The Eleventh Circuit has dealt a blow to the beleaguered syndicated conservation easement (SCE) industry in its decision upholding the Tax Court in TOT Property Holdings LLC v IRS. As I have noted elsewhere SCE is an industry based on nonsense. Investors buy into a partnership that has recently acquired a property. They then vote to donate an easement on the property to a land trust. The declared value of the easement is a multiple of the price paid for the entire property.
The Engine Of Syndicated Conservation Easement Transactions
On December 9, 2013 TOT owned 652 acres that its original partners had acquired for $486,000 (an allocable portion of a larger transaction) in 2005. It also had $100 in cash. PES Fund VI, LLC, which consisted of investors, purchased 98.99% of TOT for $1,039.200. On December 27, 2013, TOT donated a conservation easement on 637 of the 652 acres to Foothills Land Conservancy. When TOT filed its 2013 partnership tax return (Form 1065) it claimed a $6.9 million deduction for the value of the easement.
When I asked one of the smartest real estate guys I know what it really means to own land, he told me that it is a “bundle of rights”. Using round numbers TOT bought a “bundle of rights” for a million dollars. Eighteen days later it took some of those rights out of the bundle and gave them to a land trust. It claimed for purpose of a charitable deduction that that part of the bundle was worth seven times what it had paid for the whole bundle.
What makes the decision in this case of particular interest is that this appears to be the first time in cases of this sort that the judges paid particular attention to that anomaly. When the senate finance committee investigated syndicated easements in 2020 a key finding was that an inflated appraisal was the “engine of every syndicated conservation-easement transaction”. The market for undeveloped land is imperfect but it is not populated with a plentitude of stupid people. Although it is conceivable that you might sometimes buy a property for a fraction of its value, you can’t build a business model around doing that routinely.
Oddly enough, the seven fold miracle was only mentioned in passing in the valuation discussion. And the only reason that there was a valuation discussion was to determine whether the 40% gross valuation penalty applied. During the oral arguments at 10:33 one of the judges pointed it out to TOT’s attorney, Barbara Smith, and her response was that valuation is more of an art than a science so it is a matter of judgement whether a transaction a couple of weeks before the donation is relevant. There was noticeable silence after that.
The Primary Legal Issue
The IRS actually conceded that the easement was worth something. Nonetheless, they denied the deduction entirely because the easement deed had a provision about how proceeds might be allocated in the event of a sale after a judicial extinguishment of the easement. In order to meet the perpetuity requirement of a qualified conservation contribution, the regulations require that in the event of a sale after a court ordered extinguishment the proceeds need to be split between the donor and the land trust based on proportions determined at the time of the gift.
The language in the easement deed included a provision that the value of subsequent improvements would be taken off the top. The ruling indicates that caused it to flunk on perpetuity. There was additional language in the deed that indicated the regulation might override, but that was viewed as ‘conditional subsequent saving clause’.
This was the blockbuster legal issue, since the IRS has been using these sort of arguments against SCE. The problem with this approach is that it could call into question many existing legitimate easement deductions. There really should be bulletproof language available and the improvement issue is a valid concern when you consider farmers who have given up the right to develop but keep on farming.
Valuation
TOT did not attempt to defend the original valuation of $6.9 million. Their new appraiser came up with a before easement valuation of $3.9 million and an after easement value of $1.2 million making for a $2.7 million value of the easement. The IRS appraiser came up with a before value of $1,128,000. He did that without knowing about the arms length transfer which was at a remarkably similar value. The argument ends up being about “highest and best use”, The IRS appraiser argued it was recreation and timber whereas TOT was arguing for residential development.
And there is discussion of the recent transfer:
Unlike Mr. Barber, Mr. Wingard had been aware of this arm’s-length transaction when he valued the property but did not take it into account for his valuation. He reasoned that he did not consider owning a partial interest in an entity that owns property the same as owning the property itself. We reject Mr. Wingard’s reason; it makes no common sense. When the partial interest is a 99% ownership interest and complete control, as here, and when the property is the only asset of the entity (besides $100 cash), it is clear that the parties considered the price paid to be the fair market value of the property.
This sort of fact pattern is present in most if not all SCE deals. That it is now considered worthy of judicial notice may be the industry’s death knell.
There was also discussion about whether the IRS had properly followed supervisory approval process on the penalty. That issue also went for the IRS.
Other Coverage
Jeffrey Leon has Land Deal Deed Sinks $7 Million Tax Break, Appeals Court Says on Bloomberg Tax.
Dylan Moroses has 11th Circ. OKs Nix Of $7M Conservation Easement Deduction on Law360.
To check out over a decade of coverage of conservation and façade easement deduction check out my Conservation Easement Tax Deduction Coverage Round Up on Your Tax Matters Partner.