Under the Internal Revenue Code, to be deductible, a conservation easement must be made exclusively for conservation purposes, which requires that the conservation purpose of the easement must be protected in perpetuity. This means that restrictions on the use of the property will run with the land, in theory, forever. The legislative intent behind the perpetuity requirement was to provide for a legally enforceable restriction on the property owner’s use, and any subsequent property owners’ use, of the property that would be inconsistent with the articulated conservation purposes that the easement is protecting.
The Treasury Regulations provide a number of rules related to the perpetuity requirement, which pertain to mortgage subordination, extinguishment, remote future events, and surface mining. It is key to understand these rules, because failure to satisfy the perpetuity requirement could cause the IRS to determine that the easement is not a qualified conservation contribution for which taxpayers may claim a charitable deduction. Let’s review these regulations that deal with perpetuity.
How to manage mortgages
According to Section 1.170(A)-14(g)(2) of the Treasury Regulations, a conservation easement deduction will not be permitted if the property is subject to a mortgage, unless the mortgagee subordinates its rights in the property to the rights of the qualified organization to enforce the conservation purposes contained in the easement deed in perpetuity. Because of this requirement, it is important to review title work to determine whether the property is subject to any mortgages. Oftentimes, investment programs will require that the property seller satisfy all outstanding mortgages before the investment program closes on the acquisition of the property, which would satisfy the perpetuity requirement.
But what about instances where mortgages remain on the property?
In that case, it is necessary to review the easement deed and any subordination agreements to confirm that the mortgage holder is actually subordinating all of its rights in the property to the qualified organization’s rights. This is key because the Tax Court has previously disallowed charitable contribution deductions for failing to meet the perpetuity requirement when mortgages were not fully subordinated. For example, in Palmolive Building Investors v. Commissioner, a taxpayer donated a conservation easement on a property that was subject to two mortgages. Prior to granting the easement, the taxpayer obtained agreements from the lenders to subordinate their rights to the rights of the qualified organization to enforce the purpose of the conservation easement. However, the easement deed stated that the mortgagees would have priority in claims to insurance proceeds on the property. The Tax Court found that subordination of a mortgage must include subordination as to insurance proceeds in the event the property was destroyed and determined that the taxpayer was not entitled to a charitable contribution deduction because the taxpayer failed to meet the perpetuity requirement.
Can conservation purpose be extinguished?
The IRS has recognized that although conservation easement restrictions are perpetual, in some instances subsequent changes in the conditions surrounding the property may make it impossible or impractical to continue to enforce the land use restrictions. However, according to Section 1.170A-14(g) of the Treasury Regulations, an easement can still be treated as being protected in perpetuity if a judicial proceeding extinguishes the restrictions (e.g., through eminent domain) and the qualified organization uses any proceeds from a subsequent sale, exchange, or involuntary conversion of the property in a manner that is consistent with the conservation purpose in the original easement deed.
Additionally, the Treasury Regulations state that at the time of the donation, the property owner must agree that the easement gives the qualified organization a property interest that is equal to the proportionate value of the conservation easement at the time of the donation in relation to the value of the property as a whole at the time of the donation. The qualified organization will retain this property right in perpetuity. Essentially, this means the qualified organization would be entitled to the substantial majority of the proceeds if a court extinguished the easement restrictions and the property owner subsequently sold the property. For example, if at the time of the donation, the highest and best use value of the unencumbered property is $50 million, and the value of the easement is $45 million, the qualified organization would be entitled to 90% of the proceeds from a sale following extinguishment of the easement at any point in the future.
The Treasury Regulations are unconditional on this requirement—if the qualified organization is not entitled to a proportionate share of the proceeds, the conservation purpose of the contribution is not protected in perpetuity. When reviewing a conservation easement deed, it’s important to confirm that the qualified organization is provided this property right, because on numerous occasions the Tax Court has disallowed deductions because conservation easement deeds did not provide this right.
Consider, for example, instances where mortgage holders had a preference future proceeds from insurance or condemnation (i.e. eminent domain). In August 2018, in PBBM-Rose Hill v. Commissioner the 5th Circuit Court of Appeals confirmed the Tax Court’s decision to disallow a deduction because a conservation easement failed to comply with the extinguishment regulation. We’ll be covering the details of this ruling in a future blog post.
Anticipating future events
What about future events that may frustrate the conservation purpose? Helpfully, the IRS will not disallow a deduction merely because the restrictions held by the qualified organization may be defeated by the occurrence of future events, which at the time of the contribution, are so remote as to be negligible.
In some instances, the Tax Court has found that a conservation easement was not perpetual because events that would extinguish a conservation easement were not only not so remote as to be negligible, but were actually inevitable. In Wachter v. Commissioner, a taxpayer granted a conservation easement on a property located in the state of North Dakota. However, North Dakota state law limited the duration of an easement to not more than 99 years. Because the qualified organization would be divested of its rights to enforce the easement in 99 years, by operation of law, the Tax Court found the easement failed to meet the perpetuity requirement that would allow for a charitable deduction.
Ensure mineral rights don’t defeat perpetuity
Generally, if surface mining is permitted on the property, the perpetuity requirement will not be satisfied and no deduction will be permitted. Because of this requirement, it is important to review title work to determine if third parties own any mineral rights associated with the property that could defeat conservation purpose. Additionally, it is imperative to confirm that the conservation easement deed expressly prohibits surface mining. If the investment program owns the surface mining rights associated with the property and the conservation easement deed prohibits surface mining that would appear to meet the requirement that surface mining be prohibited.
However, what about the instances when the investment program does not possess the surface mining rights in the property? The Internal Revenue Code and Treasury Regulations state that a qualified conservation contribution will not be disqualified because surface mining is permitted if the probability of mineral extraction is so remote as to be negligible.
Whether the probability of extraction is so remote as to be negligible is a question of fact, considering the following factors:
- Geological, geophysical, or economic data showing the absence of mineral reserves on the property
- Lack of commercial feasibility of surface mining the mineral interest.
When encountering an investment program where surface mining rights are not owned by the investment program, it is key to review documentation from a third party, for example a consulting geologist, which opines that the chances of mineral removal at the property requiring surface mining is so remote as to be negligible. But again, this is a question of fact, and the IRS could take a view different from the geologist. if the IRS were to determine that surface mining was not so remote as to be negligible, it could deny the deduction for failing to meet the perpetuity requirement.
Due diligence questions you must ask
I want to leave you with five key due diligence questions arising from this discussion that you should be asking when determining whether the conservation purpose in the easement will be protected in perpetuity:
- Are there any mortgages against the property?
- If any mortgages will survive the closing, has the lender subordinated all of its rights to the qualified organization’s rights to enforce the conservation purposes in perpetuity?
- Does the easement deed give the qualified organization a property interest equal to the proportionate value of the conservation easement at the time of the donation?
- Are there any inevitable events that would prevent the qualified organization form protecting the conservation purpose in perpetuity?
- Is surface mining permitted on the property, and if so, is the probability of extraction so remote as to be negligible?
Look for further coverage of conservation easement-related due diligence considerations on this blog.