Author(s): James R. Walker
Published: 10/01/2008
A range war is raging in Colorado and is drawing in high-profile real estate professionals from across the state. With a critical role in real estate transactions, many Colorado brokers are now deeply involved.
Unlike our historic disputes over grazing rights and fencing, today’s range war is a battle over tax deductions earned from "conservation easements." Unfortunately, it appears that Colorado’s conservation easement battles are far from over.
In 2006, the Internal Revenue Service (IRS) opened an extensive audit program challenging income tax deductions earned from granting conservation easements. Although the program’s scope has not been formally disclosed, the IRS is challenging at least 300 Colorado conservation easements.
Two years after this program began, the resolution of this struggle is not in sight. Although Colorado passed new legislation, many audits involving pre-2008 easements are still unresolved.
What is a conservation easement?
A conservation easement is a restriction recorded on property by a deed or other instrument that limits the use of the property to certain purposes. The conservation easement is conveyed by the landowner to a charitable organization exempt under the Internal Revenue Code or to a governmental entity. An agricultural conservation easement would typically limit the property to farming and ranching uses, limit construction of buildings on the property except those used for agricultural purposes or homes for the rancher and his family and employees, and prohibit removal of minerals and other natural resources in a manner that adversely affects the land. The rancher reserves to himself, his heirs, and assigns the right to own, operate, and manage the agricultural property consistent with sound management practices.
A conservation easement that qualifies under Colorado and federal law will result in an immediate federal and state income tax charitable deduction for the value of the development rights given away by the easement. The property will be appraised without the restrictions of the conservation easement and with the value restricted to agricultural and ranching uses. The difference between the two valuations is the value of the development right given away; the result is the charitable contribution by the landowner.
What is the IRS asserting?
The IRS challenge is twofold. First, the IRS attempts to deny or disallow entirely the federal income tax deduction. Second, and alternatively, the IRS claims that deduction amounts were far too large and the amount deducted was "overvalued."
This last challenge—the valuation challenge—is complex. As long ago as 1984, the Internal Revenue Service started asserting that many conservation easements do not decrease the value of the landowners property. Without a decrease in value, the IRS will deny any tax deduction. Today in federal court, the IRS and its experts continue to use this "zero value" theory, even though no court has accepted it.
Landowners and the IRS are looking to real estate appraisers to support a proper easement value. But even the federal government acknowledges that the value of a conservation easement is "highly speculative." Adding further difficulty is the debate among real estate appraisers regarding proper appraisal methodology.
As these cases unfold, two particular valuation approaches are drawing the most fire: the "subdivision method" and the "sand and gravel valuation method."
The "subdivision method" arrives at a value by aggregating the prices of all the lots from which undeveloped property could be subdivided. While Colorado law does not allow this approach for condemnation valuation, the U.S. Tax Court accepts it in conservation easement valuations. Notwithstanding its acceptance, the approach remains controversial.
The second valuation issue involves acceptance of "sand and gravel use" as the "highest and best" value for agricultural property. Here too, the U.S. Tax Court accepted this valuation approach for agricultural land. In a 2007 case, the U.S. Tax Court recognized a very large donation value based upon sand and gravel methodology, even though this value was far in excess of the landowner’s purchase price.
Why target Colorado?
The IRS focus on Colorado is not an accident. It stems from Colorado’s tax credit program since Colorado is one of only two states that offer transferable state tax credits. In other words, a Colorado landowner granting a conservation easement secures both a federal income tax deduction (in the form of a charitable contribution deduction) and a state income tax credit that can be sold for cash.
With these dual tax benefits, Colorado landowners have special financial incentives for granting qualifying conservation easements. Both the federal and state treasuries subsidize Colorado’s conservation protection efforts.
What should Colorado landowners do?
When faced with a showdown with the IRS, Colorado land trusts and landowners are fighting back. Landowners should not be shy about asserting their rights and standing up for their tax deductions. In these battles, both sides will search for the best possible valuation expert to support their position.
At this juncture, the outcome of the IRS audits in Colorado is unknown. Rothgerber Johnson & Lyons LLP is well experienced in handling IRS tax audits and defending conservation easement transactions.
Jim Walker is RJ&L’s senior tax partner and a Fellow of the American College of Tax Counsel. He regularly represents taxpayers before federal and state administrative agencies, including the IRS, the Justice Department, and the Colorado Department of Revenue. He can be reached at 303-628-9510 or by e-mail at jwalker@rothgerber.com.