Second Circuit Limits Abuse of Conservation Easements

Conservation easements provide an attractive mechanism for preserving open spaces and historic buildings. Although some landowners undoubtedly create conservation easements out of pure altruism, tax advantages play a significant role in the creation of most conservation easements. In Scheidelman v. Commissioner, NYLJ 6/23/14, the Second Circuit made it clear that taxpayers who create conservation easements are entitled to a deduction only if the transfer reduces the value of their remaining property.

Mechanics of the Conservation Easement

In New York, section 49-0305 of the Environmental Conservation Law authorizes creation of conservation easements, and exempts them from common law rules that might otherwise apply to creation of an easement. For instance, a conservation easement may be enforced even if it is not appurtenant to any land, and even if it does not touch or concern real property. The statute provides that only “a public body or not-for-profit conservation organization” may hold a conservation easement, and that the easement shall be “of perpetual duration unless otherwise provided” in the instrument that creates the easement.

Section 49-0303 defines conservation easements to include those that restrict development or use of real property “for the purpose of maintaining the scenic, open, historic, archaeological, architectural, or natural condition” of the property. Section 49-0307 limits the power to modify a conservation easement. Unless the easement itself provides for modification or termination, RPAPL section 1951 provides the only mechanism for modifying or terminating the easement: a judicial determination that the easement is “of no actual and substantial benefit to the persons seeking its enforcement.”

Tax Benefits

A landowner who transfers a conservation easement to a public body of a conservation organization stands to obtain two different tax benefits. First, the transfer may lower the landowner's real property taxes to the extent the transfer reduces the value of landowner's land. Gibson v. Gleason, 20 A.D.3d 623 is illustrative. Landowner's parcel, which had been used for farming, was $820,000 because of its potential for residential subdivision. Landowner transferred a conservation easement, relinquishing the right to develop the property, and obtained a reduction in property tax assessment to $384,000.

Second, a landowner who transfers a conservation easement to a qualified organization is entitled to a federal income tax deduction for the value of the easement. Section 170(h) of the Internal Revenue Code details the requirements for taking the deduction. Among them is a requirement that the easement be “in perpetuity” (section 170(h)(5)(A)). Special requirements apply when landowner claims a deduction for a conservation easement in a historic district: The easement must protect the exterior of the entire building (section 170(h)(4)(B)(i)(I)) and the landowner must provide an appraisal and photographs of the building with the tax return (section 170(h)(4)(B)(iii)).

The appraisal requirement mitigates one of the potential abuses of conservation easements: an aggressive landowners who would claim a large deduction in the hope that the IRS would not devote resources to valuing the easement.

The Scheidelman Case

In 1997, Huda Scheidelman bought a townhouse in Brooklyn's Fort Greene Historic District. Six years later, she transferred a fa'ade conservation easement to the National Architectural Trust, a 501(c)(3) organization. A qualified real estate appraiser hired by Scheidelman valued the easement at $115,000, and Scheidelman claimed an income tax deduction for that amount on her tax return. When the IRS challenged the deduction, the Tax Court held that Scheidelman was ineligible because the appraisal was not a “qualified appraisal within the meaning of the Treasury Regulations.

The Second Circuit reversed, holding that the appraisal provided sufficient information to permit the IRS to evaluate Scheidelman's deduction. The court remanded to the Tax Court to evaluate Scheidelman's claim on the merits, and the Tax Court concluded that the fa'ade conservation easement did not diminish the fair market value of Scheidelman's property. As a result, the court denied the deduction. Scheidelman appealed.

In reversing, the Second Circuit started by noting that the Tax Court has the primary function of finding facts in a tax dispute, and that the court would overturn the Tax Court's decision only if that decision was not supported by substantial evidence. Turning to the merits, the court started by conceding that ordinarily, any encumbrance on real property would tend to have a negative effect on fair market value, but then held that the grant of a conservation easement effects no per se reduction in fair market value. In this case, the court concluded that there was substantial support in the record for the Tax Court's conclusion that the supposedly expert testimony offered by Scheidelman was entitled to no weight.

The court noted that one of Scheidelman's experts had testified based on the range of deductions the IRS had allowed in other cases, without focusing at all on the easement's effect on the fair market value of Scheidelman's property. Similarly, Scheidelman's other expert relied on outdated information rather than contemporaneous inspection, and used comparables from other geographic areas. By contrast, the IRS presented testimony that focused on the facts surrounding Scheidelman's property.

The court's opinion should discourage the use of appraisal mills that provide a quick and favorable appraisal for a fee without fully examining the effect of the conservation easement on the value of landowner's property. The court noted that a district judge in Ohio had already enjoined one of Scheidelman's experts from preparing any further appraisals for federal tax purposes ' in part because of the government's allegations that the expert “distorts data and provides misinformation or unsupported personal opinions to get artificially high values for” conservation easement donations. The message is clear: A taxpayer who claims a conservation easement had better obtain reliable site-specific data on the easement's effect on the property's market value.

Stewart E. Sterk, Mack Professor of Law at Benjamin N. Cardozo School of Law, is Editor-in-Chief of this newsletter.

Conservation easements provide an attractive mechanism for preserving open spaces and historic buildings. Although some landowners undoubtedly create conservation easements out of pure altruism, tax advantages play a significant role in the creation of most conservation easements. In Scheidelman v. Commissioner, NYLJ 6/23/14, the Second Circuit made it clear that taxpayers who create conservation easements are entitled to a deduction only if the transfer reduces the value of their remaining property.

Mechanics of the Conservation Easement

In New York, section 49-0305 of the Environmental Conservation Law authorizes creation of conservation easements, and exempts them from common law rules that might otherwise apply to creation of an easement. For instance, a conservation easement may be enforced even if it is not appurtenant to any land, and even if it does not touch or concern real property. The statute provides that only “a public body or not-for-profit conservation organization” may hold a conservation easement, and that the easement shall be “of perpetual duration unless otherwise provided” in the instrument that creates the easement.

Section 49-0303 defines conservation easements to include those that restrict development or use of real property “for the purpose of maintaining the scenic, open, historic, archaeological, architectural, or natural condition” of the property. Section 49-0307 limits the power to modify a conservation easement. Unless the easement itself provides for modification or termination, RPAPL section 1951 provides the only mechanism for modifying or terminating the easement: a judicial determination that the easement is “of no actual and substantial benefit to the persons seeking its enforcement.”

Tax Benefits

A landowner who transfers a conservation easement to a public body of a conservation organization stands to obtain two different tax benefits. First, the transfer may lower the landowner's real property taxes to the extent the transfer reduces the value of landowner's land. Gibson v. Gleason , 20 A.D.3d 623 is illustrative. Landowner's parcel, which had been used for farming, was $820,000 because of its potential for residential subdivision. Landowner transferred a conservation easement, relinquishing the right to develop the property, and obtained a reduction in property tax assessment to $384,000.

Second, a landowner who transfers a conservation easement to a qualified organization is entitled to a federal income tax deduction for the value of the easement. Section 170(h) of the Internal Revenue Code details the requirements for taking the deduction. Among them is a requirement that the easement be “in perpetuity” (section 170(h)(5)(A)). Special requirements apply when landowner claims a deduction for a conservation easement in a historic district: The easement must protect the exterior of the entire building (section 170(h)(4)(B)(i)(I)) and the landowner must provide an appraisal and photographs of the building with the tax return (section 170(h)(4)(B)(iii)).

The appraisal requirement mitigates one of the potential abuses of conservation easements: an aggressive landowners who would claim a large deduction in the hope that the IRS would not devote resources to valuing the easement.

The Scheidelman Case

In 1997, Huda Scheidelman bought a townhouse in Brooklyn's Fort Greene Historic District. Six years later, she transferred a fa'ade conservation easement to the National Architectural Trust, a 501(c)(3) organization. A qualified real estate appraiser hired by Scheidelman valued the easement at $115,000, and Scheidelman claimed an income tax deduction for that amount on her tax return. When the IRS challenged the deduction, the Tax Court held that Scheidelman was ineligible because the appraisal was not a “qualified appraisal within the meaning of the Treasury Regulations.

The Second Circuit reversed, holding that the appraisal provided sufficient information to permit the IRS to evaluate Scheidelman's deduction. The court remanded to the Tax Court to evaluate Scheidelman's claim on the merits, and the Tax Court concluded that the fa'ade conservation easement did not diminish the fair market value of Scheidelman's property. As a result, the court denied the deduction. Scheidelman appealed.

In reversing, the Second Circuit started by noting that the Tax Court has the primary function of finding facts in a tax dispute, and that the court would overturn the Tax Court's decision only if that decision was not supported by substantial evidence. Turning to the merits, the court started by conceding that ordinarily, any encumbrance on real property would tend to have a negative effect on fair market value, but then held that the grant of a conservation easement effects no per se reduction in fair market value. In this case, the court concluded that there was substantial support in the record for the Tax Court's conclusion that the supposedly expert testimony offered by Scheidelman was entitled to no weight.

The court noted that one of Scheidelman's experts had testified based on the range of deductions the IRS had allowed in other cases, without focusing at all on the easement's effect on the fair market value of Scheidelman's property. Similarly, Scheidelman's other expert relied on outdated information rather than contemporaneous inspection, and used comparables from other geographic areas. By contrast, the IRS presented testimony that focused on the facts surrounding Scheidelman's property.

The court's opinion should discourage the use of appraisal mills that provide a quick and favorable appraisal for a fee without fully examining the effect of the conservation easement on the value of landowner's property. The court noted that a district judge in Ohio had already enjoined one of Scheidelman's experts from preparing any further appraisals for federal tax purposes ' in part because of the government's allegations that the expert “distorts data and provides misinformation or unsupported personal opinions to get artificially high values for” conservation easement donations. The message is clear: A taxpayer who claims a conservation easement had better obtain reliable site-specific data on the easement's effect on the property's market value.

Stewart E. Sterk, Mack Professor of Law at Benjamin N. Cardozo School of Law, is Editor-in-Chief of this newsletter.