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articles & updates | article
An Important Tax Incentive for Landowners
by Stephen J. Small, Esq.
Page 2: How The New Law Works
The American Farm and Ranch Protection Act adds to the tax code a new Section 2031(c), "Estate Tax With Respect to Land Subject to a Qualified Conservation Easement."
Before we review the specific rules of Section 2031(c), let us clarify what this all means and what it doesn't mean.
It does mean that all of the existing conservation easement rules of Section 170(h), the current conservation easement section, are still intact and that Section 170(h) works exactly the same way it did before the 1997 tax code changes. If you donate an easement on land you own, and if the easement meets the requirements of Section 170(h), you are entitled to an income tax deduction for the value of the conservation easement. In addition, the value of the land is reduced for estate tax purposes.
After you have met the requirements of Section 170(h), then you can look at the additional benefits potentially available under Section 2031(c). However, at this point two things can happen. First, and more on this below, it is entirely possible that even though your easement qualified under Section 170(h) your situation may not be eligible for the additional benefits of Section 2031(c). Second, your situation may be eligible for the benefits of Section 2031(c) but for tax or other reasons the executor of your estate may decide not to elect Section 2031(c).
Put another way, an easement must qualify under Section 170(h) to be eligible for the benefits of Section 2031(c), but if the easement doesn't qualify under Section 2031(c) that has no impact whatsoever on qualification for all of the benefits of Section 170(h).
In a nutshell, this is what new Section 2031(c) says: if you have land subject to a conservation easement that meets the requirements of Section 170(h), and if you own that land when you die, and if you meet the requirements of Section 2031(c), then you can exclude an additional percentage of the value of that land from your estate in addition to the reduction in value already attributable to the easement.
Here are the important parts of new Section 2031(c).
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The new law will allow an executor to elect to exclude from a decedent's estate for federal estate tax purposes up to 40% of the value of land (not structures) subject to a conservation easement if:
- The land is within a 25-mile radius of a Metropolitan Statistical Area, as defined by the Office of Management and Budget (typically an area with a population over 50,000), or a national park or wilderness area, or within 10 miles of an Urban National Forest;
- The easement was donated, is perpetual, and otherwise meets the requirements of Section 170(h). Easements qualifying solely because they protect historic assets are not eligible for Section 2031(c) benefits;
- The land was owned by the decedent or a member of the decedent's family for at least three years immediately prior to the decedent's death;
- The easement was donated by the decedent or a member of the decedent's family; and
- The easement prohibits all but minimal commercial recreational use of the land (see more on this point below).
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The maximum amount that may be excluded from an estate under the new provisions was $100,000 in 1998, increasing by $100,000 each year up to the maximum exclusion of $500,000 in 2002 and after. The exclusion applies regardless of when the easement was donated.
Here is the simplest possible example of how the new exclusion will work.
John owns land worth $2,000,000. In 1998, he donated a qualifying conservation easement that reduces the value of his land to $1,000,000. He dies in 2003. The land is valued in his estate at $1,000,000. His executor elects to take the Section 2031(c) exclusion; 40% of the $1,000,000 land value is excluded from John's estate; $600,000 of land value is subject to estate tax.
Note: if the planning is done correctly, the estates of both spouses can be eligible for the new Section 2031(c) exclusion. |
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"Development rights" retained in the easement will be subject to estate tax. Neither the statute nor the congressional committee reports answer all the questions about exactly what is a development right. The statute defines "development right" as a right that is retained for any commercial purpose which is "not subordinate to and directly supportive of the use of such land" for farming, ranching, etc., purposes. Reserved rights to continue agricultural, farming, ranching, and forestry activities are permissible and are clearly not development rights. The right to subdivide and convey additional house lots (of whatever size) clearly is a development right and clearly will be subject to estate tax (although see more on this point below). The right to own and maintain an existing residence is not a development right.
However, development rights retained in the easement will not be subject to estate tax (which is due nine months after the decedent's death) if within nine months of the decedent's death the heirs of the property agree to give up permanently some or all of those development rights. Those rights do not actually have to be given up within nine months; the heirs have nine months to agree to eliminate them and then have up to two years after the decedent's death to give up those rights.
Some landowners and/or donee organizations prefer leaving potential future house lot sites outside of the tract of land to be covered by a conservation easement. The ability to retain or extinguish those rights may make it prudent to include them under the easement. This can provide a very important "second look," for estate planning purposes, after the landowner's death. In fact, if the extinguishment of the development rights takes the form of a conservation easement that meets the requirements of Section 170(h), the conservation easement section, the heirs may be entitled to an income tax deduction.
"Development rights" are not the same as commercial recreational activities. A golf course is clearly a commercial recreational activity, and Congress did not want a landowner to be able to reserve this sort of activity under an easement and still benefit from the Section 2031(c) exclusion. If an easement does not prohibit all but what the law calls "de minimis" commercial recreational activities the estate will not be eligible for the Section 2031(c) exclusion. |
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If there is a mortgage on the property, an amount of land value equal to the amount of the indebtedness will not be eligible for the exclusion. In other words, if land subject to an easement is worth $1,000,000, but there is a $300,000 mortgage on the property, only $700,000 of the land value will be eligible for the exclusion. Of course, the mortgage will usually be deductible as a debt of the estate. |
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To the extent the estate takes the exclusion, land will retain the same basis as it had in the hands of the landowner/decedent, rather than being entitled to a stepped-up basis, for calculating any gain on a subsequent sale. These terms need a brief explanation.
The concept of "basis" is a tax law concept. In many (but not all) situations, for tax purposes "basis" and "cost" mean the same thing. This is a very simple illustration, but if you buy stock for $1,000 and sell it for $2,000, you will pay tax on the $1,000 gain, which is the difference between what you sold it for and your basis of $1,000.
If you hold that stock until you die, the estate tax will be based on the $2,000 value of that stock. However, when your children inherit the stock it will have a basis in their hands of $2,000. The tax law refers to this as a "stepped-up basis." If the children sell it for $2,000, there will be no tax on the gain (but remember that there was an estate tax on the $2,000 value). Once again, to the extent an estate takes advantage of the exclusion, a portion of the basis of the land would not be "stepped up" but would remain the same as it was in the hands of the decedent; that is, it would be "carried over." |
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The exclusion is available when land is owned by family corporations, partnerships, or trusts as long as the decedent owned at least a 30% interest in the corporation, partnership, or trust at the time of death. |
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The amount of the exclusion will be reduced below 40% by two percentage points for each one percentage point by which the easement fails to reduce the value of the land by 30%. This complicated rule is intended to discourage "marginal" easements that don't reduce the value of land very much, although the percentage reduction in value often has little or nothing to do with the importance of the conservation values to be protected by the easement.
Here is how this rule works. If land is worth $1,000,000 without an easement and, say, $650,000 subject to an easement, the full 40% exclusion under the statute will apply because the easement reduced the value of the land by more than 30%. On the other hand, if the easement reduced the value of the land from $1,000,000 to $800,000, because this 20% reduction in value is ten percentage points less than 30%, the exclusion is reduced from 40% to 20% (two percentage points for each point the easement fails to reduce the land value by 30%).
Put another way, if an easement reduces land value from $1,000,000 to $650,000, using the exclusion the total value subject to estate tax will be $390,000 ($650,000 minus 40% of $650,000). If the easement reduces land value from $1,000,000 to $800,000, using the exclusion the total value subject to estate tax will be $640,000 ($800,000 minus 20% of $800,000). These examples assume the maximum individual exclusion amount of $500,000 is fully phased in.
One obviously critical issue that has come up about the way this particular rule works is the question of whether the 30% reduction in value is to be calculated on the date the easement was donated (assuming the donation was made during the landowner's lifetime) or on the date of the decedent's death. Although making the determination on the date of the donation would ensure certainty, it now appears that the calculation will need to be made as of the date of the landowner's death. Although there is very little data on this, in the vast majority of cases the evidence seems to indicate that once an easement is donated the percentage reduction in value attributable to the easement is not likely to decrease. In fact, the value of the easement seems likely to increase as development pressure and real estate values in the area increase.
There may be additional legislative efforts to change this rule to a date-of-donation determination, but for now a date-of-death calculation seems likely.
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