Beyond the Conservation Easement

Simon Sidamon-Eristoff Of Counsel, Kalbian Hagerty LLP March 2011

Recent decades have seen dramatic growth in the use of conservation easements as a tool for protecting privately owned land with natural, open, scenic or ecological attributes. The growth in conservation easements has been fueled by a desire on the part of individual landowners to ensure the protection of their land, generous tax benefits, and government expenditures for conservation easement acquisition programs. A complex tax regime currently provides substantial income and estate tax benefits (and in some states, tax credits) to landowners willing to donate conservation easements restricting the use and development of their land. To be deductible, the conservation easement must be perpetual, it must serve conservation purposes, and it must be donated to a nonprofit organization or a government agency. Preexisting mortgages must be subordinated, and surface mineral rights may not be severed. In addition to these tax benefits, government conservation easement purchase programs have expended hundreds of millions of tax dollars to purchase agricultural and other conservation easements protecting private land against development. Whether donated or purchased, conservation easements are generally valued based on the diminution in value of the affected property resulting from the imposition of the easement. For all the good that they have accomplished, conservation easements have not been an unqualified success story. The constraints imposed by the tax code make conservation easements relatively cumbersome to negotiate. Valuation can be challenging, and presents opportunities for abuse. Stewardship and enforcement of conservation easements can be laborintensive, expensive and problematic.

Most importantly, while conservation easements can be carefully tailored so as to protect the most important attributes of the properties they affect, they are almost completely inflexible once they are in place. The Internal Revenue Code requires that conservation easements be perpetual. Thus, even when the circumstances surrounding a property change, amendment and termination of a conservation easement can be difficult. With government resources dwindling and tax deductions of all kinds coming under greater scrutiny, this is an opportune time to consider additional approaches to restricting the use of private land for conservation purposes. Is there another way that capitalparticularly philanthropic capitalcan be deployed effectively and efficiently to accomplish conservation objectives, perhaps even on an interim basis? This memorandum briefly describes the distinct property interests created by the conservation easement and the tenancy in common. It then explores whether the tenancy in common, used in combination with a covenant between cotenants, might be a viable alternativeor indeed in some cases a preferable alternativeto a conservation easement as a means for protecting land. Conservation Easements and the Common Law. Under the common law, the property interest conveyed by a conservation easementthe right to prevent certain uses of the land for the benefit of the general publicwould be considered a negative servitude in gross. 1 There are three types of servitudes under the common law: (a) easements; (b) real covenants; and (c) equitable servitudes. Each of these types of servitude must meet certain requirements in order to be enforceable under the common law, and negative servitudes in gross are enforceable in perpetuity only under certain limited circumstances. For reasons that are beyond the scope of this memorandum, the conservation easementwhich is, after all, not even an easement in the strictest senseactually does not qualify as a valid servitude under the requirements of common law. Because of this, all 50 states and the District of Columbia have enacted enabling legislation, generally modeled on the 1981 Uniform Conservation Easement Act, specifically authorizing conservation easements. In essence, the modern conservation easement is a creation of statute, rather than common law. Background on Tenancies in Common. The tenancy in common is a form of shared ownership of real property. One tenant in common may have a greater interest in the property, but each tenant in common has an equal (or

A servitude is a private property interest that confers non-possessory rights in land possessed by others. A negative servitude allows the holder of the servitude to restrict the activities that can be performed on the land subject to the servitude, whereas an affirmative servitude allows the holder to make active use of the land subject to the servitude. A servitude in gross benefits a person or group of people without regard to land ownership, whereas an appurtenant servitude benefits an adjacent landowner.

undivided) right to possess the whole property. No tenant in common may exclude the others from the property or claim sole possession of any portion of the property Any cotenant is free to lease his or her right to possess the entire property out to third parties, although in most states the rental proceeds must be shared with the other cotenants and the lessees use must not unreasonably interfere with use by other cotenants. Upon the death of a tenant in common, that tenant in commons interest passes to his or her heirs. Any tenant in common may request a physical division of the property, known as a partition. If the parties agree to a partition, it may be effectuated voluntarily through the exchange of deeds. If the tenants in common are not able to agree, any of them may bring a suit for partition. If it is not feasible to physically divide the property, the court will order a sale of the property and the proceeds will be divided among the tenants in common in accordance with their interests. Generally, payments necessary to preserve title (such as mortgage payments and real estate taxes) are recoverable by a paying cotenant in a suit for contribution, accounting, or partition. There is no such right of contribution from other cotenants for improvements or repairs, but a cotenant who makes improvements may be entitled to an increased share of rents, or an increased share of proceeds in a partition suit. Agreements Between Tenants in Common. Tenants in common may enter into agreements among themselves restricting the use of their co-owned property or apportioning the various rights associated with the property. Such contractual arrangements (sometimes known as use agreements) may apportion the use of the property temporally (such as where one cotenant is entitled to use of the property during the winter and one during the summer) or physically (such as where one cotenant is entitled to exclusive use of one part of the property and another is entitled to use of another part of the property). Indeed, cotenants may apportion the rights to use the entire property for different uses among themselves (such as where one cotenant receives the exclusive right to hunt on the property and another receives the exclusive right to fish, or where one cotenant receives the right to extract minerals, and another receives the right to timber the property.) Outside of local land use controls, there are virtually no limits on the contractual arrangements that may be entered into between the landowners. This flexibility stands in stark contrast to the restrictions applicable to conservation easements. Alternative Ways to Protect Land: An Example. Perhaps considering a hypothetical situation is the easiest way to envision how a tenancy in common, used in combination with a covenant between cotenants, might be used as an alternative to a conservation easement.

Suppose a farmer owns farmland with high-quality soil on the scenic periphery of an urban center. The area has been identified by the local land use plan as being worthy of protection for agriculture. The farm is worth $1 million for its development potential, and only $500,000 for its agricultural value. It is subject to a $200,000 mortgage. If the farmer is willing to place a conservation easement on his land permanently restricting the use of his land to agriculture, and the bank is willing to subordinate its mortgage, the farmer can donate a conservation easement to the local land trust. If he does this he may get some tax benefits (possibly a $500,000 tax deduction and the removal of $500,000 in value from his estate). Alternatively, if there is a local farmland protection program flush with funding, the farmer may be able to sell an agricultural conservation easement to the government for up to a maximum of $500,000. Under either scenario, the future use of the property will be fixed in perpetuity now, and someone will be responsible for monitoring the use of the property on an annual basis and enforcing the terms of the easement forever. But what if the farmer doesnt want to tie up his land forever? What if he just needs temporary capital to fund improvements that will increase the efficiency of his operation? What if the bank is not willing to subordinate? What if the mineral rights have been severed and are held by a third party? What if there is no funding available for the acquisition of agricultural conservation easements? Perhaps there is an alternative: a private investor (whether a foundation, an individual, a group of individuals, or an entity) could buy a 50% interest in the farm, and then enter into a contractual arrangement regarding its use and development as a tenant in common with the farmer. Assume that a private foundation interested in protecting the farm against development is willing to purchase a 50% interest in the property for, say, $400,000. (Recall that the farm is worth $1 million and is subject to a $200,000 mortgage, which will be paid off by the farmer with the proceeds from the sale.) How might the two owners allocate the rights and responsibilities of ownership through a written agreement? Here is a summary of one possible arrangement: a. The farmer shall be responsible for real estate taxes, insurance against property damage, and maintenance and repair of all structures. If the farmer fails to perform these obligations the foundation may do so on the farmers behalf and seek contribution from the farmer. b. The farmer shall have the exclusive right to use, occupy and lease the property, which may be used for agricultural purposes, and for no other purpose.

c. The farmer will assume all liability for hazardous substances on the property, and provide insurance against environmental liability. d. In the event that either party desires to sell its interest or partition the property the other party shall have the right to purchase the sellers interest at fair market value, to be determined by appraisal. e. If the parties determine to sell the property jointly, they shall share the net proceeds in proportion to their percentage interests in the property. Note that this agreement could include a number of different exit strategies for the foundation, many of which hold the promise of enabling the foundation to protect its investment. For example, the agreement could include an option for the foundation to purchase the farmers interest at a set price after the expiration of a term of years; an option for the foundation to exchange its 50% interest for a perpetual conservation easement on the property; or a put option whereby the foundation would have the right to compel the farmer to buy the foundations interest on predetermined terms at a date certain. The possibilities are virtually endless. Enforceability of Perpetual Agreements between Cotenants. Further research will be required to determine whether an agreement along the lines of the foregoingor indeed any contractual arrangement between tenants in common concerning the land that they own togethercan be enforced by the parties and their successors and assigns in perpetuity. There is an ongoing tension in this area of the common law between two sets of important values. On the one hand, private parties should be free to enter into consensual contractual arrangements as they wish. On the other hand, restraints on the use of landthrough so-called dead hand controlgenerally are not believed to serve societys best interests. (This is the thinking that underlies the Rule Against Perpetuities, which requires that a future interest in real property must vest within an ascertainable period. Strictly speaking, the Rule itself does not apply to real covenants.) The likelihood is that a perpetual agreement between tenants and common would be enforceable as a real covenant. Generally, a number conditions must be met in order for a covenant to run at law (i.e., be enforceable by and against the original parties successors): (1) it must be in writing; (2) it must be intended to run with the land; (3) it must touch and concern the land; and (4) there must be privity of estate between the original parties and their successors. In addition the party against whom enforcement is sought must have received notice of the covenant. These requirements are relaxed somewhat when equitable relief is sought. It should be possible to craft an agreement between tenants in common that meets all of the foregoing requirements and will be enforceable even after the original parties to the agreement no longer hold any interest in the property in question.

Deductibility of Donations of Partial Interests. This memorandum focuses on the purchase of a tenancy in common. The tenancy in common is appealing because if the percentage interest in the property is acquired by a taxexempt entity by donation or through a sale at less than fair market value, there may be tax benefits for the donor. However, it is worth noting that depending on the legal form through which the farm is owned, the acquisition of an ownership interest could be effectuated through the purchase of shares in a corporation, or the purchase of a partnership interest. Further research will be needed to ascertain the efficacy of these latter approaches The general rule is that a donation of a partial interest in property is not deductible for federal income tax purposes. However, there are a few exceptions to this rule. A deduction is allowed for the donation of a remainder interest in a personal residence or a farm, and a deduction is allowed for a qualified conservation contribution (i.e. the donation of a conservation easement that meets the requirements set forth in the Internal Revenue Code). A third exception to the general rule exists for a contribution of an undivided portion of the taxpayers entire interest in property. This must consist of a fraction or percentage of each substantial property right, and must extend over the entire term of the donors interest. (For example, if all the donor holds is a leasehold, and he donates a 50% interest in his leasehold, he will be entitled to a deduction based on the value of his leasehold.) By definition, a tenancy in common is an undivided interest in real property. Therefore, a charitable contribution of such an interest (whether by gift or by bargain sale) should entitle the donor to a federal income tax deduction. So, returning again to our example: if the farmer were to make an outright donation to the foundation of a 50% interest in his farm (valued at $1 million but subject to a $200,000 mortgage), he would be entitled to a deduction of up to $400,000, representing 50% of the value of his equity. This amount would likely be reduced below $400,000 in an appraisal, since fractional interests are generally discounted by some 15% to 20% for valuation purposes. If he were to sell a 50% interest to the foundation for a bargain sale price of $200,000, he would be entitled to a deduction of up to $200,000, the difference between the $200,000 fair market value of the interest sold and the $200,000 sale price. (The amount of the deduction that can be used by the farmer in any given year is subject to certain limitations depending on the farmers adjusted gross income in either case.) Note that generally, for the full value of a donated percentage interest in real property to be deductible, the allocation of rights and responsibilities under the real covenant should correspond in value to the parties respective interests in the real property. If the donor reserves too many rights through the covenant, the Internal Revenue Service could argue that the donor has not made a donation of an undivided interest in the property. Further research will be

required to determine proper valuation methodology for gifts of percentage interests that are made in combination with real covenants. Conclusion. The tenancy in common (combined with a real covenant) is not likely to supplant the conservation easement as a tool for protecting land with special attributes any time in the foreseeable futurenor should it. Some landowners will be understandably reluctant to share ownership of their property, particularly with a government agency, and an entire generation of land conservation professionals has devoted their careers to mastering the peculiar intricacies of the tax-deductible conservation easement. Still, in many situations, the acquisition of a tenancy in common (combined with a real covenant) could serve the interests of the parties better than a conservation easement, and still accomplish significant conservation objectives. This is particularly true where more flexibility is required than would be allowed under a perpetual, tax-deductible conservation easement, or where providers of conservation capital wish to retain the option to redeploy their resources elsewhere in the future. In an era of diminished resources, land conservation professionals will need to think beyond the conservation easement. After all, the conservation easement is a relatively recent developmentthe term was first coined in 1959 by the sociologist and urban planner William H. Whyte, and the Internal Revenue Service first authorized deductions for scenic easements along federal highways in 1964. Conservationists will need to continue to develop new, dynamic land protection tools such as the tenancy in common described hereif they are to rise to the challenges that certainly lie ahead, whatever those challenges may be. Looking beyond the conservation easement represents a continuation of the rich tradition of creative thinking that brought conservation easements into existence in the first place. Simon Sidamon-Eristoff is Of Counsel to Kalbian Hagerty LLP. He served as general counsel to American Farmland Trust from 1998 to 2010 and now serves as the Trusts senior counsel. A nationally recognized expert in the field of land conservation law, Mr. SidamonEristoff has represented nonprofit organizations, private landowners, and government agencies in a broad range of conservation, real estate and tax matters in over twenty years of law practice. Mr. Sidamon-Eristoff acknowledges the support of the Castanea Foundation in connection with the preparation of this paper. Mr. Sidamon-Eristoff can be reached at 202-2235600 or at simon@kalbianhagerty.com