Judge Joseph Goeke of the United States Tax Court has finally made it clear that the syndicated conservation easement industry is an industry based on nonsense. You can’t routinely buy property and have the fair market value of an easement on the property be a multiple of the price you just paid. That is the big takeaway from his opinion in Savanah Shoals LLC- TC Memo 2024-35. We’ll start with a little background
About Syndicated Conservation Easements
Generally you don’t get a charitable deduction for donating a “partial interest” in property. Conservation easements are an exception to that rule. You own the property. You give a restriction on the use of the property to a qualified charity typically a land trust. You get a deduction for the fair market value of the easement. Only there is not a lot of buying and sell of easements making it hard to use comparable sales of easements to determine the fair market value. So the regulations provide that you can compute the value of the easement by appraising the fair market value of the property before the easement is placed on it and subtracting the fair market value of the property as it is encumbered.
Credit for the origination of the concept of syndicating easement deduction usually goes to the Kiva Dunes decision in 2009. Kiva Dunes is a golf course on the Gulf Coast which was a convenient stopping point for migratory birds. The owners wanted to keep it going as a golf course, but the value for housing was much higher. They could not use the deduction themselves, so they brought in investors who could. IRS wanted to carve back taxpayer’s $31 million deduction to less than $10 million, but the Tax Court put it at $29 million.
In 2015 I heard from a financial planner about the idea of people acquiring property and selling it to investors who would get a conservation easement deduction. It seemed like a really stupid idea. You would have to either buy the property from people who had no idea of what it was worth or, you know, sort of fib on the valuation. As it happens when investigators for the Senate Finance Committee reported on the industry in 2020 they wrote :
“The transactions discussed in this report involve land valuations that appear so inflated above their original purchase prices that they cannot reasonably be characterized as anything other than abusive tax shelters.”
In a recent article in Tax Notes– Conservation Easements Settlement Initiatives in 2020 and 2024, Hale Sheppard, coincidentally one of the attorneys representing Savannah Shoals, laid out the industry view on the valuation problem. It is about highest and best use:
“Based on the tax regulations, case law, administrative rulings, and appraisal standards, partnerships generally argue that the value of a conservation easement should be based on the HBU of the property. They further contend that the property was not being put to its HBU when the partnership acquired it, thereby explaining the low price.”
Somehow the before value for determining a conservation easement deduction is different from the fair market value for any other purpose. There is this inherent value in the land that is not recognized by the market yet, but it is there. That’s the theory as well as I can understand it.
The Issues
As is common in these cases the IRS wanted to entirely disallow the deduction for a variety of technical flaws. These are sometimes referred to metaphorically as “foot faults”. Hale Sheppard wrote an article for Tax Notes about the phenomenon last year:
“What’s the problem with conservation easements? Well, when it comes to the IRS, the answer seems to depend on the audience. In situations in which the IRS (1) urges Congress to change legislation, (2) issues administrative guidance, (3) makes presentations at conferences, or (4) places transactions on its “Dirty Dozen” list, it normally decries “inflated appraisals.” However, when the IRS attacks easements during audits and litigation, it invariably starts with purported technical problems, relegating valuation to a secondary or tertiary argument. This disconnect has caused significant turmoil in recent years. A large number of easement cases with mining HBUs are now awaiting trial, preserving hope that the IRS and Tax Court will focus on the key issue: valuation.”
Sheppard’s hope that the Tax Court would focus on valuation was fulfilled. Sometimes you need to be careful about what you hope for.
I would really like you to dig in with me on the “foot faults”. There is a fascinating discussion over what is supposed to happen when a technical termination of a partnership creates a split year. There was a lot of drama:
“Gross Collins prepared New Shoals’s partnership taxable year return with a start date of December 28 and attempted to file it electronically. The Internal Revenue Service’s (IRS) electronic filing system rejected the return, which Ms. Salvati understood was because its start date was the same as the end date reported on Old Shoals’s return. Ms. Salvati contacted the provider of the return preparation and electronic filing software (return preparation software) that Gross Collins used, which advised her to change the start date to December 29 to allow for electronic filing. Ms Salvati changed the start date as shown on the top of page 1 of the return but did not change other parts of the return that reported that the easement donation occurred on December 28, as discussed above. New Shoals retained a copy of that draft that showed New Shoals’s taxable year as December 28 to 31.”
The easement was granted on December 28, so if the short year where the lion’s share of the deductions went to the investors did not begin until December 29, there would be no charitable deduction for them. Unfortunately you have to be a partnership tax geek to appreciate the drama of all that. There were also problems with the appraisal attachments and how Form 8283 was filled out. There is pretty lengthy discussion of these issues but the bottom line is none of them blow the deduction, so as Mr. Sheppard would hope, the focus moves to valuation.
Valuation
The partnership with the short year problem, New Shoals, was the “land partnership”. The original owner of the land had contributed the land to that partnership. The 103 acres was part of a larger tract. There were two other deals that with Savannah Shoals were to raise $2.1 million. Savannah Shoals, which had the investors, acquired 92% of the land partnership. The agreed price for the property was $515,000 which amounts to $5,000 per acre. Judge Goeke indicated that $5,000 per acre was given the “most weight” in arriving at a value of $580,000. The IRS expert put the after value at $100,000 which was more advantageous to the taxpayer than the $290,000 that the taxpayers expert arrived at, so Judge Goeke went with the $100,000 as a concession. That made for a $480,000 value for the easement. The return had claimed a $23 million deduction for the easement which is well beyond the 200% threshold for the 40% penalty.
How is it that the land a day or two after it was, in effect, purchased for half a million could be worth over twenty million? Mining. The taxpayer had experts who wrote reports and testified about putting a mining operation on the land. What were they going to mine? There was a footnote about that:
“The parties disagree over what to call the subsurface materials. Their experts also refer to the subsurface materials by different names including biotite gneiss and granitic gneiss. Notably, TEC does not use either term in its report. It uses aggregate, and we adopted its term.”
Lots and lots of aggregate is needed for road building and construction projects. The taxpayer’s experts did surveys and prepared projections showing the discounted present value of a hypothetical aggregate mine on the property. And that is how they got to over twenty million. The problem though is that potential aggregate material is very common in the area and the demand for aggregate is very sensitive to location since it is expensive to move.
The IRS valuation was based on comparable sales. The appraiser came up with a before value of $420,000. He determined that the highest and best use was low-density residential and recreational uses. He did not perform an income analysis of a quarry, because that is not how mine operators decided whether to purchase a piece of land. Aggregate is abundant and quarry owners purchase land based on access to transportation and the property’s location relative to market demand.
IRS had its appraiser go above and beyond. They had him do a valuation based on the theory that a quarry on the property was the highest and best use. He found nine sales from 2011 to 2019 and in his rebuttal report an additional 14 in an expanded time frame. On that basis he came up with a before value of $770,000.
It Is About What Somebody Will Pay For It
Judge Goeke’s analysis makes clear that there is not some sort of deductible highest and best use value that is not reflected in the current market for the land:
“Even if we were to assume that the unencumbered easement property’s highest and best use was as a quarry, the record would not support Shoals’s claimed deduction. Significantly, none of petitioner’s experts who testified at trial opined as to the fair market value of the unencumbered easement property. Rather, they determined the net present value of the subsurface aggregate and ignored the regulatory definition of fair market value. The regulations require us to determine fair market value on the basis of the price that a willing buyer and a willing seller would agree to.”
What Happens To The Investors?
I’m going to give you are idea of how this might look to an individual investor.
According to the SEC Form D Savannah Shoals Investments LLC had sold investment units of $4,254,126 when it filed with a maximum aggregate offering of $4,701,200. This suggests that the ratio between investment and the 92% of the $23 million charitable deduction was 4.5. Someone who invested $50,000 would have been allocated a $225,000 charitable deduction. Just considering federal taxes and assuming the top federal rate of 39% they would have had a tax saving of $87,750 giving them a net savings of $37,750.
It is interesting to note that only about 12% of the money raised went into land acquisition.
Under the IRS offer that Hale Sheppard outlined they would be entitled to a $50,000 deduction and subject to a 10% penalty. The tax deficiency would be $68,250. Interest through today would be roughly 35%. That makes the total tab $101,305. If they invested their $37,750 net tax savings at 18% after tax they would be roughly even. Under the decision I make the tax deficiency to be $85,535. Tacking on a 40% penalty and 35% interest makes the tab $161,661. They would have needed to make 28% after tax to match that. Of course, it is possible that they spent their net savings on lifestyle.
My information on this is anecdotal but there is some indication that a large portion of the investors in these deals are HENRYs (high earnings not rich yet). I have also heard that some of them have invested year after year with encouragement from their tax advisers. The results of all this may be devastating to professionals in Georgia where the deals were concentrated.
Other Coverage
Lew Taishoff does a great summary without even devoting an entire post to the opinion in Two Memos, Nothing New.
“Savannah Shoals, LLC, Green Creek Resources, LLC, Tax Matters Partner, T. C. Memo. 2024-35, filed 3/26/24, once again justifies Judge Holmes’ celebrated dictum in Oakbrook: “Conservation-easement cases might have been more reasonably resolved case-by-case in contests of valuation. The syndicated conservation-easement deals with wildly inflated deductions on land bought at much lower prices would seem perfectly fine fodder for feeding into a valuation grinder.” 154 T. C. 10, at p. 126.
Here, Judge Goeke boots IRS’ argy-bargy about Section 708(b) termination of partnership, timely reporting of the conservation easement, proper appraisal and appraisal summary, and in thirteen (count ’em, thirteen) pages, demolishes the Shoals’ valuation, chopping them with 40% overvaluation. T. C. Memo. 2024-35, at pp. 34-47.
If you want to see what Judge Mark V. (“Vittorio Emanuele”) Holmes was talking about, here’s Judge Goeke’s take. “New Shoals claimed a $23 million deduction. The easement had a fair market value on the donation date of $480,000.”
As to the “nothing new” in the headline, I disagree. Unless I missed something this is the first of the aggregate mining decisions. More will becoming unless there is a big rush to take the latest IRS settlement offer.
See my Conservation Easement Tax Deduction Coverage Round Up for more than a decade’s worth of the good, the bad and the ugly of the subject.
Read the full article here
