Like Kind Exchanges of Conservation Easements

          A conservation easement is a restriction placed on a piece of property to protect the resources (natural or man-made) associated with the parcel. The easement is either voluntarily sold or donated by the landowner, and constitutes a legally binding agreement that prohibits certain types of development (residential or commercial) from taking place on the land.

            Ownership of a piece of property may best be described as a "bundle of rights." These rights include the right to occupy, use, lease, sell, and develop the land. An easement involves the exchange of one or more of these rights from the landowner to someone who does not own the land. Easements have been used for years to provide governments, utilities, and extractive industries with certain property rights. An easement permits the holder certain rights regarding the land for specified purposes while the ownership of the land remains with the private property owner.

            The easement is a legally binding covenant that is publicly recorded and runs with the property deed for a specified time or in perpetuity. It gives the holder the responsibility to monitor and enforce the property restrictions imposed by the easement for as long as it is designed to run. An easement does not grant ownership nor does it absolve the property owner from traditional owner responsibilities, i.e. property tax, upkeep, maintenance, or improvements.

What are the Tax Implications of Conservation Easements?

            Landowners can contribute conservation easements to charitable organizations or they can sell them. Landowners who make qualifying contributions of a conservation easement may be entitled to a charitable income tax deduction for the value of the contributed easement and may qualify for special estate tax benefits. Landowners who sell their development rights receive proceeds from the sale. In either event, landowners "cash out" of their land to a limited degree while retaining ownership and other substantial use rights in the land. The cash infusion can permit landowners to diversify into other holdings, reduce debt on the land, or expand or modernize operations.  

            The taxation of a sale of a conservation easement is tricky since there is no reasonable method to apportion basis to the easement. Accordingly, such sales use the   cost recovery method where it is impossible or impractical to allocate basis to the easement itself. In most cases, proceeds from the sale of the development right will be allocated to the land itself, not to land improvements. As a result, none of the proceeds will be taxed as depreciation recapture and the landowner will preserve depreciable basis in the improvements to offset future income at ordinary rates. Basis in the land affected by the easement (typically the entire parcel) is wholly consumed before gain, taxed at favorable capital gains rates, is recognized. If the gain is substantial, and the landowner desires to purchase another property, a 1031 exchange will allow the landowner to defer taxes on the gain.

1031 Exchanges

            Under Section 1031, if property held for productive use in a trade or business or for investment is exchanged by a taxpayer for other property that is similarly held for use in a trade or business or for investment, the result is that no gain or loss is recognized. The Section 1031 Regulations provide that in order for properties to be considered of a like-kind they must be of the same nature or character, but not necessarily of the same quality or grade. Property of one class may not be exchanged for property of a different class on a tax-free basis under Section 1031.

            In considering whether two properties qualify as like-kind under Section 1031, taxpayers need to consider all of the relevant characteristics and features of the property to be exchanged, including the property's treatment under the civil laws of the taxpayer's state, to ensure that the properties are of the same class and nature. If a conservation easement constitutes an interest in real property under state law, then, based on various IRS guidance, it will be deemed property of a like-kind with a fee simple interest in real estate for purposes of Section 1031. Thus, where both the property that will be subject to the easement and the replacement property will be held for either investment or productive use in a trade or business, it is possible to defer recognition of gain on the sale of a conservation easement by using a like-kind exchange. This treatment was confirmed by the IRS in PLR 200203042

            What is the tax result obtained in a like-kind exchange of a conservation easement? The sales proceeds should first fully reduce the basis in the land comprising the relinquished property (down to zero), with any excess resulting in taxable gain. To fully defer gain, the value of the replacement property should equal or exceed the value of the easement. The landowner's basis in the replacement property would be equal to the purchase price of the same, reduced by the gain deferred.

            For example, landowner owns a tract of land purchased for $100,000 with a current fair market value of $600,000. The landowner decides to sell a conservation easement to a land trust to protect against future development of the land. The easement was sold for $350,000. Applying the cost recovery method, the landowner's basis in the land would be reduced to zero, and the landowner would realize a $250,000 gain. If the landowner used all of the proceeds to acquire replacement property in a qualified like-kind exchange, the landowner would purchase replacement property for $350,000, and landowner's basis in the replacement property would be $100,000 ($350,000 cost less $250,000 gain deferred).

Conclusion

            Sales of conservation easements can permit landowners to diversify into other holdings, reduce debt on the land, or expand or modernize operations. Gain from the sales can be deferred if the sale is structured as a like-kind exchange. Structuring exchanges of conservation easements can be challenging, however, and a landowner considering an exchange of a conservation easement should consult with its tax advisor.