How Easements Work: A Hypothetical Example
Mr. and Mrs. Smith were both in their sixties and had a 2,500 acre ranch in southeastern Colorado. The ranch was worth approximately $2,000 per acre. The overall value of the ranch was $5 million in 2007. The Smiths also had $500,000 in the bank. After seriously considering a number of estate planning options, the conservation-minded couple decided to place their ranch under conservation easement in 2008 and 2009. The conservation easement reduced the value of the ranch by 50% (the ranch was worth $2.5 million after the easement).
In 2015, the Smiths both passed away. They were survived by two children. Between 2008 and 2013, the couple earned approximately $80,000 per year from their ranching activities. Here is how the conservation easement: 1) benefited the Smiths while they were alive and 2) benefited their children after they passed away...
Federal Income Tax Implications
Remember that the Smiths reduced value of their property by $2.5 million dollars after placing a conservation easement on the ranch. They were able to claim this property value reduction as a $2.5 million charitable contribution for income tax purposes.
While Mr. and Mrs. Smith were alive, they had an adjusted gross income (AGI) of $80,000. The Smiths were allowed to take a charitable deduction of up to 30% of their AGI in the year they made the charitable contribution ($80,000 x 30% = $24,000) and each of the five following years ($24,000 x 6 years = $144,000). (NOTE: Congress passed a federal income tax incentive for conservation easement donations that raises the deduction a donor can take for donating a conservation easement from 30% of his/her AGI in any year to 50% of his/her AGI (or 100% if the person is a qualifying rancher or farmer), so long as the donation occurs prior to 2010. The incentive also extends the number of years that this deduction can be claimed from 6 to 16 years.) In the end, the Smiths were able to avoid paying income taxes on $144,000 over the course of six years.
The Bottom Line: Because Mr. and Mrs. Smith were able to claim the charitable deduction for six years, and assuming that they filed jointly and were taxed at 25%, they saved $36,000 in federal income taxes over six years ($144,000 x 25% = $36,000).
Federal Estate Tax Implications
Since the conservation easement reduced the value of the ranch by $2.5 million, only $3 million dollars remained in the estate ($2.5 million in property value + $.5 million in the bank = $3 million). To calculate the amount owed in estate taxes after the conservation easement, the Smiths’ children were able to:
- subtract $1 million from the $3 million estate ($1 million is the standard exclusion under estate tax law); and
- subtract $.5 million from the remaining $2 million in the estate ($.5 million is the easement’s Section 2031(c) estate tax exemption).
The total estate value subject to the estate tax was $1.5 million after reductions, exclusions, and exemptions. Compare $1.5 million to the $4.5 million that would have been subject to the estate tax had the Smiths not placed their ranch under conservation easement.
The Bottom Line: Taxed at 40% (which is a rough estimate of what the actual estate tax is), their heirs (the two surviving children) were responsible for $600,000 in estate taxes. Without the conservation easement, the estate would have been subject to $1.8 million in estate taxes. In other words, the Smiths avoided paying approximately $1.2 million dollars in estate taxes by granting a conservation easement on their ranch.
Colorado Income Tax Implications
Mr. and Mrs. Smith placed their entire ranch under conservation easement through two separate transactions; half of their property went under easement in 2008, and the second half went under in 2009. Both portions of the property possessed great conservation values – particularly as wildlife habitat and open space.
Once again, remember that the Smiths reduced the value of the property by $2.5 million dollars by placing a conservation easement on the ranch. This property value reduction was a $2.5 million charitable contribution for income tax purposes.
Unlike the federal government, which offered an income tax deduction for the charitable contribution of the conservation easement, Colorado offered an income tax credit for the charitable contribution of the value of the conservation easement. Colorado’s conservation easement income tax credit program capped the maximum credit that could be received at $375,000 (based on 50% of the statutorily defined maximum $750,000 donation of land value).
As a result, the Smiths were able to claim Colorado conservation easement tax credits for both the 2008 and 2009 transactions for a total of $750,000 ($375,000 in 2008 & $375,000 in 2009). Because Colorado law also allowed credits to be transferred to third parties, Mr. and Mrs. Smith sold their credits using a tax credit broker. The Smiths sold their credits for 82% of their actual value, which was the market value of the credits.
The Bottom Line: The Smiths obtained $750,000 in tax credits over two years and sold the credits for 82% of their actual value. In the end, the couple walked away with $615,000 cash from the Colorado tax credits. They were finally able to take a family vacation, as well as implement a series of long overdue irrigation improvements on their ranch with the money. This example does not take into account income taxes/capital gains taxes that the Smiths paid on the tax credits.
Colorado Property Tax Implications
Prior to passing away, the Smiths retired the ranch. They wanted to visit family in Germany and did not want to tend to the cattle day in and day out. Mr. and Mrs. Smith sold all of their cattle at the end of the year in 2013.
Normally, the property would have been taxed as “vacant land” in 2014 and 2015, since ranching operations ceased. However, because the property was classified as “agricultural land” for tax purposes when it was placed under conservation easement, Colorado law allowed the Smiths to retain the favorable agricultural property tax status. This was true despite the fact that the property was no longer being ranched.
The Bottom Line: Mr. and Mrs. Smith were able to save thousands of dollars by retaining the agricultural tax status on their property, despite retiring it from ranching activity.
Costs of Completing a Conservation Easement Transaction
There are certain costs associated with placing a conservation easement on a property. For a complete breakdown of the costs, please refer to the costs section of this website.
Because the Smiths put their entire ranch under conservation easement in two separate transactions, they incurred transactional costs twice. Mr. and Mrs. Smith paid $40,000 to complete the 2008 transaction. Because certain costs could be avoided in the 2009 transaction (because they were already covered by elements of the 2008 transaction), the Smiths only had to pay $25,000 in 2009.
The Bottom Line: The Smiths paid $65,000 to put their entire ranch under conservation easement through two separate transactions.
A Final Look at Tax Benefits and Costs
Without the Conservation Easement: Without the conservation easement on their property, the Smiths’ ranch was worth $5 million, and they had $.5 million in the bank. Assuming that these numbers were the same when both the Smiths passed on, and that the Smiths had decided to not place an easement on their property, their estate would have been subject to approximately $1.8 million in estate taxes. In the end, the Smiths’ children would have been left with $3.7 million ($5.5 - $1.8 = $3.7 million), but they would have had to sell off a portion of the ranch to cover the estate taxes. Additionally, no irrigation improvements would have been made on the ranch.
With the Conservation Easement: With the conservation easement on their ranch, the Smiths’ property was worth $2.5 million, and they had $.5 million in the bank. Additionally, they saved $36,000 in federal income taxes, walked away with $615,000 cash that they put towards the irrigation project, maintained the favorable agricultural land tax status despite retiring the property from ranching, and only had to pay $.6 million in estate taxes (versus the $1.8 million they would have paid without the easement). To complete the easement transactions, the Smiths paid $65,000 in transaction costs.
In the end, the Smiths obtained approximately $1,850,000 in tax benefits by placing their property under conservation easement and paid $65,000 in transaction costs. Moreover, their children were able to keep the entire ranch intact because of the reduced estate tax and had an updated irrigation system for the hayfields. Finally, the Smiths could forever ensure that their ranch, which they devoted so much of their lives to, would remain undeveloped and free from subdivision.
The Bottom Line: Conservation easements are not for every landowner. They are one tool amongst many options that can be used to reduce estate taxes (see line 3 in the table below). Because Colorado has such a strong tax credit program, a conservation easement can also be used to obtain cash without having to sell off or subdivide portions of a property (see line 5 in the table below). Essentially, a conservation easement is a viable way to keep land in the family and put some cash in a landowner’s pocket.
Disclaimer: The examples on this website are merely hypothetical situations. The values, costs, and tax benefits relating to a particular easement will vary for each landowner and each property. There is no substitute for obtaining competent legal and accounting advice from consultants experienced with conservation easements, accounting, and tax law.