by George D. Forsythe
The Virginia land preservation tax credit program has proved to be an important catalyst for land conservation in the commonwealth, and it provides a worthwhile planning tool for Virginia taxpayers. The tax-credit program has allowed donors of land and easements for conservation purposes to offset their state income tax liability dollar-for-dollar with Virginia land preservation tax credits and, more important, to sell their unused credits to other Virginia taxpayers for cash.
Because the credits can be used against income tax incurred in the year of donation and carried forward for up to 10 additional years or until consumed, the typical donor generally has retained some of his credit to use against current and future income tax liability and has sold the rest as soon as possible. A relatively quick sale of at least a portion of the credit enables cash-strapped donors to recoup some or all of their expenses incurred in making the donation (legal, appraisal, survey and tax adviser fees just to mention a few).
The “as-soon-as-possible” component of that typical plan is now in question. Many tax practitioners had decided, based partly on statements from the IRS, that the proceeds of the sale of Virginia land preservation tax credits should be reported as ordinary income on donors’ federal tax returns. Recently, however, in Tempel v. Commissioner, 136 T.C. No. 15 (April 5, 2011), the U.S. Tax Court ruled that transferable Colorado conservation income tax credits were capital assets and subject to capital gains rates for federal income tax purposes. The taxpayers had zero basis in their credits because the transaction costs to establish the easement did not constitute basis in the credits, and none of the taxpayers’ basis in their land could be allocated to the credits. In addition, the holding period of the tax credits, as a capital asset, did not begin when the taxpayers acquired the land on which they donated an easement, but “at the time the credits were granted” by the state. As the taxpayers sold the credits less than a month after they were granted, the credits were held only for a short-term holding period and the proceeds were subject to taxation as short-term capital gains. The Tempel holding was generally repeated by the Tax Court last month in McNeil v. Commissioner, T.C. Memo. 2011-109 (May 23, 2011).
While these decisions by the Tax Court are not yet final, and may not necessarily bind the IRS going forward, we expect these rulings will apply to the Virginia credit because of its similarity to the Colorado credit. The inverse of these rulings is implicit; i.e., that the sale of a land preservation tax credit held for a year will generate long-term capital gains.
Thus, for the land or easement donor who claims a Virginia land preservation tax credit, an important question now arises: whether to hold some or all of the credit for a year before selling it in order to assert long-term capital gains treatment on the sales proceeds for federal income tax purposes.
The potential for tax savings could be significant. The federal long-term capital gains rate is currently 15 percent, versus ordinary income tax rates that range up to 35 percent depending upon the donor’s income tax bracket.
To illustrate the potential savings, consider the following simplified example:
Assume that on Aug. 31, 2011, the Donors, a married couple, donate a qualifying conservation easement valued at $1 million. They claim a Virginia land preservation tax credit of $400,000 and receive their letter from the Department of Taxation issuing the credit on Nov. 1, 2011. (According to Tempel, the holding period begins on the date the credit was “granted” by the state, which we believe to mean the date of the letter from the Department of Taxation issuing the credit to the donor.)
Assume the Donors are not residents of Virginia and pay no Virginia income tax, so they sell the entire credit in December 2011, realizing net proceeds of approximately $300,000 (after discounting, transfer agent fees, and the Department of Taxation’s 5 percent fee). The Donors will realize a short-term capital gain of $300,000, though they also can claim a federal charitable donation deduction at a rate of 50 percent of adjusted gross income. After applying the 50 percent deduction, the Donors will have to pay tax on $150,000 of additional income as a result of the credit sale. Assuming the highest federal tax rate of 35 percent, the sale would generate a federal tax bill of $52,500. Remember, Virginia does not tax the sale of land preservation tax credits.
On the other hand, if the Donors wait until December 2012 to sell their credit, under the common interpretation of Tempel, they will realize long term capital gains of $150,000 after applying their charitable deduction. Taxed at the current long term capital gains rate of 15 percent, they will face a tax bill of only $22,500 as a result of the sale. This example is highly simplified for purposes of illustration, but essentially the $30,000 difference between the tax consequences of the delayed sale and those of the immediate sale—approximately 10 percent of the net proceeds—could be seen as the financial cost of turning the credit into cash immediately, assuming Tempel applies as expected.
At this point, it seems that waiting a year to realize a benefit of approximately 10 percent is a no-brainer. But, like most things, in reality the decision is more complicated and can be influenced by a number of different factors. Some pertinent decision factors are listed below (note that several factors may apply to the same donor, potentially with a cumulative effect):
1. Urgent need for cash: If the donor needs cash in the short term and is unable to borrow at an advantageous rate, an immediate sale of some or all of the tax credit may be necessary regardless of tax consequences.
2. Donor is a “qualified farmer or rancher”: If the donor qualifies as a farmer or rancher under applicable federal tax law, he or she is allowed a charitable donation deduction at the rate of 100 percent of adjusted gross income. This means all of the short-term capital gain resulting from an immediate sale of the credit is offset by the deduction, thus zero federal tax and probably no tax reason to delay selling the credit.
3. Uncertainty as to future of long-term capital gains tax rates: If long-term capital gains rates increase, a donor’s benefit from holding the tax credit for a year will be reduced.
4. Rate of return in an alternative investment: Would the funds generated from the sale of the credit produce a greater investment return in an alternative investment versus holding the tax credit to utilize against future tax or sell after the long term capital gains holding period has passed?
5.Capital losses: Many investors presently have significant capital loss carryovers. Before capital gains are taxed, they must first offset existing capital-loss carryovers. Thus the donor may be able to sell some or all of the credit immediately with no adverse tax consequences.
6. Uncertain precedent: As mentioned above, both the Tempel and McNeil cases dealing with the Colorado tax credit are not yet final and may not necessarily bind the IRS going forward.
7. Life expectancy: Another consideration is the inherent risk of an individual holding a land preservation tax credit for any significant length of time, as the credit will expire upon the death of the credit holder. Even a donor in good health may decide the risk of holding a very large credit for a year is too great and might decide to transfer the credit to a pass-through entity of some sort that would survive the donor’s death, allowing the donor’s heirs to sell or use the credit. However, this strategy can be costly in terms of legal costs as well as the imposition of an additional 5 percent transfer fee due to the Department of Taxation upon the transfer of the credit to the “immortal” entity. It may be that, in combination with one or more other factors, the risk of credit expiration upon the donor’s death will compel some donors to go ahead and sell some or all of their credits in the near term.
Conclusion: The decision on how to best utilize a land preservation tax credit in the post-Tempel landscape should be undertaken carefully and should take into account all relevant factors with the assistance of a tax professional who understands the donor’s particular financial and tax situation.
George D. Forsythe, CPA, is a partner with Wells, Coleman & Co. LLP. He may be reached at .Tweet