To private landowners, participation in the Forest Service’s Forest Legacy Program can be an opportunity to do good by conserving forest lands in perpetuity – and to do well through a variety of lucrative benefits.
In the case of the Kealakekua Ranch easement, assuming that the roughly $30 million appraised value of the easement is confirmed by an independent appraisal done by the state, the total benefits could approach $31 million. They include:
- $4 million total direct payment to the Pace family from the federal government;
- Up to $25 million as a deduction against future federal tax liability.
- A tax write-off for the value of the 25 percent “match” required for the federal payment ($1.334 million).
Finally, although it is not directly linked to the Forest Legacy program, the owners will benefit from long-term cost sharing in managing the forested areas through the state Department of Land and Natural Resources’ Forest Stewardship Partnership program; for the first 10 years of the 30-year plan, this will amount to $750,000.
Other benefits are more difficult to quantify but just as real. Logging is not only allowed under the Forest Legacy easement proposed for the ranch, it is anticipated. The management plan submitted for matching funds to the Forest Stewardship Partnership program calls for timber production and livestock management, among other things. Both activities may be expected to bring additional income to the ranch owners. A “conservation land use plan” for the ranch submitted to the Hawai`i County Planning Department shows a “mauka lodge” near the upper ranch border and an area designated for “upland hunting.” An equestrian trail is planned to run from the makai border up to the 6,000-foot elevation.
Intangible benefits accrue, as well. According to one source, the ranch was initially purchased to protect neighboring land held by the Paces from encroaching development that would occur under the full build-out scenario anticipated in zoning approvals given more than a decade ago. As it stands, the Paces will be able to ensure that their house is well screened from the riff-raff that may build on the 98 lots they can still subdivide on the ranch property. (Those lots, ranging in size from 5 to 40 acres, are anticipated in the appraisal to sell for $420,000 and up.)
For the last four years, the Internal Revenue Service has been giving extra scrutiny to conservation easements, which have often been subject to abuse. Inflated appraisals, exclusive benefits to donors, easements of questionable value – all have been cited by IRS officials in explaining their efforts to crack down on such abuses.
In a talk to administrators of land trusts last year, Steven Miller, IRS commissioner for tax exempt and government entities, told the administrators of nonprofit organizations and government agencies receiving such easements that they, too, had a role to play in eliminating abusive practices. For tax purposes, the receiving organizations (including, in the case of the Kealakekua easement, the state of Hawai`i) have to give the donor a form acknowledging the gift, and while the donor assumes responsibility for assigning value, Miller urged them not to sign off on what are obviously inflated assessments of an easement’s worth. “I hear all the time that I should not hold charities and the recipients of easements accountable for the misconduct of their donors, but I must,” Miller said. “Charities and recipients cannot sit idly by while donors poison the charitable environment. A donor’s aggressive acts bring discredit to all involved… If you perceive that there is something out of whack with a transaction, if it does not pass the smell test, if it is not fairly valued, walk away.”
Greg Hendrickson, the attorney who is the architect behind the Kealakekua easement, is one of the top practitioners in his field and is no doubt more than able to defend its particulars to any IRS auditor. He has been working nearly full-time for the ranch owners since shortly after they acquired the property, although he retains an affiliation with the San Francisco law firm of Coblentz, Patch, Duffy & Bass, whose web site describes his work as “advising business, individuals, and tax-exempt organizations in land conservation, estate planning, and the income, gift, and estate tax implications of complex transactions.”
The Pace family’s “preliminary valuation” appraisal in 2005 suggests that the gross income from developing the land remaining after the easement is conveyed will come to $52 million over the next 10 years, offset by roughly $30 million in development and associated costs. With the tax liability diminished by the carry-over tax credits stemming from the “donated” value of the easement, that would mean that the income tax on anticipated profit of $21,682,503 from sales of subdivided land called out in the appraisal could be substantially reduced. If the value of the deduction exceeds the tax obligation in a given year, the remainder of the deduction can be carried over for up to 15 years. State tax obligations are similarly reduced.
In a phone interview, Hendrickson stated that the tax consequences did not drive the design of the easement. “There’s no way they can take advantage of a $30 million tax deduction at this point,” he said. “It would require $90 million in gross income, and that’s never been achieved in the history of their company.”
The Appraisal
For the deal to go through, the state must obtain an independent appraisal of the property that confirms the value of the easement is at least $5.334 million (the $4 million from the Forest Service plus the $1.334 donation of the remaining value by the landowner).
The appraisal done in 2005 for Kealakekua Ranch concluded that the “inferred value” of the conservation easement came to $30,750,000 – this for just an easement over a 8,457-acre portion of 11,500 acres that was sold in fee simple a year earlier for $11,500,000.
The high value of the initial appraisal seemed to have been a concern for Sheri Mann, who heads up the Forest Legacy program for the state. In an email to another staffer at the Department of Land and Natural Resources last May, Mann wrote, “The issue I am most interested [in] at the moment is the appraisal. The landowner (Pace family) just had a[n] … appraisal done … and it is well over $50m.” (Actually, the appraisal came in at $44 million before the easement, and $13.25 million after, but Mann had not yet seen it and was apparently relying on second-hand accounts of the results.)
“The landowner,” Mann continued, “is worried that our request for an appraisal … will be so much lower…. The landowner is much more interested in the tax benefits from the land donation than the $2 m for the actual [first] easement.”
Appraisals for the Forest Legacy program have to follow the guidance set forth in the “Yellow Book” (Uniform Appraisal Standards for Federal Land Acquisitions). The 2005 appraisal, called a “preliminary valuation” of the easement, was based on the Yellow Book guidelines, according to the cover letter to Hendrickson from the Honolulu-based Hallstrom Group. The easement’s value was “estimated through inference” by subtracting the value of the property after the easement from the property’s value before.
The appraisal assumes that all the entitlements for development included in the 1995 and 1998 Hawai`i County ordinances are still in place. Yet, with the 2003 deadline for compliance with ordinance terms and conditions having come and gone, the current status of the zoning is, as Planning Director Chris Yuen says, “in limbo.”
Aside from that, whether the “preliminary valuation” can withstand a more rigorous, thorough appraisal (with comparable sales called out, among other things) remains an open question. Also, how different would it be if the development rights in the rezoning ordinance on which the Hallstrom valuation was based were no longer in effect?
Hendrickson said that without the zoning allowed in the 1998 ordinance, the appraised value would probably be somewhat less. If the zoning were to revert to Ag-20 (minimum 20-acre agricultural lots) throughout the entire 11,500 acres of the ranch, “you’d have 575 units. I think the values would go down,.. [but] I don’t think they would go remarkably down. We’re doing something very similar next door [at Hokukano Ranch], an Ag-20 subdivision. And we have made a couple of sales on Hokukano Ranch in the upper elevation, large acreage sales. This year we made one in January and the value was $10,000 per acre. At Kealakekua, $10,000 per acre on 11,490 acres would be $114.9 million.” In a bulk sale, he said, the value of the ranch could easily reach $50 million at this point in time.
“It’s not out of the range of reasonable,” he said, “but we haven’t tested the market on that.”
In any event, “that preliminary appraisal was done to give us an idea,” Hendrickson added, and when the final appraisal is done, it will be “more cautious,” he said. Appraisers who do inflate values face harsh penalties by the IRS, he noted: “There’s been a lot of attention to appraisals lately, and appraisers over the last four or five years have become much more conservative in the way they approach these easements. That’s good.”
Quid Pro Quo?
One of the elements of any easement that the IRS considers in deciding whether it qualifies as a tax deduction is the “quid pro quo” rule. One national expert in the tax laws relating to conservation easements is Boston attorney Stephen Small, who, in a 2004 article, addressed this issue.
Suppose, Small writes, a developer approaches a town “with a plan to put houses on the eastern half of the 100 acres the developer owns and the zoning board says, ‘We will let you do that, but as a condition of approval we are going to require that you put a conservation easement on the western half of your 100 acres.’ That is an exaction by the zoning board, and the conveyance of the conservation easement is neither charitable nor deductible because it is required.”
In the case of the upper 8,100 acres of the proposed Kealakekua easement, one could argue that the case Small describes fits it to a T. As a condition of the rezoning, no development could occur on those acres for a minimum of 40 years.
Hendrickson notes that the Forest Legacy easement will be perpetual, as opposed to the 40-year moratorium on development called out in the county zoning ordinance. Yet the value of a perpetual easement over lands that can be used for limited purposes for 40 years or longer can’t amount to too much.
The high value of the easement, then, is to be found a little in the additional restrictions on the 8,100 acres of mauka lands – and a lot on the landowner’s giving up rights to develop several hundred house lots. But was it ever the landowner’s intention to develop these lots in the first place?
Until the Paces acquired the land, the previous owners were diligent in complying with the conditions of rezoning, filing annual reports and even requesting, in 2003, a one-year administrative time extension to secure a water source and develop a forest management plan. (The extension was not given.) Since the Paces took ownership, compliance has flagged – to the point the rezoning may no longer be valid.
If the landowners did not intend to develop the land to the full extent allowed by the zoning in the first place, then any appraisal based on full build-out could be suspect. In 2005, the congressional Joint Committee on Taxation noted that “at least one court … has examined the subjective intentions of the contributing taxpayer” in determining that the full fair-market value of the land at its highest and best use was not the appropriate standard for assessing the value of the easement. In a footnote, the committee notes that in McLennan v. U.S., 24 Cl. Ct. 102 (1991), the court found that “although the property could be subdivided into eight parcels, the taxpayer’s ‘strong aversion to development’ meant that a valuation based on an assumption of subdividing the entire property was ‘untenable’ and ‘directly contradicts [taxpayers’] clear intention to preserve their land from development.” “[T]he reasonable and probable use of the property was as an undivided country estate, not as a subdivision,” the court determined, and the easement did not impede this use.
Given the statement of one of the landowner’s agents that the property was purchased with the specific intention of preventing the development of the land in accordance with the rezoning ordinance, the easement’s value could well be diminished in light of this court ruling.
Hendrickson was asked about this. “The landowners wanted to come up with something different than what was entitled there,” he said. “If the alternative had not been developed for them, they would have done what they needed to do to get the property to return to them whatever sum they needed in order to pay off the debt and to satisfy non-resident family members.”
“They knew that what was proposed [in the rezoning] was not entirely consistent with their ethic and were looking for an alternative, but they didn’t know what that alternative could be…. My hope and thought would be, yeah, they didn’t intend to develop it, but it may be saying too much to assume that. I can’t say that that’s their intention right now.”
Disproportionate Benefits
The growing popularity of conservation easements occurred with little public fanfare until The Washington Post published in 2003 a series that put a cloud over many of the land deals entered into by The Nature Conservancy. The fallout from that series resulted in the IRS issuing a notice in July 2004 that spelled out its concerns with the practice. One of those dealt with disproportionate benefits to the owners from such easements: “If the donor (or a related person) reasonably can expect to receive financial or economic benefits greater than those that will inure to the general public … no deduction is allowable…. If the donation of a conservation easement has no material effect on the value of real property, or enhances rather than reduces the value of real property, no deduction is allowable.”
Small, the Boston tax attorney, points out that IRS rules say that when property values are enhanced by an easement, that needs to be factored into the appraisal. He explains, “When a landowner donates a conservation easement and as a result there is an increase in the value of any other land … owned by the landowner, the landowner’s family, or a ‘related party’ (broadly defined to include certain partners and partnerships, corporations and shareholders, trusts and beneficiaries, and so on), the value of the deduction is reduced by any such increase in value to such other property.”
The Paces own adjoining land. Will its value increase by virtue of the enhanced “view-shed,” to use their architect’s phrase, that they can expect as a result of the easement?
“Absolutely,” Hendrickson said, although he denied that the Paces would be able to view any of the lands under easement from their house. “A ridge runs between Hokukano and Kealakekua ranches, so it’s not a visual enhancement that occurs – just the knowledge that the open space is there.” In any case, he added, “the enhancement already occurred under the ordinance.” Under tax laws, he noted, “the appraiser is required by regulations .. to evaluate enhancement elements” on adjoining lands, and take those into account in the final appraisal.
— Teresa Dawson
Volume 18, Number 7 — November 2007
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