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During this time period of depreciating land values and renewed emphasis upon environmental restoration and water resource protection, many agricultural landowners are considering the use of conservation easements as a means to realize value from properties that have natural resources deemed worthy of protection, while still maintaining productivity of the land for agricultural and recreational activities.  One of the more widely used easement programs is the Wetland Reserve Program (“WRP”) administered by the Natural Resources Conservation Service (“NRCS”).  Where appropriate, in order to defer the recognition of any gain or loss upon the sale of a conservation easement, landowners often utilize Section 1031 of the Internal Revenue Code of 1986 (the “Code”) to effectuate a like-kind exchange.  However, there was a time during 2009 when the USDA modified its contract to purchase WRP easements to prevent the contract from being assigned to a third party, thus creating an insurmountable limitation on the ability to utilize the deferred like-kind exchange mechanism found under Code § 1031(a)(3).  This article analyzes the planning opportunities of utilizing WRP easements and reinvesting the proceeds therefrom under Code § 1031 and the steps that were taken over the past year to rectify the restrictions imposed by the USDA upon its contracting process to allow sellers of WRP easements to once again utilize the deferred exchange planning opportunities.

What is a WRP Easement?

The Wetlands Reserve Program was first authorized by Congress in 1990 as part of the Food Security Act (Farm Bill) of 1985, and has been reauthorized in every subsequent Farm Bill.  The program came as a response to the recognition of both the importance of functioning wetlands and an acknowledgement of the loss of a large portion of the natural wetlands in this country.  In fact, some states have lost as much as 90 percent of their wetlands from the 1780’s to the 1980’s.1  WRP is administered by the NRCS, whose stated goal for the program is “to restore wetland functions and values to natural conditions to the extent practicable, while maximizing wildlife habitat values.

As of 2008, slightly over 2 million acres were enrolled in the WRP.  The 2008 Farm Bill increased the cap on enrollment in the program to 3,041,200 acres; an increase of over 750,000 acres.  The program is limited to private and Tribal lands, and offers three enrollment options: Restoration Cost-Share Agreements, 30-year easements and permanent easements. 

On land enrolled in the permanent or 30-year WRP options, the NRCS attempts full hydrologic restoration of the property, then shifts management responsibility for the restored wetland to the private landowner, with assistance from the NRCS.  Landowners participating in the easement programs continue to have exclusive control over access to their property, retain recreational use of the land, and may lease or engage in other activities on the property not inconsistent with the purpose of the WRP easement.  The government does not purchase a fee simple interest, taking over ownership and responsibility for the land, but instead removes certain rights from the land, for fair value, and cooperates with the landowner to maintain the restored system.  To qualify for the WRPprogram, the landowner must have owned the property for at least seven (7) years and meet certain income from farming requirements.

Our experience has been that a WRP easement is a valuable tool for family-owned agricultural operations to realize value from wetlands, maintain ownership and control of the lands, while simultaneously restoring important natural functions of the land.  In short, the property owner benefits, and so do the natural systems and society as a whole.

Taxation of a WRP Easement

The sale of a WRP easement is no different from the sale of any other type of conservation easement.  The threshold tax issue is to determine if the property rights sold are significant enough to treat the transaction as a sale of all of the taxpayer’s rights in the real property.  If not, then the transaction is treated as a return of the taxpayer’s capital.  If so, then the transaction is treated as the sale of an interest in real property.  See Rev. Rul. 59-121, 1959-1 C.B. 212. 

Generally, a taxpayer must recognize gain or loss upon a sale or exchange of property, as set forth in Code § 1001(c).  However, Code § 1031 provides an exception from the general rule requiring the current recognition of gain or loss realized upon the sale or exchange of property.  Under Code § 1031(a), no gain or loss is recognized when property held for productive use in a trade or business or for investment is exchanged solely for property of a like-kind that can be held either for productive use in a trade or business or for investment.  Like other “non-taxable exchange provisions,” Code § 1031 provides an exception only from current recognition of the gain realized.  The realized gain is deferred until the “replacement property” received in the exchange is disposed of in a subsequent taxable transaction.

For long-time agricultural landowners, a Code § 1031 exchange is commonly used for the sale of land which may have nominal or de minimis tax basis.  Some have a per-acre basis of less than $100.00 in land having a current fair market value of 30 to 100 times that amount.  Thus, the potential exists for a significant tax liability for those participating in the WRP program.

In 1991, in an effort to provide clear rules for typical deferred exchange transactions, the Treasury Department issued Regulations which provide four “safe harbors” which, if followed, and all other requirements of Section 1031 are met, allow the transaction to qualify as a tax-deferred exchange under Code § 1031.  Although it is still possible to accomplish a qualifying exchange outside of the safe harbors, the 1991 Regulations are so user friendly that virtually all exchanges that have taken place after the Regulations were issued have been structured to conform to one or more of the safe harbors.

Three of the safe harbors include restrictions on the taxpayer’s receipt of exchange funds, requiring sales proceeds to be held in an escrow or trust account, and usually by a “qualified intermediary.” See Treas. Reg. § 1.1031(k)-1(g).  A “qualified intermediary” is an entity or a person who enters into an agreement with the taxpayer to acquire the taxpayer’s relinquished property, transfers it to the buyer, receives and retains possession of the sales proceeds, acquires the replacement property and transfers it to the taxpayer.  Treas. Reg. §1.1031(k)-1(g)(4)(i).  The most common method of transferring the properties sold and purchased is through an Assignment Agreement, assigning the qualified intermediary into the contract, coupled with an instruction that the relinquished property be deeded directly from the taxpayer to the buyer and the replacement property be deeded directly from the seller to the taxpayer.  

Recent Developments

Despite the relative ease of implementing a deferred exchange, the NRCS created a significant problem for taxpayers selling WRP easements.  The NRCS adopted a new WRP easement contract effective in the Fall of 2009.  The new contract used by the NRCS to acquire such an easement expressly prohibited the seller from assigning its rights under the contract, with no exceptions for assignments to qualified intermediaries.  Therefore, except in the situation of the now rare simultaneous exchange, all new sellers would be forced to pay tax on the transaction since Code § 1031 deferred exchange would not be available.

The NRCS recently agreed in one transaction to revise the WRP contract for new sales and amend existing WRP contracts in a manner that allows taxpayers to utilize Code § 1031 for deferred exchanges in relation to the sale of the WRP easement.

Conclusion

The WRP easement program continues to yield excellent results for the public and the environment, and the tax planning opportunities afforded landowners for a deferred exchange appear to remain intact.  Similar to the WRP easement program, the sale of a conservation easement may also be structured to qualify for the benefits of Code § 1031.

 

 


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