Earlier this month, the U.S. Tax Court handed down an oddly reasoned memo opinion rejecting a North Carolina developer’s conservation easement deduction in Wendell Falls Development, LLC v. Commissioner, T.C. Memo 2018-45 (April 4, 2018).

Practitioners in this field know that the deductions claimed for conservation easements can be hotly contested by the IRS, whose litigation strategy relies on the kitchen sink method—a method that is frequently successful due to the complexity of the regulations and the difficulty donors have complying with them. Here, however, it seems as though the kitchen sink method could have been avoided because the easement in question clearly appears to have been either purchased for its full value or granted in exchange for development rights. But, instead of going the easy route, the Tax Court opinion focuses on whether the donor’s remaining property was enhanced by the easement, finding that it was—contrary to the opinions of two appraisers hired by the donor and one appraiser hired by the IRS.

A Little Background

 Wendell Falls is a 1,200-acre development in the town of Wendell, a suburb of Raleigh, North Carolina. The original developer of Wendell Falls was Mercury Development, which was founded in the early 2000s by Greg Ferguson and Mike Jones, the two individual taxpayers named in the Tax Court decision. It took Ferguson and Jones years to acquire the numerous contiguous parcels that now comprise Wendell Falls. Over a decade after the community was first conceptualized, and after the original developer went bankrupt and the property foreclosed, Wendell Falls finally welcomed its first residents in 2015 and is now the largest master-planned community in the region. The current owner expects it will take another decade to complete the project, which will include 4,000 homes and 2 million square feet of retail space.

No Quid Pro Quo for Development Permits

The Tax Court decision relates to the 2007 tax year when the original owner of the Wendell Falls development granted a conservation easement over 125 acres of the land to Smoky Mountain National Land Trust and then sold the underlying fee title of those 125 acres to the local county to be used as a public park. Concurrently with the negotiations regarding the park easement and sale transactions, the owner applied for permission from the neighboring town of Wendell to annex the rest of the owner’s adjacent land to the town and develop a master-planned community. The town’s permit mentioned the owner’s intent to conserve the park land, but the approval specifically stated that the owner received no preferential zoning in exchange for setting aside the park. The Tax Court opinion notes that “this statement is consistent with the rest of the record” and then does not raise the quid pro quo permitting issue again.

This is puzzling because the Tax Court has previously looked past such official statements to determine whether the governing agency actually did expect the conservation action when it approved a development application, such as in Pollard v. Commissioner, T.C. Memo 2013-38 (February 6, 2013). Arguably, an owner-applicant’s promise to set aside a park while applying for development permits could have some impact on the decision-makers, and also probably general public opinion regarding the development.

No Inquiry into County’s Purchase of Property at Fair Market Value

Another oddity in this case is the initial appraised value of the 125-acre park upon sale to Wake County. Prior to the sale, the parties appraised the park property and agreed that the property was worth approximately $3 million. The county also agreed to permit the owner to place an easement on the park before the county’s property purchase, so that the land would be permanently protected for park purposes. However, the parties did not decrease the underlying value of the land by the easement value and the county paid the full fair market value for the purchase.

Typically, the purchase price or charitable deduction for a conservation easement is valued by looking at the before and after conditions of the property: How much was the land worth before the easement? How much is the land worth after the easement? The difference equates to the easement’s “value,” or the allowable charitable contribution attributable to the resultant reduction in land value. Since the county paid the full fair market value of the land, without a reduction for the easement’s value, the owner arguably received full consideration for both the easement and the underlying land. Similar to the question of whether the development permit created a quid pro quo, the court does not delve into this issue for some reason.

Substantial Benefit and Enhancement, Instead

Instead of digging into the quid pro quo development permit question or the fact that the county paid full value for easement and fee title combined, the Tax Court focused on whether the park would enhance the value of the surrounding development and thus provide a “substantial benefit” to the owner, which would disprove the owner’s donative intent to make a charitable contribution and thereby negate the deduction.

The Treasury Regulations governing easement values provide two specific valuation methods where the taxpayer owns nearby property. In Section 170A-14(h)(3)(i), if a donor or the donor’s family member owns other property contiguous to the easement property, then the easement appraisal must include both pieces of property as a single parcel in the “before” and “after” analysis to determine the value of the easement (the “contiguous property rule”). Further, if the donor or a related party owns property in the vicinity of the easement property, then the appraisal must discuss whether the easement will enhance the value of the other property and the value of the easement will be reduced by the amount of such enhancement (the “enhancement rule”).

Despite these two valuation rules set forth in the regulations, the Tax Court decided sui sponte to apply its own “substantial benefit” analysis to the valuation, stating that none of the three appraisal experts got this portion of the valuation right. Instead of discussing or applying the contiguous parcel rule, which should have been applicable in this case, the Tax Court focuses on whether the owner expected a “substantial benefit” for donating the easement, finding that the 125-acre park’s enhancement to the development was a “substantial benefit” expected by the owner, proving that the owner had zero donative intent and that the easement on the park was worth absolutely nothing.

The court’s reasoning here adds to the puzzlement of this memorandum opinion: Typically, even if nearby property is enhanced by an easement, the easement’s value is reduced, rather than nullified entirely. It is difficult to determine whether there is a “substantial benefit” due to an easement’s effect on nearby property, which is presumably why there is a valuation process in the regulations. Not all planned communities have sufficient green space, because their developers focused on maximizing the houses that could be built. Obviously, green space enhances a community, but it is arguable as to whether that enhancement equals the same value that could be derived from selling more houses. The court’s opinion does not rely on any data to come to the conclusion that the “substantial benefit” to the owner due to the enhancement value to the rest of the community completely offset the potential development value that was extinguished by the easement (the easement’s “value”).

Proponents of easements over golf courses in denser regions in the Midwest and East Coast would argue strongly that, although the golf courses enhance the surrounding residential communities, they are tempting to develop for further profit in the future and should be protected as some of the sole remaining green space in such areas. Golf courses aside, many easement donors do have nearby properties that are subject to development plans. Does this mean that easements near such properties should not be deductible? Why would conservation of open space not be as valuable near a development as elsewhere?

 Even more interesting (and puzzling), to further support its reasoning that the easement had no value, the Tax Court uses the tautological argument that the “highest and best use” of the easement property was as a park, because that is what the owner actually decided to do with the property. The “highest and best use” impacts the value that an appraiser assigns to the land in the absence of a conservation easement, because it sets the “before” condition. The court’s argument here begs the question: If the “highest and best use” is determined to be whatever the owner actually does with the land, then any conservation easement would be worthless, wouldn’t it?

Honing in on the quid pro quo or county purchase price issues would have made a whole lot more sense than the court’s twisty reasoning regarding substantial benefit and enhancement, but you know the saying: bad facts make bad law. It is unclear why the court created a substantial benefit shortcut past the quid pro quo analysis and the regulations’ enhancement and contiguous parcel rules. We’ll see whether the IRS attempts in future litigation to use the same shortcut around the regulatory appraisal rules to argue that any easement adjacent to a development is worthless due to enhancement.