Published in The Blood-Horse
Generally, the entire basis in the land affected by a conservation easement is recovered before gain is recognized upon a sale of development rights. It is possible to do a like-kind exchange in conjunction with a sale of development rights. When development rights are sold for less than the reduction in fair value resulting from restricting development on the land, a charitable income tax deduction may be available. Proper planning early in the process is essential to maximize tax benefits. For more information on PDR programs in your area, check The American Farmland Trust's Web site (www.farmlandinfo.org), The Nature Conservancy's Web site (www.nature.org), or your local land trust. There are a number of governmental and charitable programs for the purchase of development rights. In these programs, farm owners sell their development rights by placing a perpetual easement on the land restricting the rights of current and future owners to develop the land. Typically, the sale is for the difference between the fair market value of the land before and after the easement.
GENERAL TAX RULESWhen a landowner sells his development rights, he is selling an interest in land. Under general tax rules, when a taxpayer sells a part of a larger property, his basis in the entire property must be allocated between the interest sold and the interest retained. However, in the case of easements, there is substantial authority in the tax law to the effect that it is impossible to allocate basis between the development rights and the other rights retained by the landowner. In that case, tax law provides that the landowner recovers his entire basis in the land before recognizing gain on the sale. Note that when a landowner sells his development rights to only a portion of the land owned by him, only basis in the land affected by the easement may be used to offset proceeds from the sale. Also, sales of development rights typically do not reduce the value of improvements on the property. The discussion that follows assumes this more typical case. However, it is possible for an easement to reduce the value of improvements with the result that some of the proceeds from the sale will be allocated to the improvements, and the landowner will reduce basis in those improvements as well. Assume that a landowner has property purchased 10 years ago for $350,000 and used in his farming operation. At the time of purchase, $100,000 of the purchase price was allocated to land. The current appraised value of the land (not including improvements) without a restriction on development rights is $500,000. The current appraised value of the land with a restriction ondevelopment rights is $200,000. If the landowner sells his development rights in the land for $300,000, he recovers his $100,000 basis in the land and recognizes a gain of $200,000 that will be taxed at favorable capital gain rates. The landowner has not used any of his basis in the improvements to offset the proceeds from the sale of his development rights. While this increases the capital gain recognized currently, it preserves depreciable basis in the improvements to offset ordinary income in the future. What if the landowner sells his development rights worth $300,000 for $100,000? This is considered a bargain sale. If the easement preserves openspace either for the scenic enjoyment of the general public or pursuant to a federal, state, or local governmental conservation policy, and in either case yields a significant public benefit, and the organization receiving the easement is a qualified organization, then the landowner is entitled to a $200,000 charitable income tax deduction (the difference between the value of the easement and the amount received on the sale). This charitable deduction is limited to 30% of adjusted gross income and the landowner has the current year and five subsequent years to use the deduction. Note that in order to meet the "scenic enjoyment" requirement, it is not necessary for the general public to have physical access to the property--visual access is sufficient.Tax law provides in the case of a bargain sale to a charity, the taxpayer must allocate a portion of his basis in the land to the charitable contribution. Using the facts in our example above, the taxpayer would allocate $40,000 of his $100,000 basis in the land to the charitable contribution ($200,000 charitable value/$500,000 total value). He would then use the remaining $60,000 basis to offset his $100,000 proceeds from the bargain sale, resulting in a $40,000 gain taxed at capital gain rates. In this case, the taxpayer no longer has any basis in his land. However, because the value of the improvements was not decreased as a result of the easement, the landowner's basis in these improvements is undiminished. LIKE-KIND EXCHANGETax law also makes it clear that a conservation easement is an interest in real estate that is of like-kind to a fee simple interest. Thus, it is possible to do a like-kind exchange in connection with the sale of a conservation easement if all of the other requirements are met. As a result of the cost-recovery rules discussed above, a like-kind exchange of a conservation easement for other real property frequently will result in the landowner's basis in the land affected by the easement being transferred to the replacement property. If instead of taking the $300,000 proceeds from the sale of the easement, our landowner exchanged the easement for other qualifying real estate, his basis in the landsubject to the easement would be zero; his basis in the improvements on the retained property would be undiminished; and his basis in the replacement land would be the $300,000 invested less the $200,000 gain deferred, or $100,000. If the new property consists of land worth $75,000 and improvements worth $225,000, the landowner should allocate his basis between the two elements based on their relative fair market values--$25,000 to the land and $75,000 to the improvements--and begin depreciating the improvements.Additionally, a landowner may couple a bargain sale of his development rights with a like-kind exchange of the proceeds from the sale. In that circumstance, using the example above, the landowner would receive a $200,000 charitable income tax deduction; $40,000 of his basis in the land would be allocated to the charitable contribution. If he exchanged the rights to the $100,000 sale price of the easement for qualified property, his basis in the replacement property would be the $100,000 invested less the $40,000 gain deferred, or $60,000. Needless to say, there are many factors that a landowner should take into consideration when evaluating a sale of development rights, including his cash needs, his desire for additional property, his ability to absorb capital gains without current income tax due to tax losses, and his ability to use a sizable charitable income tax deduction. Early consultations with the organization accepting the easement, with tax advisers, and with a qualified appraiser will facilitate determining the best way to structure the sale and/or donation of a conservation easement.
The table above summarizes the results in each of the examples discussed. Note that the figures discuss only the income tax consequences of dispositions of development rights. There are substantial estate tax benefits to making contributions (vs. sales) of development rights as well.Continued...