not take away with the executive hand what it gives with the legislative”
The transfer of the tract to MR36 actually occurred a bit before the filing of MR36 articles of organization. IRS argued that this demonstrated “a lack of attention to detail and no intent to form a true partnership”. Reilly’s Fourth Law of Tax Planning – Execution isn’t everything but it’s a lot. Judge Gustafson was satisfied that the entity met the standard of being considered a valid partnership under Georgia law and for federal income tax purposes prior to the filing.
Then there was the question of whether there was enough of a conservation purpose going on. The IRS was pushing for a very high standard of a very wild area where rare endangered species are present. Judge Gustafson ruled that the tract met the standard of a “relatively natural habitat of fish, wildlife, or plants, or similar ecosystem” and that was good enough. There was also the scenic view that the tract provides. Judge Gustafson was dismissive of IRS concerns that at 33 acres the tract was too small and that reserved rights to do forestry or agriculture destroyed the conservation value.
There were also some compliance issues raised by IRS. The first was that the appraiser was not qualified because of things that the principals were aware of. That objection went nowhere. The second was that people other than the primary appraiser who worked on the appraisal should also have signed the appraisal. That is the sort of thing you will see referred to as a foot fault. The people were employees and the signature by the appraiser who was taking responsibility for their work making their signatures unnecessary.
The IRS had also gone after fraud penalties, which would have been really disastrous. There is a pretty complicated discussion about that but most notable was the judge’s observation that everything they did had been properly disclosed.
Valuation
It has been more than three years since the Senate Finance Committee issued its bipartisan report on syndicated conservation-easement transactions. My key takeaway from the report was that the “engine of every syndicated conservation-easement transaction” is an inflated appraisal. This was not true of the early transactions like Kiva Dunes, where people who had a deduction they could not use from property they had held for some time effectively sold their deduction. There were just not enough of those sort of deals to create an industry. The only way that you can buy land and within a short period have a deduction that is a multiple of what you paid is by fibbing on the valuation.
Judge Gustafson was extremely skeptical about the practicality of the taxpayer’s appraisal that was based on a 677-unit assisted living facility. The withdrawn preliminary zoning approval a was thin reed to lean on given the subsequent applications for other properties. Even allowing the 677 unit facility as the highest and best use, though, the value arrived at by the taxpayer’s appraiser would still only be a fraction of what was claimed.
Both the original valuation of $8,935,000 and the $6,935,000 presented at trial were based on completed facilities in other counties. Judge Gustafson puts himself in the shoes of a developer of an assisted living facility and looks at the available places in Harlan County where such a facility could be built and finds many that had been granted conditional approval. He did not have to look far. There are ten examples. They all have docketed Tax Court cases. One has three cases, which I think is because of a procedural issue which I have not sorted out. Those three are being heard by Judge Goeke. The rest are with Judge Gustafson.
Judge Gustafson nicely sums up the logic in accepting the IRS valuation that is just over 10% of the claimed contribution.
“A developer intending to build a facility would never have contemplated buying the Mill Road Tract for $6.7 million but would instead have bought one of the many other tracts available at much lower prices. As a prospective developer would do, we view the price of a comparable undeveloped lot in Henry County as the proper “substitute” by which to value to the Mill Road Tract. Mr. Kinney’s valuation of $900,000 was based on such comparables, and we adopt his valuation.”
In this decision I see the first clear contradiction of the position expressed by Robert Ramsay of Partnership For Conservation in Tax Notes that the value of a conservation easement can be greater than the value of the land.
Salt In The Wound
As the industry gets sharper about compliance and some of the IRS theories are defeated in court, IRS keeps coming up with new gimmicks to blow up the transactions independent of the valuation issue. They had one in this case. Sometimes when you donate property, you are limited to your cost basis as a deduction rather than the fair market value. And that taint can be transmitted when property is contributed to a partnership. In this case it was a matter of the land being inventory in the hands of the original owners who transferred the property to the partnership. That cut the contribution deduction from the $900,000 valuation conceded by the IRS to $416,563.
Ironically Tax Notes recently published a article about how wrong the IRS is for taking this position – Taking Inventory of the IRS’s Latest Attack on Qualified Conservation Easements. The lead author was Vivian Hoard who represented the taxpayers in the Champions Retreat case, which I covered here. Champions Retreat was a Kiva Dunes sort of case.
The authors note the huge backlog of Tax Court conservation cases estimated at 750 putting the blame on the IRS. Judge Gustafson may be offering some hope of sweeping through as we shall see.
Financial Engineering
The inspiration for the syndicated conservation easement industry came from a 2009 Tax Court decision – Kiva Dunes. Kiva Dunes is a golf course, whose continuation as a golf course, rather than conversion to housing, was helpful to migratory birds. The owners wanted to continue it as a golf course, but could not use the conservation easement charitable deduction. So they, in effect, sold the deduction by creating a special class of partnership unit that allowed the loss to be allocated to investors. The IRS ended up just fighting about valuation and the taxpayer prevailed.
Aerial panorama Kiva Dunes Public Golf Course Gulf Shores Alabama
The Kiva Dunes fact pattern is not something that you can build an industry around. The 2009 decision on a case docketed in 2006 was about a 2002 transaction concerning property acquired in 1992. MR36 is a 2023 decision of a case docketed in 2020 about a 2016 transaction concerning property acquired in 2014. It is indicative of the financial engineering that became the hallmark of the SCE industry. There are plans to build eleven assisted living facilities in relatively close proximity to one another. Each one supports a conservation easement deduction based on the end value of the built facility.
The deals are so similar that Judge Gustafson has consolidated the case management. He has also ordered that there be a status report before the end of the month of November on the other twelve cases in the light of the MR36 decision. The taxpayers are looking to kick the cans down the road on all the other cases in the event that MR36 appeals to the Eleventh Circuit, but in his most recent order, yesterday, Judge Gustafson is still holding their feet to the fire.
This decision may be a turning point. We shall see.
Other Coverage
I was surprised that Lew Taishoff did not cover this decision. After my inquiry he did give it some acknowledgement which I found touching.
“My colleague Peter Reilly, CPA, striving to get down to the end of the North American mainland on Thanksgiving Day to see his alma mater (and that of Judge Albert G (“Scholar Al”) Lauber, and my nephew Jim) play the 100th in a historic series, asked me to deputize (alas, I cannot). In addition, he asked me to comment upon Mill Road 36 Henry, LLC, MR36 Manager, LLC, Tax Matters Partner, T. C. Memo. 2023-129, filed 10/26/23. That same day the Kraske opinion came down, which I thought much more worthy of comment than another Dixieland Boondockery overvaluation case, even one where land bought at $28K per acre suddenly was worth $280K per acre when syndicated.”
The event I was hoping he could cover is the 100th instance of the longest running high school football rivalry in the history of New York City, Xavier v Fordham Prep. Xavier High School students back in the day were all part of not only a student body but also a regiment and we all showed up for the game in uniform.