07 Nov Use a Conservation Easement Donation to Create a $63,000 199A Deduction

Posted at 00:53h in Taxes by

Does your out-of-favor specified service business give you a zero Section 199A tax deduction because your taxable income is more than¹

  • $415,000 on a joint return or
  • $207,500 on all other returns?

Whether or not you have an out-of-favor business, you qualify for the full 20 percent Section 199A deduction if your taxable income is equal to or less than²

  • $315,000 on a joint return or
  • $157,500 on all other

Example. You are in an out-of-favor specified service business, as we explain in New IRS 199A Regulations Benefit Out-of-Favor Service Businesses. You are married and have taxable income after itemized deductions of $600,000.

You invest $120,000 in a qualified conservation easement that produces a charitable tax deduction of

$285,000. Now your taxable income is $315,000 and your 20 percent Section 199A tax deduction is $63,000.

Observations

You likely noticed that you invested $120,000 to create a $285,000 tax deduction. Here’s why that can work: When you donate a conservation easement to a qualified charity or government entity, you deduct “fair market value,” not the amount you paid for the property.

To measure fair market value of a conservation easement, you generally compare the fair market value of the property before and after the granting of the easement.³ The deduction for the fair market value is what makes the $120,000 investment produce a $285,000 tax deduction.

To put this in context, think of a charitable donation of publicly traded stock. Say you paid $1,000 for the stock several years ago and now donate it to a qualified charity when it trades on the stock exchange for $25,000. You have a $25,000 tax deduction. 4

Conservation Easement 101

Lawmakers created a provision in the tax law allowing property owners to donate their development rights in property in exchange for a calculated fair market value charitable contribution deduction. 5

The conservation easement is a land-preservation agreement between a landowner and a qualified land protection organization. The conservation easement is recorded on the property’s deed, which provides for permanent preservation of the property through a development restriction.

To qualify for the tax deduction, the conservation easement must be exclusively for conservation purposes, which include 6

  • preservation of the land areas for outdoor recreation by or for the education of the general public;
  • and will yield a significant public benefit; or protection of a relatively natural habitat of fish, wildlife, or plants or a similar ecosystem; preservation of open space (including farmland and forest land) where the preservation is for the scenic enjoyment of the general public or pursuant to a governmental conservation policy
  • preservation of a historically important land area or a certified historic

The conservation easement terms can include reservation of certain rights, provided they don’t impair the conservation purposes. These can include recreation, hunting, timbering, and traditional agricultural uses.

The law limits your conservation easement charitable deduction to 50 percent of your adjusted gross income, but you can carry forward any unused amounts for up to 15 years. 7

Your Options

You generally have three ways to get your conservation easement charitable deduction:

  • You live in a historic district and donate the rights to alter the building façade to a qualified organization. 8
  • You own a parcel of land and donate the development rights to that land to a qualified organization.
  • You invest in a real estate partnership that acquires land and donates the development rights to that land to a qualified organization.

For the real estate partnership strategy, you don’t need the land or the building, you simply need the cash to invest. It works like this:

  1. You invest cash in a partnership.
  2. The partnership buys property.
  3. The partnership donates the property’s development rights.
  4. The partnership passes the conservation easement charitable deduction to the partners on their Schedule K-1s

Many reputable firms and conservation organizations facilitate these real estate partnerships so that investors can use their cash to both

  • help preserve open space and
  • gain a tax benefit from doing

 

Example

 Let’s walk through an example where the conservation easement strategy has a great outcome. Paul and Sarah, a married couple, will have the following items on their 2018 tax return:

Paul is an attorney with an S corporation. His reasonable compensation wage is $150,000 with pass-through income of $300,000.

  • Sarah is an employee with wages of $100,000.
  • They pay $30,000 in state and local taxes as well as $20,000 in mortgage

Since Paul is an attorney (an out-of-favor specified service business), married, and will have taxable income above $415,000, he will lose his Section 199A deduction in full.

Based on this information and before they implement their conservation easement strategy, their total federal tax is $133,379, as shown below.

Wages – Sarah $100,000
Wages – Paul $150,000
Pass-Through Income $300,000
Total Income $550,000
Adjusted Gross Income $550,000
Itemized Deductions $30,000
Tentative Taxable Income $520,000
Section 199A Deduction $0
Taxable Income $520,000
Tax $133,379
AMT $0
Total Income Tax $133,379

Assume Paul and Sarah invest $50,000 cash in a conservation partnership and will receive a pass-through $220,000 conservation easement charitable deduction in 2018.

The conservation easement deduction reduces their total tax to $46,179, as shown below.

Wages – Sarah $100,000
Wages – Paul $150,000
Pass-Through Income $300,000
Total Income $550,000
Adjusted Gross Income $550,000
Itemized Deductions $250,000

 

Tentative Taxable Income $300,000
Section 199A Deduction $60,000
Taxable Income $240,000
Tax $46,179
AMT $0
Total Income Tax $46,179

 

Let’s summarize Paul and Sarah’s results from the conservation easement strategy:

  • 100 percent restoration of their Section 199A deduction
  • $87,200 total federal tax savings (cash in their pockets)
  • 74.4% return on investment  9

 

Don’t Forget State Taxes

If your state provides a deduction for your conservation easement charitable contribution, then you’ll have an even better outcome and a much higher return on investment.

Let’s assume Paul and Sarah live in Montgomery County, Maryland, which allows the deduction:

  • They’ll have a state income tax reduction of $19,690. 10
  • Their return on investment will increase to 113.8%  11

 

Compliance Issues

The IRS recently made the use of a real estate partnership to facilitate a conservation easement charitable deduction a listed transaction in certain circumstances.12 This requires:

  • Filing of Form 8886, Reportable Transaction Disclosure Statement with the tax
  • Full disclosure of the transaction details on the tax return.

You’re probably concerned now that there’s something wrong with this strategy because the IRS appears to be targeting it. Don’t worry—the strategy is sound if properly administered. Certain promoters were not acting properly, causing some taxpayers to ultimately lose the deduction or get a substantially reduced deduction upon examination or litigation.

Key Point. Work only with reputable organizations that have a history of successful and legally proper conservation easement donations.

Takeaways

If you are in one of the out-of-favor specified service businesses, don’t just give away your Section 199A pass- through deduction.

Take it back and get a huge tax reduction with a conservation easement charitable donation. You can get your deduction by

  • donating the development rights to land you own to a qualified organization,
  • donating the rights to alter your building façade to a qualified organization, or
  • investing in a real estate partnership that acquires land and donates the development rights to that land to a qualified organization.

And remember, if you work with a third party to facilitate your conservation easement donation, be sure that third-party follows the law to the letter and that you are working only with a third party that has a solid track record in successful easement donations.

Footnotes:

  1. IRC Section 199A(d)(3).
  2. Ibid.
  3. Reg. Section 1.170A-14(h)(3).
  4. IRC Section 170(b).
  5. IRC Section 170(h).
  6. IRC Section 170(h)(4).
  7. IRC Section 170(b)(1)(E).
  8. IRC Section 170(h)(4)(B).
  9. The return on investment is $37,200 ($87,200 less $50,000 investment), and the return on investment percentage is 4% ($37,200 return over $50,000 investment).
  10. Assumes 5.75% state income tax rate and 3.2% local income tax rate on the $220,000 conservation easement charitable deduction.
  11. The return on investment is $56,890 ($106,890 less $50,000 investment), and the return on investment percentage is 8% ($56,890 return over $50,000 investment).
  12. IRS Notice 2017-10. The notice states that a listed transaction occurs when an investor receives promotional materials that offer prospective investors in a pass-through entity the possibility of a charitable contribution deduction that equals or exceeds an amount that is two and one-half times the amount of the investor’s investment—that’s 250