Conservation Easements and Estate Planning
May 30, 2004

by James Wyse, Esq.

In 2001, Congress enacted major changes to the federal estate tax laws - changes that were heralded at the time as a "repeal" of the estate tax. Of course, Congress did not repeal the estate tax at all. The new law phases in higher exemptions from the tax over a period of time, and a moderate reduction in the top estate tax rate. The exemption has increased from $675,000 in 2001 to $1,000,000 in 2002 and 2003. It will increase again to $1,500,000 in 2004, to $2,000,000 in 2006, and to $3,500,000 in 2009. Finally, in 2010, the estate tax is eliminated, but only for one year. In 2011, barring any further Congressional action, the estate tax would automatically be restored, with the exemption reverting to the $1,000,000 level and the maximum rate going back to 55%.

If this sounds unrealistic to you, you are not alone. Most professional estate planners expect Congress to enact some sort of legislation to change the situation. Unfortunately, no one knows what that change will be. One outcome could certainly be a continuation of the estate tax at some level. And, of course, even under current law repeal is eight years away. So, if you have assets of substantial value you still need to plan to minimize the impact of estate taxes. And this is particularly true if you own land that is important to you; that you would like to be able to leave to your children, or wish to see protected.

Unfortunately, many families fail to grapple with the fact that the value of their family lands has increased to such an extent that it is impossible to pay the estate tax without selling it, or a substantial part of it, for development. The use of qualified conservation easements can often make the difference between having to sell your property and being able to pass it down intact to your children. If you love your land and wish to see it preserved for future generations, the conservation easement is a tool you should become familiar with.

At the end of this article I have set out several examples illustrating how Helen Smith, a fictional landowner, whose land is worth $3 million and who has other assets worth $400,000, could reduce her probable estate tax liability from $1,121,000 to zero through the use of a properly drawn conservation easement.

Most people donate conservation easements during their lifetimes. However, the estate tax benefits illustrated in the examples below would be the same whether the conservation easement was given by Helen during her lifetime, given in her will, or given by her executor, with the agreement of her heirs, after her death (a so-called "post-mortem" donation). In the case of a post-mortem donation, the easement transfer must take place before the due date of the estate tax return. Although there is no difference from an estate tax perspective, a donation during one's lifetime can have significant income tax benefits as well, since the value of the easement can be taken as a charitable income tax deduction, up to 30% of your adjusted gross income over as many as six years.

Conservation easements can also facilitate the gifting of property to your heirs during your lifetime. For example, suppose you wish to transfer your property to your children over time by making annual exclusion gifts. Currently, the maximum value that can be given by you to each child without any gift tax consequences is $11,000 per year ($22,000 for a married couple). If you were willing to use up your gift and estate tax exemption amount, you could give up to $1 million in property value before incurring a gift tax. By granting a conservation easement to a qualified organization before making the gift, you may be able to complete the transfer of the property through annual partial gifts much more quickly. Or, you may reduce the value of the land sufficiently that the gift tax is eliminated, or at least substantially reduced, even on an outright transfer.

So, what is a conservation easement? In the simplest terms, a conservation easement is a legal agreement between a landowner and an eligible organization that restricts the activities that may take place on a property in order to protect the land's conservation values. The agreement itself must be carefully planned to suit the features of the particular property, the interests of the landowner, and the policies and objectives of the easement holder. There is no "off the shelf" document that will work for all properties and circumstances, and this is especially true for properties that are being actively used by their owners. Conservation easements are perpetual agreements, and thus require a balancing of flexibility and specificity. On the one hand, a clearly worded, comprehensive agreement will help to avoid misunderstandings and disputes. On the other hand, a document that is too rigid may not be able to accommodate changes in our understanding of things like best agricultural and forest management practices.

For easements to yield tax benefits, they must comply with a variety of requirements contained in the regulations adopted under Section 170(h) of the federal Internal Revenue Code. There is nothing particularly surprising in these requirements, which reflect the public policy of using tax incentives to encourage only those easements that further a bona fide conservation purpose, are perpetual in duration, contain provisions that prevent destruction of the land's conservation values, and permit the easement holder to effectively monitor and enforce the easement's restrictions.

Probably the least understood aspect of these requirements is the "conservation purposes" test. Many people mistakenly believe that any easement that restricts the future development potential of a property will qualify for a tax deduction as a conservation easement. That is not the case. To use an extreme example, suppose a landowner gave an easement that simply said that the property could not be further subdivided or developed for residential, commercial or industrial uses, other than for agriculture, and the continuation of the existing single-family residential use. Five years later a new owner decides to cut down every tree on the property, bring in a bulldozer, and re-grade the entire land surface right up to the streambank, thus destroying all of the native vegetation and causing ongoing siltation problems in the stream. The easement may have prevented development, but it did nothing to protect the land's former conservation value.

The tax law defines conservation purposes to include the following four things the preservation of land areas for outdoor recreation by, or the education of, the general public; the protection of relatively natural habitats of fish, wildlife, or plants, or similar ecosystems; the preservation of open space, including farmland and forest land, either for the scenic enjoyment of the general public, or pursuant to a clearly delineated governmental conservation policy; in either case, such open-space preservation must yield a significant public benefit; and the preservation of a historically important land area or a certified historic structure. In northern New Jersey, most conservation easements are for open space preservation, the third conservation purpose noted above. Such easements must yield a significant public benefit, either by preserving a scenic viewshed visible to the general public, or by furthering a "clearly delineated" governmental open space protection policy. However, it is not necessary to permit public access to the property.

Not every property possesses sufficient conservation value to qualify under the conservation purposes test. The easiest example would be a non-descript vacant building lot in the middle of a subdivision. Although you might agree not to build on the lot and thereby reduce its value, there would be no significant conservation benefit in such a restriction. Organizations like Upper Raritan Watershed Association maintain extensive data files and GIS maps to help identify the conservation values associated with particular properties within their areas of concern, and governmental open space protection policies that may be applicable to them. Conservation easements should be as specific as possible in identifying the particular features and conservation values present on the property.

Although a conservation easement cannot allow a landowner to destroy significant conservation interests associated with the property, landowners are permitted to reserve various rights to use and, to a limited degree, further develop it. The extent to which a landowner may reserve such rights will depend largely on the nature and character of the land itself, and its existing uses. For instance, reserving the right to build a farm manager's cottage, or even to create one or two additional house lots on a large parcel of land, is probably allowable, provided they can be located in such a way as not to destroy significant scenic and conservation values. Bear in mind though, the more significant the reserved rights, the lower the value of the conservation easement will be for tax purposes.

In many cases it makes sense to apply different levels of restriction to different areas of the property. There might be one set of restrictions to protect an area that contains important wildlife habitat and stream corridor buffer values, more lenient restrictions in an area devoted to open-field agriculture or woodland management, and less restrictive provisions in an area designated for the house, barns, and other structures. If the landowner reserves the to right carry out active uses of the property, baseline documentation must be prepared before the transfer. The baseline report should accurately describe the current condition of the property, and will usually consist of photographs, survey maps, and written descriptions of existing structures and natural features. It may also include a species inventory and other pertinent scientific data. Although it is the owner's obligation to provide baseline information under the tax regulations, in most cases the data is compiled by the land trust staff.

As with any other agreement, a conservation easement is worthless unless the parties have an effective right to enforce its terms. Tax regulations require, at a minimum, that the holder have a right of access to the property to carry out routine monitoring inspections, and the right to take legal action to enforce the restrictions, including the right to require restoration of the property to its former condition in the event of a violation. The easement must require the landowner to notify the easement holder before exercising any reserved right that might harm or damage conservation values protected by the easement. For its part, the holder must undertake monitoring and enforcement obligations. These can be quite costly over time, necessitating ongoing site visitations, staff evaluations, preparation of reports and, in the event of a violation, possible legal expense. For this reason, recipient organizations often request a donation to help cover the cost of their ongoing stewardship obligations.

The donation of a conservation easement will only qualify for beneficial tax treatment if the recipient is a qualified organization, i.e., either a governmental entity or a nonprofit organization with conservation or historic preservation purposes, that qualifies as a publicly supported charity under Code Sections 501(c)(3) and 509(a)(2). Private foundations are not acceptable donees. The donee must have the commitment and resources to enforce the conservation restrictions.

Because of the many issues that must be considered and dealt with, it is best to start the process of donating an easement early. Several site meetings are often needed. At these meetings, the staff of the land trust should become familiar with the property and the owner's historical and intended uses of the land, the easement terms should be discussed, and a fairly detailed but understandable conservation plan should be developed. This plan will serve as a guide for those who draft the easement document. A title search should be obtained early on, to identify potential title concerns. For example, if there is a mortgage on the property, the mortgage will have to be subordinated to the conservation easement in order for the easement to qualify for tax benefits. That can take some time. If it is desirable to identify different areas of the property for different kinds of restrictions, a surveyor may need to be hired to prepare the necessary descriptions, prepare a site drawing, and place appropriate monuments. Although it is not necessary to appraise the value of the easement before it is donated, families may want to get at least a preliminary indication of the likely reduction in the property's value before proceeding.

The impact of the conservation easement on the estate tax value of the property will be determined by appraisal. The importance of obtaining a good, competent appraisal cannot be overstated. The appraiser should have experience with the appraisal of conservation easements. Easements are valued by first determining the value of the property for its highest and best use before the conservation restrictions. Then the property's value after the conservation restrictions is determined. The difference between the "before value" and the "after value" represents the value of the conservation easement. However, if the family owns other contiguous lands that will be benefited by the conservation restrictions, the easement value must be adjusted downward to take that benefit into account. Naturally, an appraiser will not be able to accurately assess the property's "after value" until the essential terms of easement have been negotiated. The appraisal is the donor's responsibility, as is defense of the appraisal conclusions in the event of an audit.

As you might expect, there is much more to know about conservation easements than could be covered in this brief article. Above all, it is important that you go over the tax advantages that might accrue to you carefully with your own legal and tax advisors.

Example 1: Helen Smith, a widow, owns a large estate property on which she resides. Her daughter also breeds and trains horses there and would like to live on the property after her mother passes away. They grow hay on part of the property. The property has a trout stream surrounded by woodland habitat, which is used for fishing by Helen's extended family. The property is worth $3,000,000. Helen also has cash and investments worth $400,000. She plans to leave the property to her daughter, and would like her to be able to continue her horse breeding business there. If she does no planning, the tax on Helen's $3,400,000 estate will be approximately $1,121,000 - far more than her cash assets.

Example 2: Rather than do nothing, Helen decides to grant a qualified conservation easement on her land, which permits it to be used as it always has been, but reduces its value to $1,000,000. Her estate is now worth only $1,400,000, and her estate tax is reduced to $167,000.

Example 3: Using the same facts as above, we also know that the property has been in the family for at least three years, and the easement prohibits all but de minimis commercial recreational uses. Because it is a qualifying conservation restriction under Code Section 2031(c), Helen's estate may also elect to take an additional estate exclusion equal to 40% of the already reduced value of the land (but not improvements), up to a maximum exclusion of $500,000. After applying the exclusion (ignoring improvement value for purposes of this illustration) the value of Helen's taxable estate would be only $1,000,000, and the estate tax will be $0. Note that if Helen's daughter dies owning the property, her estate will also be entitled to take the additional 40% exclusion, as will her heirs for as long as the family owns the land.