Does your out-of-favor specified service business give you a zero Section 199A tax deduction because your taxable income is more than
- $415,000 on a joint return or
- $207,500 on all other returns?
Let me tell you about Rick. He is in an out-of-favor specified service business, is married, and has taxable income after itemized deductions of $600,000. His Section 199A deduction is zero.
Rick invests $120,000 in a qualified conservation easement that produces a charitable tax deduction of $285,000. Now Rick’s taxable income is $315,000 and his 20 percent Section 199A tax deduction is $63,000.
You likely noticed that Rick invested $120,000 to create a $285,000 tax deduction. Here’s why that can work: when you donate a conservation easement to a qualified charity or government entity, you deduct “fair market value,” not the amount you paid for the property.
To measure fair market value of a conservation easement, you generally compare the fair market value of the property before and after the granting of the easement. The deduction for the fair market value is what makes the $120,000 investment produce a $285,000 tax deduction.
To put this in context, think of a charitable donation of publicly traded stock. Say you paid $1,000 for the stock several years ago and now donate it to a qualified charity when it trades on the stock exchange for $25,000. You have a $25,000 tax deduction.
Conservation Easement 101
The conservation easement is a land-preservation agreement between a landowner and a qualified land protection organization. The conservation easement is recorded on the property’s deed, which provides for permanent preservation of the property through a development restriction.
To qualify for the tax deduction, the conservation easement must be exclusively for conservation purposes, which include
- preservation of the land areas for outdoor recreation by or for the education of the general public;
- protection of a relatively natural habitat of fish, wildlife, or plants or a similar ecosystem;
- preservation of open space (including farmland and forest land) where the preservation is for the scenic enjoyment of the general public or pursuant to a governmental conservation policy and will yield a significant public benefit; or
- preservation of a historically important land area or a certified historic structure.
The conservation easement terms can include reservation of certain rights, provided they don’t impair the conservation purposes. These can include recreation, hunting, timbering, and traditional agricultural uses.
The law limits your conservation easement charitable deduction to 50 percent of your adjusted gross income, but you can carry forward any unused amounts for up to 15 years.
You generally have three ways to get your conservation easement charitable deduction:
- You own a parcel of land and donate the development rights to that land to a qualified organization.
- You live in a historic district and donate the rights to alter the building façade to a qualified organization.
- You invest in a real estate partnership that acquires land and donates the development rights to that land to a qualified organization.
For the real estate partnership strategy, you don’t need the land or the building; you simply need the cash to invest. It works like this:
- You invest cash in a partnership.
- The partnership buys property.
- The partnership donates the property’s development rights.
- The partnership passes the conservation easement charitable deduction to the partners on their Schedule K-1s.
Many reputable firms and conservation organizations facilitate these real estate partnerships so that investors can use their cash to both
- help preserve open space and
- gain a tax benefit from doing so.
The IRS recently made the use of a real estate partnership to facilitate a conservation easement charitable deduction a listed transaction in certain circumstances. This requires
- filing of Form 8886, Reportable Transaction Disclosure Statement, with the tax return; and
- full disclosure of the transaction details on the tax return.
You’re probably concerned that there’s something wrong with this strategy because the IRS appears to be targeting it.
Don’t worry—the strategy is sound if properly administered.
Certain promoters were not acting properly, causing some taxpayers to ultimately lose the deduction or get a substantially reduced deduction upon examination or litigation.