On August 17, 2006, President Bush signed into law the Pension Protection Act of 2006 that contains a significant expansion of the federal income tax incentive for land conservation. The income tax savings from these new incentives can be significant and substantial for a landowner. The 2008 Farm Bill renewed this powerful conservation tax incentive for voluntary conservation agreements that had been scheduled to expire.
How Were the Incentives Increased?
- The deduction an ordinary donor can take for donating a conservation easement was raised from 30 percent of their adjusted gross income (AGI) a year to 50 percent;
- To honor qualifying farmers and ranchers, these individuals may deduct up to 100 percent of their AGI a year;
- The number of years over which a conservation donor can take these income tax deductions was extended from six to 16 years, allowing more individuals to take full advantage of the benefit.
The renewed incentive is retroactive to the beginning of 2012, and is in effect through the end of 2013, and hopefully beyond.
Under the prior law, a landowner earning $50,000 a year (AGI) who donated a conservation easement worth $1 million could take a $15,000 deduction for the year of the donation, as well as $15,000/year for another five years–a total of $90,000 in tax deductions.
Under the new law, that landowner can deduct $25,000 for the year of the donation, and $25,000/year for the next 15 years–a total of $400,000 in deductions. If the landowner qualifies as a farmer or rancher, they could zero out their AGI taxes altogether. In such cases, these qualified donors can take a maximum of $800,000 in deductions ($50,000/year) for their $1 million gift. A remarkable difference from the old law!
Qualification as a Farmer, Rancher, or Working Forest Owner
A farmer or rancher is defined as someone who receives more than 50 percent of his or her income from “the trade or business of farming.” The law references an estate tax provision (Internal Revenue Code (IRC) 2032A(e)(5)) to define activities that count as farming. Specifically, those activities include:
- cultivating the soil or raising or harvesting any agricultural or horticultural commodity (including the raising, shearing, feeding, caring for, training, and management of animals) on a farm;
- handling, drying, packing, grading, or storing on a farm any agricultural or horticultural commodity in its unmanufactured state, but only if the owner, tenant, or operator of the farm regularly produces more than one-half of the commodity so treated; and
- the planting, cultivating, caring for, or cutting of trees, or the preparation (other than milling) of trees for market.
The qualified farmer or rancher provision also applies to farming families that are organized as C corporations. For an easement to qualify for the special treatment, it must contain a restriction requiring that the land remain “available for agriculture.”
Other Conservation Restrictions Still Apply
Conservation easement donations are subject to the same restrictions they were before. For example, easements must meet the “conservation purposes” test defined in the existing law; they cannot be donated as part of a “quid pro quo” agreement; and they must be donated to a qualified organization such as a land trust, government agency or other publicly-supported charity that has “a commitment to protect the conservation purposes of the donation, and … the resources to enforce the restrictions.”
To be clear about how conservation easement tax incentives may help you and your family, contact your tax advisor about the following potential benefits.
How the Tax Benefits Might Help You
Tax incentives have helped many landowners take advantage of conservation opportunities. When a conservation easement meets federal requirements as a charitable gift, the donor of the easement may be entitled to a reduction in income and/or estate taxes. Contrary to popular belief, it is rare for a conservation easement to affect property taxes. The existing tax structure for conservation easement donations runs through December 31, 2013, and it is yet unknown whether they will remain in effect into 2014 and beyond (contact Prickly Pear Land Trust for updates). As with all issues related to tax law, it is recommended that landowners consult an accountant and/or attorney familiar with conservation easement law. Prickly Pear Land Trust retains a list of professionals we know have such qualifications, and we are happy to provide that list to anyone interested.
Income tax benefits accrue at the federal level based on the value of the charitable gift associated with conservation easements. The value of the charitable gift for donating a conservation easement is determined by a qualified appraiser who evaluates a property at the present market value and then again based on its value with the proposed easement restrictions applied to it. The difference between the two values is considered the charitable gift for tax purposes.
For example, let’s assume the appraisal for a potential conservation easement on the Smith Ranch determined the before value of the ranch at $2,000,000. The appraisal then also valued the ranch after placing a conservation easement that permitted the continuation of agricultural and other uses at $1,250,000. Suppose also, that Prickly Pear Land Trust was able to apply for and be awarded a grant of $250,000 to be paid to the landowners for the protection of the Smith Ranch. The charitable gift in this scenario would total $500,000.
Before Value: $2,000,000
After Value: – $1,250,000
Grant Award: – $250,000
Charitable Gift: $500,000
There are two formulas for deducting that gift from federal income taxes, and it depends on a person’s primary source of income. First, let’s assume that the owners of the Smith Ranch are a traditional ranching family. As a traditional rancher, Mr. Smith could be considered by federal statute as a “qualified farmer or rancher,” meaning that more than 50 percent of his gross income is derived from farming or ranching (defined under Section 2032A(e)(5) of the federal tax code). With that qualification, Mr. Smith is permitted to deduct up to 100 percent of his adjusted gross income (for individuals), or 100 percent of taxable income if the Smith Ranch were owned as a qualifying C-corp or other qualifying corporation. That benefit is available to Mr. Smith (or a qualified corporation) for the year the conservation easement is recorded, and then for 15 years following, or until the entire gift has been deducted, whichever occurs first. As an example, let’s assume Mr. Smith earns a $50,000 adjusted gross income. Using the charitable gift example of $500,000 from above, Mr. Smith could deduct 100 percent of his AGI for the year the easement is recorded and then for nine years following, thus allowing him to take full advantage of the tax benefit.
In the case where the owner of Smith Ranch does not earn more than 50 percent of their income from farming or ranching, the tax benefit changes a bit. In this example, assume the owner of the ranch earns $125,000 a year in AGI. That owner would be able to deduct half of that sum, or $62,500 per year, for a total of eight years including the year that the easement was recorded in order to again take full advantage of the gift donation.
It is important to note that some of the costs associated with completing a conservation easement are also deductible. Legal and appraisal fees, as well as the cost for compiling a “baseline report” of the condition of the property at the time of the donation are all deductible expenses depending on the individual situation. Again, it is critically important to consult an accountant to understand all your potential benefits fully.
Estate tax is based on the value of an estate (including one’s land holdings) at the time of a landowner’s death, not at the time a piece of property was purchased. Ranches that have been owned by one family over generations have seen the value of their land appreciate considerably. In many cases, estate taxes are such a significant cost to one’s heirs, the families are forced to subdivide and sell a ranch in order to pay for this exorbitant cost.
Through proper estate planning this scenario can be avoided, and conservation easements can be a useful tool in that planning process. Generally, the first $5,000,000 in estate assets (including land) is not subject to estate taxes. However, the federal estate tax levied on amounts exceeding that exemption is 35 percent. Conservation easements, by way of restricting the development options on a piece of land, reduce the fair market value of a property. This reduction in fair market value can be the difference between passing a ranch down within a family and being forced to subdivide and sell.
As an example, let’s assume that the Smith Ranch was valued at $8,000,000. Upon the death of the patriarch in the family, his heirs would be responsible for a 35 percent estate tax on $3,000,000. His children would need to pay the federal government $1,050,000. If, however, Mr. Smith had arranged a conservation easement on the Smith Ranch and reduced its fair market value by 40 percent or $3,200,000, the value of that ranch would then be $4,800,000, and his children would not be responsible for paying any estate tax, saving the family over $1,000,000! Obviously, this is a very simplified scenario, but it is one that has played out many times. Please contact your tax advisor to determine how donating or selling a conservation easement can help you and your family.