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Easements and tradable tax credits: bursting bubble or self-correcting mechanism?

Amanda Hawn

With the huge growth of the land trust movement throughout the United States, the use (and misuse) of conservation easements recently has become the subject of a great deal of debate. The Ecosystem Marketplace looks at how markets in easement tax credits have fueled this controversy in ways both good and bad.

18 November 2004 | In a recent speech that he described as somewhat “confessional”, Steve McCormick, the President and CEO of The Nature Conservancy (TNC), compared the gangbusters growth of the land trust movement in the United States to that of a start-up company. “This start-up phase,” he said, “is a phenomenon of the late 20th century: a time of rapid expansion, vigorous application of conservation tools and furious pursuit of financial support, a certain zealous fervor. All the earmarks of a start-up.” Delivered as it was at the Land Trust Alliance Rally of 2003 in Northern California -the epicenter of the dot-com bubble collapse- the comparison seemed as much a cool warning as it did a warm accolade. Having just survived a firestorm of controversy at TNC surrounding the use of conservation easements – the favored tool of the land trust movement – McCormick probably intended the analogy to cut both ways. Conservation easements are legal contracts that restrict the use and development of a piece of land, usually in perpetuity. They have been used for a variety of purposes: to conserve valuable ecosystems, as well as to preserve farms and a rural way of life. During the past two decades, the growth in the use of easements across the US has, indeed, boomed like something out of the dot-com era. Land trust holdings -which use easements to accomplish their goals- have mushroomed in large part because of tax incentives encouraging landowners to donate conservation easements on their land. Congress made easement donations tax-deductible in 1976, and state revenue collectors have continued to sweeten the pot ever since. In a political climate wary of government regulation, federal and state tax incentives have become an increasingly popular means of achieving bottom-up land conservation. To be sure, these tax incentives have accomplished a great deal. At least some of the critical habitat for 95% of the nation’s threatened or endangered species is located on privately owned parcels. If biodiversity conservation is to succeed in the US, a large percentage of the work must happen on private land. And, by allowing property owners to continue to use their land while ensuring its future ecological integrity, easements have helped to protect some 6 million acres nationwide. Over 1,260 local land-trusts now work toward a variety of scientific and social aims in the United States. Among other things, land-trusts have used easements to knit together wildlife corridors, protect watersheds, and buffer national parks. Despite this success -or perhaps because of it- increased tax incentives for easement donations have also drawn sharp criticism in recent years because of some apparent abuses of the system. The federal tax incentives were originally designed to reward the good-will donations of easement donors whose primary motives were conservation related. Accordingly, the tax code defines the characteristics qualifying a conservation easement for deduction very broadly. The addition and expansion of state tax incentives in the last decade, however, has meant that today’s easement donations often are driven by finance rather than altruism. “The more an easement donation looks like a good business deal,” argues Nancy McLaughlin, a law professor at the University of Utah, “the more strain will be placed on the aspects of [the tax code] that are vulnerable to exploitation.” Any entrepreneur will tell you that growth generally arrives at the party towing a host of unforeseen consequences. As they emerge from their heady, start-up years, the trick for land trusts using conservation easements will be sorting out the good company from the bad.

A Tale of Two States

Land trusts in Colorado and Virginia, in particular, have experienced growing pains in recent years. Both states recently passed novel legislation allowing easement donors to sell their state tax credits on a secondary market. In Colorado, the credits are allocated on a dollar for dollar basis for the first $100,000 of the appraised value of an easement and on a 40 cents to the dollar basis for every dollar thereafter, up to a cap of $500,000. This provides for a maximum income-tax credit of $260,000 per easement donation. While donors are permitted to carry-over unused credits for up to 20 years, it often makes more economic sense to sell credits that cannot be used within a year or two in order to avoid devaluation. “The purpose of the transferability,” explains Russ Shay, Director of Public Policy at the Land Trust Alliance, “was to allow cash-poor donors to participate.” Colorado taxes its residents’ income at a rate of 4.63%, so a donor would need to have an income of roughly 5.5 million dollars in order to use $260,000 worth of credits in a single year. The legislation in Virginia was driven by similar concerns but was structured slightly differently. In Virginia there is no cap on how many credits an easement donor may earn per easement – the state awards credits on a basis of 50 cents to the dollar for every dollar of an easement’s appraised value. Thus, an easement with an appraised value of $24 million would generate $12 million in state tax credits. Unlike Colorado, however (where high-income earners are free to purchase and redeem as many easement credits as they like), tax payers in Virginia can only pay up to $100,000 of their income taxes with credits in any given year. The respective placement of the cap within each of the systems has meant that the credit market in Colorado (where credit supply is limited, but buyer demand is not) has been less volatile than the one in Virginia (where credit supply is not limited, but buyer demand is). In Virginia, donors sell tax-credits to investors for prices that range from 23 cents on the dollar all the way up to 80 cents on the dollar. In Colorado, on the other hand, the market has stabilized at around 80 cents on the dollar. Despite their differences, both transferability systems have generated significant increases in easement donations. Virginia’s Department of Taxation, for instance, reports that properties with a fiscal monetary value of $22.3 million were put under conservation easements in the two years prior to the state’s 2002 transferability legislation. These easements earned a total of $7.6 million in Land Preservation Credits (LPC) for their donors. By contrast, $187.3 million in easements were registered for the program in the two years since the law’s enactment, earning $93.6 million in tax credits; a growth of over 800% in the value of easement donations and over 1200% in the value of the tax credits. “The increase in easements in Virginia certainly corresponds with the change in law allowing sales and transfers of LPCs from 2002 onward,” says Robert Schultz, the tax commissioner in charge of compliance for the state. Similarly, land trust officials estimate that the number of easement donations has tripled in Colorado since the state’s tax credits became easily transferable in 2001. Mike Strugar, who founded Colorado’s Tax Credit Exchange, says he has seen the number of credits changing hands skyrocket during the past three years. In 2001, the non-profit Tax Credit Exchange handled $700,000 in transactions. Last year, the brokerage handled $14.5 million in transactions, and six other for-profit brokerage firms -which had opened their doors in the interim- did another $14 to $15 million worth of business. Based on value and acreage conserved, transferable tax credits seem to be an incredibly effective incentive for easement donors. Experts warn, however, that the land trust movement must move beyond measuring success solely in terms of land and lucre. That, unfortunately, may prove a tall order for reasons scientific, economic and legal.

Bumps in the Road

On the scientific side, a recent study in the journal Conservation Biology argued that legal arrangements pertaining to land easements are evolving so rapidly, that it is difficult to assess their conservation accomplishments and long-term viability. “We do not know if the new organizations [created to manage these easements] will last and hold down their end of the deal and we do not know if the prescriptions in the easements are the optimal ones for achieving the stated goals,” says Sally Fairfax, one of the study’s authors. “I am sure that some donated easements will be very valuable and some a complete wash.” To address these sorts of problems, and to remedy the lack of a cohesive framework for measuring its conservation success, The Nature Conservancy recently rolled out a series of science-based criteria for use around the country. Following their lead, the Land Trust Alliance says it, too, is developing a strategic plan that will provide an integrated set of standards for its member organizations. These and other actions may help land trusts catch up scientifically with the rapidly evolving pattern of easement deals created by new tax incentives. For now, however, the jury is still out on exactly who is conserving what. The economic efficiency of transferable tax credits linked to easements is similarly up in the air. While the incentives were designed to attract land-rich, cash-poor donors like tobacco farmers in Virginia and cattle ranchers in Colorado, early feedback suggests the systems may be netting a very different kind of fish. “Since transferability became available,” says Schultz, the Virginia tax official, “we have noticed that the largest consumers of the tax credit in Virginia are real estate development companies. Prior to that time, the donors were generally owners of farm property.” He adds that the state is “concerned that real estate developers, in concert with unethical appraisers, are using the LPC program to promote abusive tax shelter schemes.” While it should not matter from an economic or scientific standpoint whether an easement donor is a little old lady named Betty or a newly solvent Donald Trump, it certainly matters to those concerned with economic efficiency if easements are being valued incorrectly. John Echeverria, Director of the Georgetown Environmental Law and Policy Institute, stresses that paying to stop unwise land use is expensive no matter how you do it. But, as is self evident, paying premium rates (via tax credits) to a developer who wants to intersperse conservation with McMansions, may not be the most efficient use of public money. It certainly does not help the state achieve its conservation priorities. And, while the use of tax credits makes a financial burden less visible, it does not eliminate it. Furthermore, if easement values are inflated consistently, the financial burden on the state may simply prove too great for the tax system to bear. “The valuation of slivers of property is just incredibly difficult to do,” says Echeverria, “and so the potential – if not for abuse, at least for gross error – is huge. Every property is different and so is every conservation easement. The comparables are almost impossible to identify.” McLaughlin, from the University of Utah, is somewhat more optimistic. She points out that as easements mature and properties encumbered by them begin to change hands, sales data from these transactions will generate a frame of reference for future appraisals. McLaughlin argues that increased sales data-coupled with tax authorities’ adoption and enforcement of easement appraisal standards-would greatly increase the reliability and consistency of easement appraisals. The financial difficulties surrounding valuations also give rise to a number of enforcement issues. The IRS only looks at some 2% of the returns it processes, so the likelihood that cheats will slip through the cracks is extremely high. Similar problems exist at the state level. “Tax authorities are not always willing to do something about tax shelters,” says an official at the Land Trust Alliance, “so it is difficult.” That, too, may be changing. The IRS announced earlier this summer that it would be cracking down on charitable deductions associated with land and easement gifts throughout the U.S. Likewise, the Department of Taxation in Virginia says it has hired independent appraisers to determine appropriate valuations on the easements it credits. At the point of valuation and beyond, those in the land trust business have realized that, unless conservation easements are monitored and enforced by a stronger network of practices, they may deteriorate into an expensive artifact of poor public policy. To give but one example: In 1998 a court battle to uphold a single easement near Philadelphia cost a local land trust nine-years and roughly $100,000. Fights requiring so much time and money are an especially troubling portent for the many local trusts facing strict budget and staffing constraints. Since 1990 the number of local land trusts in the United States has multiplied five-fold, but a survey recently published by the Land Trust Alliance reported that half of them operate on volunteer staff and budgets of less than $27,000 a year. As the burdens of easements are passed to subsequent landowners who may be less committed in their conservation aims, social and legal challenges to the validity of land easements are likely to multiply. If easements are to survive, new enforcement mechanisms will need to grow with their use.

An Interesting Twist

In fact, such growth may already be happening, and it may be coming from a somewhat unexpected source: the markets themselves. The Colorado Tax Credit Exchange, which has transferred over $18 million worth of easement credits in the last four years, says it reviews the valuations and legal contracts behind every deal it facilitates. In an increasingly competitive marketplace – 14 credit brokerages now exist in Colorado – managers of the Exchange believe it is in their own best interest to ensure that every deal they broker is squeaky clean in the eyes of a newly watchful revenue service. “The result,” says Strugar, “is that many more eyes are scrutinizing these deals than before the credits became transferable.” “In general, I think the facilitators are raising the standards,” says McLaughlin. Of the three hundred transactions he has reviewed in the past year, Strugar says he initially refused to process 40% of them because of contractual and appraisal problems. But, he notes, 90% of the deals he kicked back were subsequently completed after the problems were fixed. “When I compare what I see now to what I saw two years ago,” he adds, “the appraisals I see now are much better.” The idea that the very problem potentially created by transferable tax credits – a loosely monitored network of sloppy legal deals driven by greed – could be fixed by the brokers who peddle them, is an interesting one. While some wonder whether for-profit exchanges will truly be inclined to quell deal-fever rather than stoke it (brokers generally make 5 cents per credit dollar traded), there is some evidence that for-profit brokers might be driven to filter out bad easement deals by the buyers’ requirements for cleaner deals and tax certainty. Easements, in short, may be witnessing the kind of curious plot twist that only markets can author: transferable tax credits appear to be solving some of the very problems they have helped to create. Adam Smith’s invisible hand may yet help to moderate, if not burst, this particular bubble. Amanda Hawn is a regular contributor to The Ecosystem Marketplace. She is an evolutionary biologist and science writer currently living in Minneapolis. She has written about science and the environment for a variety of publications including The Economist, Sierra Magazine, and others.

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