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Issue 89 Article 163
With increasing frequency, the question arises as to whether a landowner may structure the conveyance of a conservation easement as a like kind exchange for tax purposes. There is no clear approval of eligibility for deferral of gain or loss under IRS Code Section 1031 or the Regulations when the relinquished property is a conservation easement and the replacement property is a fee simple interest. There are a significant number of Tax Court decisions and IRS determinations that lead one to the conclusion that the IRS will accept such exchanges as qualifying like kind property.
Some of the clearest guidance comes from PLR-152599-01. Private Letter Rulings only apply to the transaction for which they are issued and may not be cited by other parties as controlling. They do provide valuable guidance as to the analytical approach that the IRS is likely to take. Unless the facts of a transaction vary or unless the IRS changes its position, Letter Rulings provide a measure of comfort that a conforming transaction will be viewed favorably upon audit. The following are the pertinent facts of the cited ruling:
"Taxpayers are members, along with other persons, of Family Group No. 3. The persons comprising Family Group No. 3, along with the entities comprising Family Group No. 1 and Family Group No. 2, are co-owners of the fee interest in Old Ranch in State X.
Family Group No. 1 operates a cattle ranching business on Old Ranch through a limited liability company (LLC). Family Group Nos. 2 and 3 lease their respective undivided interests in Old Ranch to LLC for grazing of cattle. In addition, the co-owners of Old Ranch (including Taxpayers) have formed a general partnership (GP) under state law to perform routine maintenance on Old Ranch. However, GP does not hold any interest in Old Ranch and will not own any interest in property to be received in the planned exchange. All of Old Ranch, consisting of approximately 11,500 acres, is used for cattle ranching purposes except for approximately 6 acres used for personal residences of some of the co-owners. Taxpayers and other co-owners wish to engage in a like-kind exchange with ConOrg, a § 501(c)(3) organization. Under an agreement entered into by Taxpayers and the other co-owners with ConOrg, Taxpayers and the other co-owners will convey a PCE on the Old Ranch to ConOrg in exchange for the fee estate of New Ranch, in State X, which will also be burdened with a PCE when received by Taxpayers and the other co-owners.
The planned transaction will be a simultaneous, two-sided exchange (i.e., involving no accommodation parties, third party sellers of replacement property or third party buyers of relinquished property). Following the exchange, New Ranch will be held by Taxpayers and the other co-owners in the exact same proportions as the interests they now hold and will retain in Old Ranch burdened with the PCE."
The Ruling references appropriate state statutory citations supporting the principle that in the state where the property is located a conservation easement is an interest in real property. The ruling notes that a conservation easement is voluntarily created and it may be conveyed by any lawful method for the transfer of interest in real property. In that State, the statutes require that a conservation easement shall be perpetual in duration and shall constitute an interest in real property notwithstanding the fact that it is negative in character.
The IRS analysis is fairly straightforward. "Section 1.1031(a)-1(b) of the Income Tax Regulations provides that, as used in section 1031(a), the words "like kind" have reference to the nature or character of the property and not to its grade or quality. One kind or class of property may not, under that section, be exchanged for property of a different kind or class. The fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class. Unproductive real estate held by one other than a dealer for future use or future realization of the increment in value is held for investment and not primarily for sale."
The ruling makes a clear analytical progression from fee to easement supported by regulations and rulings. "Section 1.1031(a)-1(c) of the regulations, as an example, provides that no gain or loss is recognized if a taxpayer who is not a dealer in real estate exchanges city real estate for a ranch or farm, or exchanges a leasehold of a fee with 30 years or more to run for real estate, or exchanges improved real estate for unimproved real estate. Rev. Rul. 55-749, 1955-2 C.B. 295 holds that where, under applicable state law, water rights are considered real property rights, the exchange of perpetual water rights for a fee interest in land constitutes a nontaxable exchange of property of like kind within the meaning of § 1031(a). Rev. Rul. 72-549, 1972-2 C.B. 472, holds that an easement and right-of-way, which were permanent, granted to an electric power company, were properties of like kind with real property with nominal improvements and real property improved with an apartment building."
Under these citations, the spectrum of lesser real estate interests that are considered by the Service to be like kind with fee interests in real estate is very broad. These revenue rulings acknowledge that perpetual easements in the form of water rights and right-of-ways are of the same kind or class of property as fee interests in real estate. The conservation easement in this ruling is also an easement. Under the cited state law, it is a perpetual interest in real estate like a fee. The ruling concludes that "based upon the above authorities and the facts and representations submitted, and assuming the proposed PCE is, by virtue of state law, an interest in real property, Taxpayers’ exchange of a PCE in real property, under § 1031(a), for a fee interest in other real estate that is also subject to a PCE will qualify as a tax deferred exchange of like-kind property, provided that the properties are held for productive use in a trade or business or for investment."
The North Carolina Legislature adopted the Historic Preservation and Conservation Agreements Act in 1979. The Act is set out in NCGS Sec. 121-34, 3t seq. NCGS Sec. 121-38 provides for the validity of these agreements as follows;
"(a) No conservation or preservation agreement shall be unenforceable because of
(1) Lack of privity of estate or contract, or
(2) Lack of benefit to particular land or person, or
(3) The assignability of the benefit to another holder as defined in this Article.
(b) Such agreements are interests in land and may be acquired by any holder in the same manner as it may acquire other interests in land.
(c) Such agreements may be effective perpetually or for shorter stipulated periods of time.
(d) Such agreements may impose present, future, or continuing obligations on either party to the agreement, or their successors, in furtherance of the purposes of the agreement."
Conservation agreements that are created pursuant to this Act, and that are perpetual, should comply with the requirements of the Letter Ruling. Easements that are not perpetual run the risk of being disallowed. The court in Wiechens v. U.S., 2002 WL 31387470 (D.Ariz.) ruled that a transfer of water rights that are not perpetual and are subject to priority limitations in exchange for a fee interest in land does not satisfy the "like properties" requirement of Section 1031. The 30-year term interests that have been ruled as qualifying have also been possessory or in some way dispossessory. While not articulated as a distinguishing factor, it seems to be a logical inference that possession (or dispossession) may be significant in qualifying term interests. Since conservation easements are typically not possessory, it may not be unlikely that the Service would find term agreements too limited to qualify in an exchange for a fee interest even if they extend for more than thirty years.
It should be noted that counties are authorized to purchase agricultural conservation easements pursuant to NCGS Sec. 106-744. This provision makes no statement that they are "interests in land" except that they are negative easements in gross. The statute references NCGS Sec. 106-737 that, in turn, references NCGS Sec. 121-35. It can be argued that the convoluted references include the provisions. It would seem advisable to make specific reference to NCGS Sec. 121-38 in any instruments prepared in anticipation of receiving favorable Sec. 1031 treatment. Conveyances under the Wetlands Restoration Program NCGS Sec. 143-214.8, et seq. and soil and water conservation easements authorized under NCGS Sec. 113A-235 would benefit from inclusion of a reference to Chapter 121 as well.
Our Federal and State Governments have clearly evidenced a public policy position in favor of conservation easements by the extensive legislation and favorable tax treatment adopted in support of these programs. It would seem that as long as the bundle of rights that a landowner foregoes in creating these easements is substantial, the Service should be inclined to interpret them as qualifying for favorable Sec. 1031 treatment.