Excerpt from Exchange, The Journal of the Land Trust Alliance Vol 22 No 3 Fall 2003
“Local Land Trust Signed A Fraudulent Tax Form!”
—The Daily News, July 31, 2004
by Stephen J. Small, Esq.
Now that I have your attention… I made up this headline; it is not real—yet. But if land trusts are not careful, we might see this very headline some day soon. This article is a “heads up.”
Fortunately, almost all the conservation easement deals I’m hearing about these days are fine. The vast majority of landowners and land trusts are using good judgment in how they go about protecting important open space in their communities. Conservation easement appraisals are better than they used to be and too-aggressive appraisals for such easements are still quite uncommon.
But bad “conservation deals” are starting to happen, albeit in small numbers. And the land trust movement that historically has been good at policing itself needs to be increasingly aware of this emerging problem.
In the last issue of Exchange [see Spring 2003, available on www.LTAnet.org] , I talked about what I call “abusive” conservation easements, meaning those that allow far too much building, too many house lots or too much destruction of a property’s conservation values. “Too many houses” can be a subjective judgment, but anyone familiar with the conservation easement rules in the federal tax code must agree that for any and every piece of land there comes a point when there are too many houses on that piece of land to preserve the conservation values.
Here is the problem I wrote about in the last issue of Exchange. I am increasingly hearing about easements that don’t measure up to the spirit of the federal tax code rules because they allow too much building. Every single land trust needs to understand this problem. Every single land trust needs to know where it will draw the line on whether a conservation easement is acceptable or not. Every single land trust needs to know when to say “No.”
3 Reasons Why Land Trusts Should Be Alarmed
The emphasis in my last Exchange article was on the “conservation” side of the deal. This article looks at the “business” side of the deal. There are at least three reasons why land trusts need to understand the worst-case scenarios in the ever-expanding marketplace of conservation easement deals.
First, most of these are complex transactions driven by consultants or other professionals who sound like they know what they are talking about and may be in a position to mislead the unschooled. The vast majority of professionals should not be impugned by these few bad actors who may not know or even care if they are selling a product that has serious tax flaws. That’s where heightened vigilance on the part of land trust professionals comes in. If a few disreputable dealmakers are selling questionable packages under the heading of “land conservation” or “conservation easements,” land trusts must know when to reject them outright. This requires a full understanding of some of the tax rules, a healthy skepticism of the numbers and some basic common sense.
Second, many of the organizations formed to hold the questionable easements in these deals are outside the mainstream of the land trust movement and may lack a true conservation mission. This nuance is hardly noted by the national media, let alone the general public. But this doesn’t prevent one bad story about a misnamed “conservation” group from tainting the more than 11,000 easements held by true land conservation groups.
Third, let’s talk about the mock headline at the beginning of this article and the relevant tax form. As many readers know, when a donor claims an income tax deduction for a charitable contribution greater than $5,000, the donor must fill out a Federal Form 8283, Noncash Charitable Contributions, and attach it to the donor’s income tax return. Form 8283 identifies the asset contributed and its value, is signed by the appraiser and is signed by the organization accepting the donation. Just above the donee’s signature, the form states: “This acknowledgement does not represent agreement with the claimed fair market value.”
I have heard some well-intentioned people say that this “disclaimer” language on the form absolves the donee of any responsibility for an inflated valuation. Does it? If the deduction is clearly overstated, and is audited, and the donor gets in serious trouble with the IRS, the mock headline at the beginning of this article may become very real indeed.
What Would Your Land Trust Do?
Last year, at the Land Trust Alliance Rally in Austin, Texas, I posed this question in one of my workshops: “What would you do if you were handed a Form 8283 with a claimed valuation of a donated conservation easement when the value is clearly fraudulent? I don’t mean aggressive, or arguably too high, but clearly fraudulent. In spite of the disclaimer, do you sign it? Do you refuse to sign it? Do you sign it and attach a statement that you think the valuation is fraudulent? Are you participating in a tax fraud if you sign it?” I did not then and I do not now have an answer to this question. Yet land trusts need to start thinking about this because if it has not yet happened to your land trust, it will.
All of these issues and problems have taken on heightened visibility after the publication of a series of articles by The Washington Post raising questions about some of the deals and practices of The Nature Conservancy.
What’s Wrong with this Picture?
The following examples are based on real-life situations that have come up in my practice. The exact situations and numbers have been changed for confidentiality reasons, but are still in the same general ballpark. As you read each, ask yourself, as those children’s books used to say, “How many things can you find wrong with this picture?”
■ Example 1. My client, a major real estate developer in a southern city, held an option to buy a very large tract of land, say 3,000 acres, for $15 million. The land was located outside the immediate metropolitan area but directly in the path of development.
A “consultant” appeared, offering to “package a conservation easement deal” for a flat fee plus a kicker based on the size of the deduction. My client said, “It just sounded too good to be true…The consultant told me I could develop 75 percent of the property, put a conservation easement on the remaining 750 acres, and get a $25 million deduction for the easement.” It was too good to be true, for at least three reasons—which I hope every one of you noticed!
1. Grossly inflated value. It’s no secret that anyone can buy property in a hot market and increase its value simply by getting planning approvals and preparing it for development. But the numbers in this example pop out as grossly excessive. To get the $25 million deduction for the 25 percent left undeveloped, the consultant was essentially saying that the value of the entire property would quickly jump to more than $100 million, an astronomical leap from the current market value of $15 million. That’s a major red flag that should have been apparent.
2. Grossly inflated promises. Watch out whenever a consultant throws out such hard numbers at the outset, usually without knowing the particulars. As many readers know, the value of real estate depends on a host of variables: the approval process, relevant market for the developed product, rate of price change (if any) over the coming months, world conflict, the U.S. stock market, etc. The consultant in this example was promising a packaged deal with a pre-ordained result that obviously did not depend on the real world for its delivery—another red flag.
3. The “kicker.” Any deal with a payment tied to the size of the income tax deduction is inherently suspect. A cautious land professional would immediately recognize that the promoter’s self-interest could drive an oversized deduction, whether or not the numbers are justifiable factually, ethically and legally.
■ Example 2. Another client had been battling regulators for permits to develop a large tract of land (say, again, 3,000 acres) on the outskirts of a different southern city. The property had important environmental values, but was also ideally suited for development. Frustrated by two years of delays, my client was looking at possible “exit strategies.”
He first said he’d “sell it in a minute” if he could get $20 million for it (a fair price under the circumstances). But he also had another “great idea” for a more creative exit strategy. “I think I can put a conservation easement on the property,” he said, “eliminate the development and still be left with three or four pieces I can sell off as hunting clubs or big estates. There are buyers out there who would love to have a place like this.”
“Sounds good to me,” I said. Knowing my client was a capitalist, I asked, “Do you have any sense of what a conservation easement is worth?” “That’s the great part,” he said. “There’s this guy, a consultant, who says he knows a lot about conservation easements. He gave me the name of an appraiser he works with. The appraiser just sent me a preliminary appraisal report, and he says the easement is worth about $90 million.”
No, my friends, that is not a typo. For the purposes of this example, I actually adjusted that number down from the actual appraiser’s higher figure!
Noticed what’s wrong with this picture? You might have had a wild hunch that something is awry with the appraised value. Some people, and worse, some appraisers, don’t understand a fundamental concept: The correct “fair market value” of any piece of real estate at any point in time must take into account its true development potential. In valuing a conservation easement, some appraisers mistakenly think it is possible to go through a theoretical economic exercise that somehow ignores this rule.
Using the facts in this example, an appraiser might say, “Well, if we take that $20 million piece of property, get a 3,500-unit Planned Unit Development (‘PUD’) approved, build and sell all those units over 20 years, then the property would be worth $100 million. So if we can establish all of that through the planning process, and we give up most of those development rights with a conservation easement, the easement could be worth roughly $90 million.”
Wrong. If in fact the property is now “worth” $20 million (because that is what the client as a very savvy businessperson would sell it for), then the marketplace is clearly saying this: No one in his right mind would now pay a higher price based on the value of a 3,500-unit PUD that could conceivably be approved under local zoning but would never be built. The market simply does not exist for so many units in that particular place at that particular moment in history! In short, if the hypothetical development has no possible chance of being built, then that hypothetical development has nothing to do with the value of the property.
I have seen material from at least one “consultant,” in the business of marketing conservation easements on golf courses, who apparently relies on a similar incorrect appraisal technique to “sell” income tax deductions. “Without a conservation easement,” the promised appraisal will say, “you could bulldoze the golf course and build 2,500 condo units, so a conservation easement on a golf course generates a $15 million deduction.” Maybe such a development plan could be approved, but no developer in his or her right mind would do that because the market simply doesn’t exist for that kind of development.
■ Example 3. Here is the substance of a “proposal” I was asked to comment on. As Watergate’s Deep Throat said, “Follow the cash.”
A promoter has identified property that is currently for sale for $3 million. Working with an “expert” consultant and his recommended appraiser, the promoter claims he can get an appraised value of $12 million for a conservation easement on the property. (I’m not making this up.) Here is the deal they put together.
Promoter will purchase the property for $3 million. He will then find 10 investors and each will pay $500,000 for a 10 percent interest in a limited liability company (“LLC”). The LLC, which will have raised $5 million from the 10 investors, will buy the property from Promoter for $5 million. If the LLC donates a conservation easement before it has owned the property for a year, the deduction will be limited to cost or basis, so the LLC will hold the property for at least one year. In say 14 months the LLC will donate a conservation easement and claim a $12 million income tax deduction for the easement; the deduction flows through to the investors who each get a $1.2 million income tax deduction. (In some deals, the easement will reserve 10 house lots on the property, and at some later point the LLC will distribute one house lot to each of the 10 investors, which makes the $12 million deduction even more suspect.)
What’s wrong? Again, looking at the numbers, the property is really worth $3 million, not $5 million, and a conservation easement (which is something less than the whole of the property) is worth something less than $3 million, not $12 million. The only reason the investors are willing to pay $5 million is the expectation of a $12 million deduction. The only thing the promoter is selling is income tax benefits, and if the transaction is audited neither the IRS nor the Tax Court will allow that.
Local Land Trust Signed a Fraudulent Federal Tax Form!
Now that all of you have passed the test of recognizing what’s wrong with these three examples (please tell me you passed), let’s get back to the headline. Here are three very important things each land trust must do to avoid getting slapped with this headline:
1. Know what’s going on in the “land conservation” business and understand why some of these deals can be abusive.
2. Know when to say “No.”
3. Start thinking about what you will do if you are asked to sign a Federal Form 8283 with a claimed valuation so high that it could be abusive.
Figuring out what to do in this situation is not a simple task, so get started on this project soon. Setting a high standard for all of our practices can help us and the public identify true conservation transactions. Conversely, a single bad headline can hurt us all.
Stephen J. Small is a tax attorney at his own firm in Boston, the Law Office of Stephen J. Small, Esq., P.C., where he specializes in private land protection projects. From 1978-1982, Small was an attorney advisor in the Office of Chief Counsel, Internal Revenue Service, where he wrote the income tax regulations on conservation easement donations. He is the author of The Federal Tax Law of Conservation Easements and three Preserving Family Lands books [ordering info at www.lta.org]. He served on the LTA board from 1991-97, and is a frequent presenter at LTA Rallies. At Rally 2003 in Sacramento, California, Small will present “Preserving Family Lands: Protecting Your Land for Future Generations,” “Legal & Ethical Aspects of Managing a Nonprofit Organization,” “Preserving Family Lands-Part 1,” “Preserving Family Lands-Part 2,” and “Conservation Easements Today: The Good and the Not-So-Good.”