An apple a day keeps the doctor away. How many of us have repeated this old aphorism to our children or grandchildren? Yes, apples are a tried-and-true staple of the American diet, but how did the lowly apple become a folklore recipe for good health?

History tells us that the connection between apples and good health began in Wales. As early as 1866, there is reference to the rhyme, “Eat an apple on going to bed, and you’ll keep the doctor from earning his bread.”[i] The apple’s health properties have since been confirmed by science. According to the British Medical Journal, prescribing an apple a day to all adults aged 50 and over would prevent or delay around 8,500 vascular deaths from heart attacks or strokes every year in the United Kingdom.[ii] The Journal of the American Medical Association also confirmed that “the small fraction of U.S. adults who eat an apple a day do appear to use fewer prescription medications” (even though the JAMA found that apple consumption does not necessarily correspond with fewer doctor visits).[iii]

Folklore, “old saws,” and conventional wisdom are often based on fact, but it’s important to remember that they’re not always exact. Sometimes, they’re not even true. We must apply the same discernment to advice on using real estate to make charitable gifts—some is based on good law, while other advice may actually create a host of unpleasant problems.

In this issue of Options, we look at some of the issues that can cloud real estate gifts, including:

• Donations of Real Estate: The “Clean Underwear” Approach
• Misused and Misunderstood: Snake Oil and Conservation Easements

Of all the commonly heard parental warnings, one of the most humorous and perplexing is, “Always wear clean underwear in case you’re in an accident.” Sharp-witted offspring quickly realize the last thing medical providers would take notice of is underwear. Nonetheless, this admonition has persisted across generations, with many a child who was baffled by the comment eventually saying the same thing to their own children.

As with most such statements, the underlying premise is good advice—make sure you have everything in place so that even an unexpected, in-depth review will not cause a problem. While actual dirty laundry may not matter to a physician treating a patient, “dirty laundry” in the form of barriers or hurdles connected to a charitable gift of real estate can present significant issues for an individual and the designated charity. Consequently, it pays to carefully examine real estate gifts, beginning with how to make them.

Now or Later?

For many donors, the first question is whether to make a current gift of real estate or a bequest. A bequest, of course, will not be completed until the donor has died and the donor’s will has been probated. A bequest does not provide the donor with income tax savings. A current, outright gift of real estate, on the other hand, qualifies the donor for an income tax deduction based on the current fair market value of the property. The deduction, of course, is subject to annual limits based on the donor’s adjusted gross income, but any amount in excess of this limit can be carried forward for up to five subsequent years.[iv]

Appreciated Property

When considering a charitable gift involving appreciated real estate (property held for more than one year), a donor has decisions to make that may have additional tax consequences.

The donor may decide to sell the appreciated property and donate the proceeds from the sale. While straightforward, this method does not provide the most attractive tax advantages. In fact, the donor will end up paying capital gains tax on the property’s appreciation at the time of the sale, resulting in a gift that is less than the full fair market value of the property.

On the other hand, if the donor gives the real estate directly to a charity that is willing to accept the gift, the donor avoids the recognition of capital gain on the long-term appreciated property.[v]

For example, Stewart, a medical executive in the highest income tax bracket, wants to make a donation to his favorite charity. He purchased land years ago for $40,000 that is now worth $200,000. Stewart calculates that if he sells the property and donates the cash, he would receive a charitable income tax deduction for the donation, but he would have to pay capital gains tax on the property’s $160,000 appreciation. At the capital gains tax rate of 20%, that comes to $32,000 in tax, meaning his donation would only amount to $168,000. Instead, Stewart chooses to donate the appreciated land directly to the charity. By making a lifetime gift, he avoids capital gains tax while still qualifying for the full charitable income tax deduction.

A Bargain Sale

There may be occasions when a donor sells a parcel of real estate to a charity at a price that is less than the fair market value.[vi] This transaction, commonly referred to as a “bargain sale,” is actually part sale and part gift. The excess of the fair market value over the bargain sale price is treated as a charitable contribution.[vii]

Of course, all the charitable giving requirements under IRC §170 still apply to the contribution, as do the percentage limitations on deductibility. However, the donor’s basis in the appreciated property must be allocated between the gift and sale portions, as in this example.[viii]

Kris, a commercial pilot, bought a field near her college for $50,000, planning to build a house and retire there some day. Over the years, the campus expanded until it was adjacent to the still-undeveloped field. Kris decided that instead of building, she would sell the land for its current worth of $150,000. However, when she put it on the market, the school asked if she would be willing to sell the land to the school at an “alma mater” price. Kris agreed to a bargain sale to the school for $75,000. Now Kris needs to determine what portion of her basis is allocated to the sale and the gift.

Allocation of Basis

Amount Realized FMV

$ 75,000 $150,000

= .5

$50,000 Adjusted Basis

=

$25,000 Allocated Basis

This would result in:

Amount Realized	$75,000
Bargain Sale Basis (allocated)	$25,000
Gain Recognized	$25,000

Kris will recognize a gain of $25,000, but assuming she itemizes, she will also have a charitable income tax deduction of $75,000 ($150,000 FMV – $75,000 bargain sale price).

Loss Property

If a property has decreased in value, the donor should not directly donate the property. From a tax standpoint, the donor would be better served to sell the property, take the loss, and then donate the proceeds to charity.

Charitable Real Estate and Mortgages

Much of the inventory of real estate, whether held for personal use or investment, is subject to a mortgage. It is important for a donor who intends to transfer property that is subject to a mortgage to be aware of the federal tax treatment of the mortgage. In general, the amount of a charitable contribution is limited to the donor’s equity in the property. The value of the real property donated is reduced by the mortgage (or any other encumbrance) on the property. According to federal tax regulations, the mortgage in a bargain sale transaction is treated as an amount realized by the donor—even if the charity does not assume the debt or agree to pay it.[x]

If property is transferred subject to an indebtedness, the amount of the indebtedness must be treated as an amount realized for purposes of determining whether there is a sale or exchange to which section 1011(b) and this section apply, even though the transferee does not agree to assume or pay the indebtedness.

Interestingly, a taxpayer did obtain a private letter ruling on mortgage payments that were made in connection with real property given to a charity. In PLR 9329017, the taxpayer owned a farm with a $110,000 fair market value and an $80,000 outstanding mortgage. As part of a charitable gift transaction, the taxpayer would donate the farm but remain liable for the mortgage. The taxpayer also proposed to make improvements to the property. The Internal Revenue Service agreed with the taxpayer and said that the gift of a remainder interest in the farm to charity would result in a deduction equal to the present value of the charity’s future interest in the $30,000 equity.

As the mortgage was paid down in future years by the donor, this would generate additional deductions for the charity’s remainder portion of the principal payments. Likewise, if the donor made improvements to the farm, and if these improvements were treated under local law as part of the real property, then the present value of the remainder interest in such improvements would also be considered charitable gifts. (If the improvements were treated as tangible personal property under local law, they would be nondeductible as partial interests, falling outside the special exception for remainder interests in farms and personal residences.) However, the entire amount of the mortgage had to be considered in calculating the amount realized for capital gain purposes under the bargain sale rule.

Real Estate Complexities

As with most issues of tax and real estate, charitable real estate donations and bargain sales have many layers of complexity. Advisors should carefully review the donor’s tax and legal situation to determine how various laws impact the donor. Careful examination can ensure confidence that all the necessities are as “compliant” as can be.

At the turn of the century, thousands of immigrants from China came to the United States. More than a few came looking to work on the railroads and in the mines that needed a never-ending supply of workers. The Chinese brought a variety of medicines with them, including an oil from the Chinese water snake.[xi] Historians claim that this particular snake oil was very high in omega-3 acids, which made it helpful in reducing inflammation from bursitis and arthritis.[xii]

Unfortunately for consumers, men like Clark Stanley, who was called the “Rattlesnake King,” began producing snake oil allegedly made from rattlesnakes. However, when the Stanley Snake Oil was examined, the oil actually contained only beef fat, red pepper and turpentine—no actual snake oil.[xiii] Thanks to Stanley (and others like him), the term “snake oil salesman” refers to anyone who offers a “quack remedy” or fake cure. Charitable gifts of conservation easements can represent a kind of snake oil. In cases that comply with strict restrictions, these gifts are a legitimate donation. Unfortunately, taxpayers may be tempted to take liberties that abuse the system.

A conservation easement is a restriction on a portion of real estate that requires the property to be maintained in a certain condition by the charity holding the easement. The donor who itemizes may take a charitable income tax deduction for contributing a perpetual restriction on real property such as an easement or a restrictive covenant.[xiv]

A qualified real property interest for donation purposes consists of one of three interests: an entire interest in real property, a remainder interest in real property, and a perpetual conservation restriction (including an easement, a conservation restriction, a restrictive covenant or other similar state law provision). A conservation easement can only be granted to governments and publicly supported charitable organizations.[xv] Conservation purposes include public recreation or education, protection of environmental systems, and preservation of open space.[xvi]

IRS Criticism

Even though the conservation easement is a legal and widely used tool for conservation and tax planning, problems with conservation easements (both intentional and inadvertent) have resulted in taxpayers taking liberties with this arrangement. As a result, the IRS has this language on its website:

The IRS has seen abuses of this tax provision that compromise the policy Congress intended to promote. We have seen taxpayers, often encouraged by promoters and armed with questionable appraisals, take inappropriately large deductions for easements. In some cases, taxpayers claim deductions when they are not entitled to any deduction at all (for example, when taxpayers fail to comply with the law and regulations governing deductions for contributions of conservation easements). Also, taxpayers have sometimes used or developed these properties in a manner inconsistent with section 501(c)(3). In other cases, the charity has allowed property owners to modify the easement or develop the land in a manner inconsistent with the easement’s restrictions.Another problem arises in connection with historic easements, particularly façade easements. Here again, some taxpayers are taking improperly large deductions. They agree not to modify the façade of their historic house and they give an easement to this effect to a charity. However, if the façade was already subject to restrictions under local zoning ordinances, the taxpayers may, in fact, be giving up nothing, or very little. A taxpayer cannot give up a right that he or she does not have.^[xvii]

Conservation easements provide an excellent tool to protect land while providing a tax benefit. Professional advisors certainly do not want the conservation easement to have a “snake oil” reputation. Before a client makes such a gift, it is worthwhile to review the legal basics necessary to claim conservation easement tax benefits.

Elements of a Conservation Easement

A “qualified conservation contribution” is a contribution of a real property interest to a qualified organization, exclusively for conservation purposes.^[xviii] The regulations further state that a qualified real property interest is the entire interest in the real property, other than a qualified mineral interest.^[xix] The exclusion of the mineral interest does allow a donor to retain an “interest in subsurface oil, gas, or other minerals and the right of access to such minerals.”^[xx]Only a qualified organization can accept a conservation easement.[xxi] The Internal Revenue Code provides that a qualified organization includes a governmental unit or a charity or foundation that meets the Code requirements.[xxii]The Code provides a bit more information about the requirement that the conservation easement be used for conservation purposes. The term “conservation purpose” is defined as:

1. The preservation of land areas for outdoor recreation by, or the education of, the general public;
2. The protection of a relatively natural habitat of fish, wildlife, or plants, or similar ecosystem;
3. The preservation of open space (including farmland and forest land) where such preservation is (a) for the scenic enjoyment of the general public, or (b) pursuant to a clearly delineated Federal, State, or local governmental conservation policy, and will yield a significant public benefit; or
4. The preservation of a historically important land area or a certified historic structure.[xxiii]

The Code also requires that the conservation purpose “must be protected in perpetuity.”[xxiv] The IRC states “a contribution shall not be treated as exclusively for conservation purposes unless the conservation purpose is protected in perpetuity.”[xxv] As the 10th Circuit noted in Mitchell v. Commissioner, the IRC does not clearly “define or otherwise describe how a taxpayer may accomplish this statutory mandate” but did direct the IRS to promulgate rules to “ensure that a conservation purpose is protected in perpetuity.”[xxvi]

A very important requirement found in the regulations, and an issue that plays into a number of tax cases, is that the conservation easement may not be subordinate to any mortgage. The IRS position on mortgage subordination has held up in court. The 10th Circuit reviewed the issue of the subordination of a mortgage to a conservation easement in the case of Mitchell v. Commissioner.[xxvii]

In Mitchell, the plaintiffs asserted that the mortgage subordination sections do not specify a time frame and, alternately, that the plaintiff should be allowed the deduction despite the lack of subordination since the deed contained sufficient safeguards to protect the conservation easement and that the risk of foreclosure was so remote as to be negligible. The court rejected Mitchell’s argument based on a plain reading of the Code, which clearly states that no “deduction will be permitted under this section for an interest in property which is subject to a mortgage unless the mortgagee subordinates its rights in the property”^[xxviii] (emphasis in original). The court also rejected Mitchell’s alternative argument, stating “the Commissioner is entitled to demand strict compliance with the mortgage subordination provision, irrespective of the likelihood of foreclosure in any particular case.”^[xxix] The Tenth Circuit concluded “the regulations do not permit a charitable contribution deduction unless any existing mortgage on the donated property has been subordinated, irrespective of the likelihood of foreclosure.”^[xxx]

Conservation easements are a valuable tool and should not be dismissed or avoided despite the IRS’s strong comments. However, like a frontier consumer, the modern donor needs to make sure any conservation easement meets the requirements of the Internal Revenue Code and is not simply a modern version of Stanley’s fake snake oil.

Nearly everyone has heard that a person needs to drink eight glasses of water every day to be healthy. However, according to Dr. Aaron E. Carroll, the advice is not absolutely true, but is rather a misinterpretation of a 1945 recommendation that said people need 2.5 liters of water a day.[xxxi] Dr. Carroll notes that most people miss the next sentence in the report: “most of this quantity is contained in prepared foods.” Contrary to folklore, Dr. Carroll concluded that there’s no real scientific proof that, for otherwise healthy people, drinking extra water has any health benefits.Apples and underwear, snake oil and water—all have wisdom that can similarly be applied to taxes and charitable giving:

• Follow the tax law every day to keep the IRS away.
• Make sure your charitable donation transactions are clean and free of troubling issues.
• Don’t fall for fake “snake oil” conservation easements—to nonqualified charities, for example.

Drink the water you need, but understand that it is the big picture rather than just one glass at a time.Endnotes[i]The Phrase Finder.

[i] The Phrase Finder. https://www.phrases.org.uk/meanings/an-apple-a-day.html

[ii] “An Apple a Day Keeps the Doctor Away,” Science Daily, Source: British Medical Journal (BMJ), December 17, 2013. https://www.sciencedaily.com/releases/2013/12/131217210549.htm

[iii] Matthew A. Davis, DC, MPH, PhD, Julie P. W. Bynum, MD, MPH, and Brenda E. Sirovich, MD, MS, “Association Between Apple Consumption and Physician Visits: Appealing the Conventional Wisdom That an Apple a Day Keeps the Doctor Away,” JAMA Internal Medicine, May 2015. https://jamanetwork.com/journals/jamainternalmedicine/fullarticle/2210883

[iv] IRC §170(b)(1)(B).

[v] IRC §170.

[vi] Treas. Reg. §1.170A-1(c)(2).

[vii] Treas. Reg. §1.1011-2.

[viii] IRC §1011(b).

[ix] John L. Connell and Ketna S. Connell v. Commissioner, 51 T.C.M. 1654 (1986).

[x] Treas. Reg. 1.1011-2(a)(3); Ebben v. Comm’r, 783 F.2d 906 (9th Cir. 1986) and Rev. Rul. 81-163.

[xi] Lakshmi Gandhi, “A History of ‘Snake Oil Salesmen,’” Code Switch: Word Watch, NPR, August 26, 2013. https://www.npr.org/sections/codeswitch/2013/08/26/215761377/a-history-of-snake-oil-salesmen

[xii] Id.

[xiii] Id.

[xiv] IRC §170(f)(3)(B)(iii).

[xv] IRC §170(h)(3).

[xvi] Reg. §1.170A-14(c)(1).

^[xvii] “Conservation Easements,” IRS website, last updated April 3, 2018. https://www.irs.gov/charities-non-profits/conservation-easements

^[xviii] R.P. Golf v. Commissioner of Internal Revenue, 860 F.3d 1096, 1099 (2017) citing Treas. Reg. §1.170A-14(a). See also: IRC §170(h)(1).

^[xix] Treas. Reg. §1.170A-14(b)(1).

^[xx] Treas. Reg. §1.170A-14(b)(1)(i).

[xxi] IRC §170(h)(1)(B).

[xxii] IRC §170(h)(3).

[xxiii] IRC §170(h)(4)(A).

[xxiv] IRC §170(h)(2)(C).

[xxv] IRC §170(h)(5)(A).

[xxvi] Mitchell v. Comm’r, 775 F.3d 1243 (2015).

[xxvii] Mitchell v. Comm’r, 775 F.3d 1243, 1247 (2015), 138 T.C. 324, (T.C. 2012).

^[xxviii] Id, quoting 26 C.F.R. §1.170A-14(g)(2).

^[xxix] Mitchell.

^[xxx] Id.

[xxxi] Aaron E. Carroll, “No, You Do Not Have to Drink 8 Glasses of Water a Day,” The New York Times, August 24, 2015. https://www.nytimes.com/2015/08/25/upshot/no-you-do-not-have-to-drink-8-glasses-of-water-a-day.html