The federal government has long used tax incentives to further the good of the country – both economically and socially.
There are multiple examples of tax breaks and deductions designed to spur economic growth and also further social causes.
If you know anything about the tax code, it’s that it favors risk-takers and entrepreneurs over those who punch a clock – taxing income earned from wages (ordinary income) at higher rates than profits earned from business ventures and partnerships (capital gains) for the high earners. The top capital gains rate is 20% while the top tax bracket for earners is 37%. The difference is significant.
Not only is the entrepreneur’s income taxed at lower rates, but the amount of income that is taxable is also often lower.
Ignoring any other deductions, for the very top earners, what would you guess is the amount of taxable income between a single entrepreneur/passive investor and a single doctor both earning $500,000?
IS THIS YOUR GUESS?
Tax = $500,000 x .20 = $100,000
Tax = $500,000 x .35 = $175,000
$175,000 – $100,000 = $75,000
If you guessed the difference in taxes paid between the passive investor and the doctor was $75,000, you would be wrong!
That’s because the Tax Reform of 2017 sweetened the pot even further for passive investors by allowing them to deduct up to 20% of their business income from a partnership.
In the scenario above, that would mean the passive investor would only pay tax on $400,000 of income instead of $500,000. That would mean a tax of only $80,000 instead of $100,000.
With the 20% business income deduction, the passive investor is now $95,000 better off in the second scenario as opposed to $75,000 better off in the first scenario compared to the doctor.
You can see why private equity and hedge fund investors were over the moon when the Tax Cuts and Jobs Act (the Tax Reform) passed in 2017.
The bias towards entrepreneurs doesn’t stop there.
The tax code also incentivizes taxpayers to contribute to social causes. One of the major components of the 2017 Tax Reform was the implementation of the Opportunity Zone program that offers investors substantial tax incentives including significant capital gains deferrals for investing in distressed neighborhoods through private funds.
The social component encouraged business and real estate development in overlooked communities in addition to spurring job growth.
Like Opportunity Zones, another tax program with a social component designed to incentivize entrepreneurs is related to conservation easements.
Under a conservation easement, a property’s owner gives up the right to make certain changes to that property, to preserve it for future generations. It’s a conservation initiative designed to protect the land from development for the benefit of wildlife in addition to future generations.
When a conservation easement meets certain criteria spelled out by the IRS, the owner may qualify for significant charitable deductions based on the property’s reduction in value.
Here’s a summary of the major tax benefits:
- Basic Deduction. Donations of qualified conservation easements can be claimed as an itemized deduction of up to 50% of the donor’s adjusted gross income (AGI).
- Farmers. Individuals who were able to qualify as a farmer or rancher and make a donation of a qualified conservation easement are allowed a deduction up to 100% of AGI.
- Carryover. Conservation easement donors are allowed a tax deduction for the current year, as well as a 15-year carryover of unused conservation contributions, for a total of 16 years to utilize the deduction.
As with most charitable donations, the conservation easement deduction can also be used to reduce state tax liability.
Here’s a simple example of how a deduction from a Conservation Easement works:
Your Aunt Marge owns a dairy farm just outside town that she and your Uncle Joe paid $300,000 in 1971. The farm is now worth $5 million. Aunt Marge decides to donate to the local land trust a conservation easement encompassing the farm that lowers the value of the farmland to $1.5 million.
Aunt Marge now has a $3.5 million federal income tax deduction for the donation of the conservation easement that she can use to reduce 100% of her AGI for the current year and up to 15 years thereafter.
Qualified Conservation Purposes
Four types of conservation purposes could qualify for the deduction:
- Protect open space or critical habitat on your land– whether it’s a family farm or ranch, wetland, pasture, or forest—from encroaching development.
- Preserve the agricultural value and traditional uses of your land by allowing for continued farming, ranching, and timber harvesting.
- Safeguard a historically or culturally important structure or area on your property.
- Conserve land that has a significant scenic, biodiversity, or other value for the outdoor recreation or education of the public.
For a valid deduction, the property rights must be donated for conservation purposes to a “qualified conservation organization,” which can include:
- Governmental Units.
- Certain Other Tax-Exempt Groups.
The appraisal is where some donors run into trouble with the IRS. The donor wants the maximum deduction without running afoul of the IRS and this will require a fair appraisal of the donated easement.
In our example, the fair market value of the farmland was $5 million, and the value of the land after the donation once the productive use ceased was $1.5 million.
You can imagine how this deduction can be abused. What if Aunt Marge inflated the value of the land by double and underestimated its value after the donation to $1 million? She’d be claiming $9 million in deductions as opposed to $3.5 million.
That’s a big red flag for the IRS and will surely trigger an audit.
The IRS has established guidelines for the appraisal process. An appraisal has to consider the value of the property at its highest and best use. General appraisal guidelines define the highest and best use as:
The reasonably probable and legal use of vacant land or an improved property, which is physically possible, appropriately supported, financially feasible, and that results in the highest value.
- Permissible Use. What uses are permitted by zoning and other legal restrictions?
- Possible Use. To what use is the site physically adaptable?
- Feasible Use. Which possible and permissible use will produce any net return to the owner of the site?
- Maximally Productive. Among the feasible uses which use will produce the highest net return, (i.e., the highest present worth)?
Highest and Best Use should not be confused with current use. The highest and best use of a property may be a commercial development instead of a farm. When appraising the value of a conservation easement, just remember that pigs get fat and hogs get slaughtered.
The Syndication Opportunity
Syndications are a popular vehicle for investors to pool their resources to take advantage of conservation easements by acquiring undervalued land and donating that land for a qualified conservation purpose to take advantage of the available deductions.
Because of abuse by many syndications in overvaluing land and undervaluing its reduced value post-easement, many syndications have triggered audits and the ire of the IRS.
The threat of audit shouldn’t deter potential investors from pooling their resources to take advantage of the tax benefits from donating conservation easements.
Vetting the Sponsor
The sponsor is central to the success of a conservation easement syndication. When vetting a sponsor, first start with their TRACK RECORD. TRACK RECORD. TRACK RECORD.
Has the sponsor ever operated a conservation easement syndication before? If so, have they ever been audited?
Do they incorporate the following best practices?
- Do they properly vet qualified appraisers? Who are their appraisers?
- Do they hire a second, separate, and independent qualified appraiser to review and confirm the first qualified appraisal’s findings?
- Do they acquire a written and independently verified opinion from a qualified real estate attorney confirming the feasibility of the Highest and Best Use (HBU) identified in the qualified appraisal?
- Do they examine the title of the property subject to the proposed conservation easement meticulously back at least 50 years?
- Do commission a current survey that identifies the property subject to the conservation easement?
- Do they hire a third-party attorney, with no prior exposure to the particular conservation easement to complete a thorough, independent legal compliance review?
Conservation easements are another opportunity for entrepreneurs and passive investors to take advantage of a tax incentive designed to further a social cause. The deductions can be substantial when done right.
If you’re considering syndication to take advantage of the deductions, be sure to vet the sponsor to make sure they’re doing things by the book to avoid IRS scrutiny and in the worst case, loss of the deduction.
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