Calculating The Exclusion

The estate may exclude from taxation up to 40% of the restricted land's value-subject to the $500,000 maximum-even if the easement was donated before passage of the 1997 law that created the estate tax exclusion. In some cases, however, the exclusion percentage will be less than the 40% max. The easement must reduce the land's value by at least 30%, as of the date of the gift, to be eligible for the full 40%, says estate planning attorney David A. Handler, with Kirkland & Ellis in Chicago. When the land value falls by less than 30%, each percentage point under that threshold reduces the exclusion percentage by two points. For example, an easement that lowers the land value by 22% (eight percentage points less than 30%) decreases the applicable exclusion percentage by 16 points (eight times two), from 40% to 24%, Handler says.

The exclusion percentage is applied to land value only, not the worth of structures. At estate tax time, therefore, the value of the land (with the restriction on it) and the value of any improvements are appraised separately, with the exclusion percentage applied only to the land value. Moreover, any mortgage on the property at date of death reduces the amount eligible for exclusion. If the land is worth $1 million but subject to a $250,000 mortgage, only $750,000 is eligible for the exclusion percentage, Handler says. Another subtraction: the value of retained development rights. Small says, "If the client has a farm with a principal residence and barn, and under the easement he reserves the right to have two more house lots, the value of those lots needs to be appraised out. Those retained development rights are not eligible for the exclusion." (The appraised values of the residence and barn are also ineligible.)

Small notes that when the exclusion is elected, the land does not get full step-up in basis. But for families intending to hold their property, this is not an issue, he says.

Planning Dilemma

Is it better to donate a conservation easement during life or after death? Either way, you get the estate tax exclusion, but there are added benefits for doing it while alive, which is what experts typically recommend. For one thing, a lifetime easement donation makes the client's preservation objectives settled business.

Then there's the income tax deduction: a charitable contribution, equal to the difference in the property's appraised market value before and after the easement, limited to 30% of adjusted gross income, with five-year carryforward. "So you've got six tax years to work off the deduction," says The Trustees' Ward. Unlike the estate tax exclusion, the income tax deduction does not require the client to have owned the property for three years.

Therefore, conveying an easement during life on recently acquired property virtually guarantees a federal tax benefit, whereas doing it through the will does not. A few states (notably Virginia, Colorado and North Carolina) offer easement donors a generous income tax credit to boot. Further, a lifetime easement facilitates a program of gifting property interests. The reduced land value, post-easement, means that gifts consume less of the $1 million lifetime exemption. A final advantage to a lifetime easement is that it may reduce property taxes (since the restriction lowers market value) and, concomitantly, the client's cash-flow requirements.

For those daunted by the specter of medical costs late in life, donating the easement via will may be more appropriate. "Generally I tell these clients, 'Put a conservation easement in your will. That way, you can sell the property if you need to, but if you die next week, you won't need money for a nursing home and your property will be protected, plus you'll save estate tax,'" Small says.

In the will, simply stating, "A conservation easement shall be placed on my farm," may not be sufficiently clear, Small says. "You should include in the will, or as an attachment to the will, the text of an easement that works out all the details. That makes it easier for the estate, the donee organization and