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Estate Planning – Conservation Easement Example

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Chapter Nine in A Tax Guide to Conservation Easements by C. Timothy Lindstrom published by Island Press

The primary object of most estate planning efforts is to reduce the size of the taxable estate. There are a number of means of doing this. Conservation easements can dramatically reduce a landowner’s taxable estate. Of course, this is accomplished by permanently removing value from the easement land. For some families, this is anathema because eventually liquidating land that has been in the family is seen as the key to wealth and independence. For others, however, keeping family land intact is the primary objective, either for sentimental reasons or for reasons of lifestyle and livelihood.

Where the principal goal of a family is to preserve family land, conservation easements should be one of the primary tools used to achieve that goal. By reducing the value of easement land overall, conservation easements make other means of reducing the size of the taxable estate more efficient. For example, the Exclusion Amount (discussed in chapter 7) will shelter many more acres of farmland if that land has first been reduced in value by a conservation easement.

In this chapter we will take a brief look at how conservation easements may be used in concert with other planning tools to help families keep land intact. Remember, if the goal is something other than maintaining family land, conservation easements may be counterproductive. Where keeping land intact is important, easements are key.

I. Use with the Annual Gift Tax Exclusion

As noted in chapter 7, an important estate planning technique is to remove value from a future estate by making annual gifts over a period of time. The gifts can be sized to fit the annual gift tax exclusion (currently $12,000). A husband and wife may make gifts under the exclusion of $24,000 per year per donee. Thus, if a couple has four children, they can gift $96,000 (4 x $24,000) tax free. Such gifts are not subject to the gift tax, and, because they remove value from the estate, they reduce the size of the couple’s future taxable estate.

Because conservation easements reduce the value of the easement property, they can play an important role in maximizing use of the annual $12,000 gift tax exclusion. By reducing the value of the property subject to the gift, a conservation easement allows transfer of, for example, a family ranch to the children much more quickly than if the property were transferred at its unrestricted value.

In addition, the entire family gains the assurance that, regardless of how different family members may feel about using their share of the ranch, its future use and potential development will be controlled by the terms of the easement, and the easement will control each gift made thereafter.

Example: John is a widower. His son Paul works with him on the family ranch and wants to continue to do so. The value of the ranch is $5 million. Using the annual exclusion, John can transfer 0.24 percent of the value of the ranch to Paul annually ($12,000/$5,000,000). However, if John placed a conservation easement on the ranch that reduced its value to $2.5 million, he could transfer 0.48 percent annually, double the amount of land. Remember that he only needs to reduce the value of the ranch (including the rest of his estate) to the Exclusion Amount ($2 million in 2008). Even so, at the rate of $12,000 per year, it would take him over 41 years to transfer the $500,000 ($500,000/$12,000) of value necessary to reduce the estate to the $2 million Exclusion Amount (which will increase to $3.5 million in 2009). In other words, while a conservation easement can accelerate the rate of transfer, the use of the annual exclusion alone to transfer value still can take a very long time.

John’s problem of transferring an already valuable piece of land will be compounded by future appreciation in the value of the ranch. While a conservation easement will not eliminate appreciation, it will increase the amount of land john can transfer annually, thus reducing the period during which appreciation will affect John’s estate. The easement will also likely reduce the rate of appreciation.

An important question is how to actually make annual gifts of land. Because subdivision is likely to be costly – and may be prohibited by local law – family partnerships, limited liability companies, and corporations are often used to convert land into partnership interests, membership interests, or shares that can be more easily conveyed.

One of the added values of a conservation easement in connection with gifting strategies is that it ensures that future use of the land after the current owners have conveyed a majority interest to their children.

II. Use with the code Section 2032A Special Valuation Provisions

By reducing overall farm or ranch values, conservation easements can also effectively increase the amount of a farm or ranch that can pass through a decedent’s estate under the special-use valuation rules of Code section 2032A (see the discussion of this provision in chapter 7). Section 2032A is currently (in 2008) limited to reducing the value of qualified land by no more than $960,000. A conservation easement can reduce the value of land by an unlimited amount and bring the value of a family farm or ranch much closer to the $2,900,000 that can be sheltered by the combination of the special-use valuation provisions and the Exclusion Amount.

Example: John’s ranch is reduced in value from $5 million to $3.5 million by a conservation easement. Under the Exclusion Amount available in 2008, the year of John’s death, $2 million of the ranch’s value will pass free of estate tax. The exclusion available under Code section 2031(c) removes an additional $500,000, bringing the taxable estate down to $1 million ($3,500,000 – $2,000,000 – $500,000).

However, if using a conservation easement in combination with Code section 2032A, it is important to be careful not to reduce the value of a farm ranch in a decedent’s estate so that it makes up less that 50 percent of the value of the estate. Doing so would disqualify the estate for use of Code section 2032A.

III. Use with the $2 Million Exclusion Amount

Again, because a conservation easement reduces the value of property, it also allows the transfer of more land under the current $2 million Exclusion Amount.

Example: John wants his ranch to go to his son Paul. The ranch is valued at $4 million. The tax on the ranch, after subtracting the Exclusion Amount will be $900,000 ([$4,000,000 – $2,000,000] x .45). However, assume that John places a conservation easement on the ranch before he dies. The easement reduces the value of the ranch to $2 million, which is entirely sheltered by the estate tax exclusion of $2 million, making it possible for the ranch to pass to Paul estate-tax free.

IV. Value Replacement

Value replacement is an estate planning technique whereby a person converts the income tax savings resulting from a charitable donation into additional cash for her estate. This works particularly well when the income tax savings results from the contribution of a conservation easement, because such tax savings represent “new money” to the donors (as opposed to the contribution of a liquid asset, such as cash, stocks, or bonds).

Example: Assume that John and Joan are aged 51 and 43 respectively. Assume that they donate a conservation easement worth $1,800,000 and that the income tax deduction resulting from that donation saves them $738,000 in income tax. They spend $58,000 on a new car and buy a “second-to-die” life insurance policy (such a policy pay out when the surviving spouse dies, and premiums are generally lower than on a single-life policy) with the remaining $680,000 of their income tax savings. They place the policy into an inter vivos trust (a trust created during their lifetimes) for the benefit of their children and transfer all of the “incidents of ownership” to the trust.

Assume that a premium payment of $680,000 for a second-to-die policy on a couple John’s and Joan’s ages will buy approximately $12,500,000 in coverage. If the policy is properly placed in an inter vivos trust, there will be neither income tax nor estate tax on the policy proceeds. Using value replacement, John and Joan have replaced $1,800,000 in land value lost due to the conservation easement with $11,820,000 (face value of the policy less the premium) in tax-free cash payable directly to their children.

Note that investing the $680,000 in stock or mutual funds transferred to an inter vivos trust could generate substantial results, as well. There are many variations.

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