Conservation Easements Creating Complicated Tax Issues for Investors
Conservation Easements have been a regular piece of brokerage firms’ arsenals, part of the package of heavy weaponry they deploy to their “high net worth” clientele. Packaged as Regulation D private placements, brokerage firms have sold Conservation Easements to clients based on the potential windfall they represent to an investor’s tax bill. Here is how they were supposed to work. Generally speaking, a “conservation easement” is an agreement restricting the use of land to protect its conservation values. It is a high-minded concept intended to preserve specific tracts of land for future generations and protect them from development or exploitation. This easement deprives the property owner of something of value – the right to develop the property – which lowers the usefulness and as such the value of the property. The Property Owner then has the right to claim a deduction on the value of the property.
These conversation easements get a little tricky when they are sold as part investment, part tax shelter. Traditionally, the investments have been structured through some form of syndication. These structures are highly complicated and can involve several permutations, but generally follow a similar structure:
- A Sponsor creates a “conservation easement syndicate”, almost always as an LLC. It has to be taxed as a partnership for the tax strategy to work. If the LLC does not already own the property to be converted to a conservation easement, it is contributed by the owners in exchange for the LLC interests in a transaction that is considered a “non-recognition” transaction for federal income tax purposes. What this means is the parties to the transaction do not have to recognize the gain or loss on the transaction for federal tax purposes.
- The LLC acts through a manager, sponsor, employee, agent or subsidiary of the “Sponsor”. The LLC engages the services of a conservation manager who assists in planning, organization, and executing the conservation easement. The Manager contacts a land trust and works in conjunction with the land trust to draft the deed of the conservation easement and the baseline documentation, which in turn describes the property at the time of the donation, as required. The Manager will also hire an appraiser and assist in determining the highest and best use of the property for appraisal purposes.
- This “Appraiser” prepares an “initial valuation” of the proposed conservation easement. In creating this initial valuation, the appraiser uses unrealistic assumptions, violates standards governing appraisal practice and prepares valuations that grossly overvalue the conservation easement. This initial, bloated valuation is what is used to market and sell the LLC interests to investors. The appraisers know their valuations will be used for precisely this purpose.
- The LLC or Manager then engages a law firm to provide a tax opinion letter, and private placement memorandum to be distributed to prospective investors. These same absurd valuations of the conservation easement are used throughout the “legal” materials.
- The LLC interests are marketed and sold as securities that are exempt from registration under Regulation D of the Securities Act. Many of these investments are sold by and through registered broker/dealers. Those in the highest income tax bracket are targeted for these investments, because they stand to gain the most from the alleged tax saving pass through.
- Prospective investors are given offering packages with marketing materials, transactional documents, private placement memorandum, tax opinions, operating, and subscription agreements. This package includes the anticipated value of the conservation easement, the anticipated value of the tax deduction, and confirmation that a draft deed of conservation easement has been approved by a land trust.
- Each investor who wants to purchase LLC interests fills out forms and checks boxes that they are “accredited investors”.
- After all of the offering is fully subscribed , the closing transaction is executed. Investor money flows into the LLC and is first used to pay fees and expenses related to the offering, redeem the membership interests of the original LLC members, and to set up an operating account and an audit reserve fund.
- Shortly after the offering is funded, the Manager makes a recommendation to the members regarding the use of the property – to place a conservation easement over the property.
- An appraiser, usually the same one who provided the initial ridiculous valuation, finalizes the value of the conservation easement by preparing a “final appraisal” that purports to be a “qualified appraisal” per 26 U.S.C § 170. The appraiser uses the same flawed methodology used in the initial valuation to arise at essentially the same grossly overstated value. Sometimes a second appraiser will be hired who surprisingly comes to the same ridiculous valuation conclusions.
- The LLC tax return is then prepared. As part of this process, each investor receives a K-1 on which the investor’s share of the deduction is reported.
- Investors then file their personal tax returns reporting the overvalued charitable contribution deductions arising from the conservation easements. The overstated deductions reduce the investor’s reported tax liability.
These conservation easement structures are extremely complicated and potentially violate Internal Revenue Code regulations and tax laws. One such “conservation easement syndication” has drawn the ire of the United States Department of Justice. See United States v. EcoVest Capital Inc., et al. 18-cv-05774 (N.D. Ga. 2018). The IRS just announced in November 2019 that it intends to step-up enforcement and scrutiny of syndicated conservation easements. Should the IRS determine a particular conservation easement violates the tax code, as usual, investors will be left holding the bag and will be required to pay those tax savings back, plus interest and penalties in all likelihood. Brokerage firms nationwide have sold hundreds of millions of dollars in conservation easement syndications, most using highly questionable structures. The higher the promised tax deduction, the less likely the structure is legitimate. Some that the IRS have specifically targeted involved transactions where the promised deduction was worth 2.5 times the investment. So, if the investor invested $100,000, he would receive a tax deduction of $250,000. As the adage goes, when something looks too good to be true, it probably is.
The brokerage firms that sold these conservation easements must perform adequate due diligence on these tax shelters, including obtaining an independent appraisal of the easement to determine its legitimacy. Any tax deduction scheme that offer investors a multiple of their investment in the form of a tax deduction should catch the eye of any competent compliance or due diligence officer. Of course, since these entities are structured as Regulation D private placements, the brokers and their firms receive massive commissions for selling these investments and as such, due to this direct conflict of interest, look the other way when red flags pop-up.
If you invested in a conservation easement that has been ruled to violate tax laws, or that you are concerned may result in an adverse tax ruling, please call Stoltmann Law Offices, P.C. at 312-332-4200 for a no-obligation free consultation. We are a contingency fee firm which means we do not get paid until you do.