Last week, Representative Mike Kelly (R) of Pennsylvania and Representative Mike Thompson (D) of California introduced the Charitable Conservation Easement Program Integrity Act of 2017 as H.R. 4459. The Act is simple; comprising only two pages, it addresses a certain type of abusive conservation easement transaction that has been proliferating over the past decade: the syndicated easement.
The Act
If passed, H.R. 4459 would amend Section 170(h) of the Internal Revenue Code (which governs the federal tax deduction for conservation easements) to prohibit a charitable tax deduction to be claimed by any partner in any partnership that donates a conservation easement, where the following conditions are met:
- The partnership is not a family partnership,
- The amount of the charitable contribution claimed would exceed 2.5 times the partner’s basis (typically, the partner’s investment) in the partnership, and
- The donation has occurred within the first five years following the partner’s initial investment in the partnership.
Family partnership means a partnership where substantially all of the interests are held by related individuals, as defined “within the meaning of Internal Revenue Code Section 152(d)(2).” Section 152(d)(2) includes children, siblings, step-siblings, parents, step-parents, ancestors of parents and step-parents, nieces and nephews, aunts and uncles, siblings-in-law, parents-in-law, daughters- and sons-in-law, and members of the taxpayer’s household (but not spouses).
Syndicated Easements
You might inquire as to what evil has inspired this increasingly rare cross-aisle cooperation in the House.
The syndicated easement typically involves a promoter who assembles unrelated investors to invest in a partnership or LLC entity (treated as a partnership for tax purposes) that owns or will soon acquire an undeveloped piece of real estate. Typically, the promotional materials assure the investor that, in the event the partnership elects to convey a conservation easement, the investor will likely receive a tax deduction that greatly exceeds the amount of money required for the investment. Then, within a year or two following the investment, the entity will indeed convey a conservation easement worth many times the purchase price of the property, providing the investors with an inflated charitable tax deduction. This is called a tax shelter and is undermining the good work that is being done by legitimately conservation-oriented donors.
In a recent notice, the Land Trust Alliance, a national umbrella organization with over 1,000 member land trusts, points out that IRS data released this summer shows that short-term investors are claiming, on average, federal tax deductions valued at 900% of their original investment and that, from 2013 to 2014, the value of donated conservation easements nearly tripled – from $1.1 billion to $3.2 billion.
The Land Trust Alliance has been battling syndicated easements for some time. It issued a tax shelter advisory to its members in August 2016, which provides an overview of the red flags that indicate when a syndicated easement might be a tax shelter. The Alliance has recently encouraged its members to advocate for the passage of H.R. 4459.
The IRS also has been concerned with syndicated easements, first issuing Notice 2017-10 in December 2016 and the follow-up Notice 2017-29 on May 1, 2017. The IRS Notices provide that certain syndicated easements are listed transactions, which requires participants and advisers to self-report the potentially risky transaction to the IRS and thereby invite audit scrutiny. These IRS Notices defined the listed syndicated easement as a conservation easement that is (1) conveyed on or after January 1, 2010 (2) by a pass-through entity (3) that is organized by a promoter with promotional materials (written or oral), (4) and is comprised of unrelated investors, (5) and an investor claims a charitable deduction worth 250% or more of the investment cost. The definition is similar to the easement described in H.R. 4459.
Even with the IRS Notices classifying certain syndicated easements as listed transactions, the perception is that the shelter promotions have not decreased. The Charitable Conservation Easement Program Integrity Act of 2017 is meant to address the growing abuse of conservation easements by promoters who are “selling” tax deductions based on unrealistic, if not wholly fantastical, assumptions of value.
Potential Issues with H.R. 4459
The 250% Limit
Some proponents of conservation easements worry that the 250% litmus test on deduction value uses too broad a brush. In their view, there are conservation easements conveyed by unrelated partners that could legitimately exceed 250% of the partners’ initial investment due to a real increase in the appraised fair market value of the property, where the increase is created by completed development plans and vested entitlements. These proponents argue that the real culprit of an inflated syndicated easement value is the appraisal, which is what should be scrutinized. Despite these concerns, it appears that the IRS is unable or unwilling to scrutinize every syndicated easement’s appraisal to determine whether it is inflated and Congress is taking a different tack by focusing on unrelated partnerships and value thresholds, instead.
This makes good sense from a policy perspective. To put the numbers in perspective, let’s determine how quickly a property would need to appreciate in five years to meet the statutory disallowance of 250% of the investor’s basis. Assuming the intended easement represents 50% of the property’s value at the time of the “donative” conveyance, let’s say that the subject piece of property was acquired today for $1 million, its present fair market value. To yield a $2.5 million deduction (250% of the acquisition price), the property would have to appreciate in value to $5 million. That means that, in order to reach $5 million within the specified 5-year period, the property would have to appreciate in value by approximately 38% per year, compounded annually. Few pieces of conservation property will do that and, of course, if the partnership is anxious to conserve its newly-acquired property, the partnership need only wait for a little over five years to avoid the Act’s purview.
The Family Partnership Definition
The Act’s goal of quashing the syndication tax shelter is admirable. However, there is one glaring flaw with H.R. 4459 as drafted: its definition of family partnership.
The Act understandably contains an exception for family partnerships. This is because large family partnerships often have elderly family members who gift their interests to younger family members. The younger recipient of the gift will step into the shoes of the elderly member with regard to basis, which is often very low compared to present value – meaning that if the partnership donates a conservation easement within five years of the gift and the partnership is not shielded from H.R. 4459, the younger family member may not be able to claim a deduction for his or her share of the partnership’s charitable contribution.
While the Act should contain an exception for family partnerships, linking the definition of “family partnership” to Internal Revenue Code Section 152(d)(2) is problematic. Section 152(d)(2) does not include spouses and does not include step-aunts, step-uncles, step-nieces, step-nephews, or step-in-laws.
So, it appears that a partnership that includes spouses could lose the protection of the family partnership exception to this new rule. Partnerships that include too many step-aunts, step-uncles, step-nieces, step-nephews, or step-in-laws could fall out of the family partnership exception as well. The Act should be slightly modified to address this issue.
Time will tell whether the same promoters hone in on the family partnership as new grounds for the same tax shelter scheme. But, at least one large segment of tax shelters will be shut down by H.R. 4459 nonetheless.