When President Trump signed into law the Tax Cuts and Jobs Act in December 2017, few Americans recognized the continuation and significance of conservation easements. Yet the Internal Revenue Service claimed “most syndicated easement donation transactions are patently abusive.” As financial advisers, one of the primary tenets we are taught is to propose investments that have income and appreciation potential, with tax benefits as a secondary consideration. Conservation easements, if done correctly, may disprove this statement by offering significant tax benefits to suitable investors.

In a typical easement transaction, a taxpayer enters an agreement with a charitable organization (“land trust”) or government to permanently give up development rights to his or her property for purposes of preserving natural areas. In return, the landowner gets certain federal and state tax benefits, including a federal charitable-contribution deduction. This past December’s tax legislation changed the deduction limit from 50 percent to 60 percent of a taxpayer’s adjusted gross income, or 100 percent of adjusted gross income for farmers and ranchers.

The conservation easement’s purposes will vary depending on the character of the particular property, the goals of the land trust or government unit, and the needs of the landowner. An easement’s purposes (often called “conservation objectives”), for example, might include:

• Maintain and improve water quality
• Perpetuate and foster the growth of a healthy forest
• Maintain and improve wildlife habitat and migration corridors
• Protect scenic vistas visible from roads and other public areas
• Ensure lands are managed for sustainable agriculture and forestry

When structured properly, this may offer significant tax benefits to the investor. The IRS is more than aware of abuses that have occurred, however. In January 2017, the IRS issued Notice 2017-10, which put conservation easement partnerships and limited liability companies on its list of tax shelters if they promise investors charitable-contribution deductions equal to or exceeding two-and-a-half times the amount invested. If a taxpayer is offered a $250,000 tax deduction for a $100,000 investment in a syndicate, for example, the conservation easement underlying the investment would be a “listed transaction.” This may increase the chances for an audit, but primarily it creates more work for investors and sponsors in the extra reporting they have to do.

Investors considering this type of investment should be leery of any deduction greater than five times their original investment. In April 2017, IRS Commissioner John Koskinen testified before the Senate Finance Committee that the abuse of the tax benefits of conservation easements had reached a fever pitch, as average easement donations then syndicated were at multiples of nine to one and above. Investors putting $100,000 into the syndication would then take out a charitable contribution of $900,000 a year or two later. Given the 2018 top marginal income-tax rate of 37 percent, this could result in lowering federal taxes by 333 percent of the initial investment. And that does not include the deduction for individual state taxes.

Given the appealing nature of this investment, it’s no wonder abuses may abound. Since 2010, more than 550 programs (and more than 15,000 individuals) have taken part in these transactions, claiming aggregate charitable deductions totaling approximately $20 billion. Total deductions nationwide for conservation easements reached a high of $3.2 billion in 2014, up from $1.1 billion in 2013 and $971 million in 2012. Conservation easements, if structured and documented correctly, provide an opportunity to claim charitable tax deductions that can offset both federal and state taxes, and can be used against all types of income, not only income generated from passive activities. This provides investors, who may not be eligible to use other forms of tax credits, the opportunity to reduce their tax liability.

Nevertheless, let the buyer beware. From an investor perspective, the maximum annual penalty for failure to include required information with respect to a listed transaction is currently $100,000. This failure-to-file penalty may be imposed in addition to any other related penalties (e.g., accuracy-related penalties), as determined by the IRS. Ultimately, the IRS will focus on the economic substance of the transaction — investors must be able to prove their economic position has objectively changed as a result of the investment. With many transactions, the property is unlikely to achieve its appraised highest and best use, as the owners’ primary intent is a charitable-contribution deduction, not development. Such a transaction results in a deduction that is not matched by an equivalent economic loss or expense (e.g., debits may be greater than credits).

The computation for a charitable deduction can be as simple as it is controversial. In a typical syndication, a property may be purchased for a specified sum, and then appraised for its “highest and best use.” A vacant parcel of land may be purchased, for example, and could be considered for mining if there are other properties within the vicinity that may be used for say, limestone mining. An appraiser would then estimate the future value of the land if it were a successful mine. This value would then be deducted from the purchase price of the raw land to create the deduction. Investors would have the choice of putting a mine on the land, developing it in some other way (e.g., residential housing), or leaving it for conservation easement purposes, in which case it would never be developed. The land must be given to a charity (or government) and be designated for this use permanently.

With tax benefits as potentially appealing as previously mentioned, investors should only consider a sponsor whose due diligence process is robust. This would include:

• Engaging two property appraisals from independent, qualified appraisers to determine the fair market value of the conservation easement
• Working with industry experts, such as attorneys, appraisers, architects, zoning experts, structural engineers, brokers and property developers
• Ensuring the easement would be legally permissible, physically possible and economically viable.
• In addition, a qualified sponsor should maintain significant audit defense reserves for each offering, typically comprised of cash, an audit-defense insurance policy, and may also include the estimated values of an alternative investment and the liquidation value of the property.

Clearly, conservation easements are not for the faint of heart. But those qualified investors seeking a tax-
advantaged investment may consider this, provided adequate due diligence is done on — and provided by — a qualified sponsor.

Dana Woodbury is president and CEO of Buttonwood Investment Services, and Vince Brady is vice president of due diligence.