Court ruling clarifies process for deferring proceeds received in sale of development rights

In David C. Costello, et ux. v. Commissioner, TC Memo 2015-87, the taxpayer was denied a deduction for the donation of a conservation easement, but could defer the income recognition of monies received from the sale of development rights.  

The exchange of conservation easements and development rights are a common practice with many real estate developers. A developer’s ability to increase or decrease density at or around a project site directly impacts its underlying real estate value. The Internal Revenue Service (IRS) recently challenged a number of taxpayers’ deduction of conservation easements donations due to taxpayers’ aggressive valuations and lack of documentation when computing such deductions. While Costello was no exception, the holding did provide taxpayers an opportunity to defer the monies received from the sale of development rights when the basis in those development rights could not be determined.

Costello granted a conservation easement to Howard County, Maryland, as part of a quid pro quo exchange for transferable development rights under the Howard County Agricultural Land Preservation Program. Shortly thereafter, the taxpayer sold the development rights for $2.56 million. The taxpayer claimed a charitable deduction for the conservation easement rights granted to Howard County based on a third-party valuation. The IRS claimed the easement was granted to the taxpayer as part of a quid pro quo exchange and, therefore, not eligible for a charitable deduction. However, the ruling clarified the taxpayer’s reporting of the sale of development rights, concluding that proceeds from the sale should first reduce the taxpayer’s basis in the land before recognizing excess proceeds as a capital gain.

When a taxpayer sells an asset, generally, a gain is recognized to the extent the proceeds from the sale exceed the taxpayer’s basis in the asset. While in some circumstances this is an easy rule to implement, determining the proper basis of the asset sold is often difficult. Development rights are typically not assigned basis separate from the underlying property. In Costello, the IRS agreed the taxpayer is entitled to allocate basis to the development rights; however, the question remained of how much basis should be allocated?

The Tax Court relied on Rev. Rul. 77-414 which states that when it is impossible to determine the basis of the property sold, the amount received from the sale should first reduce the basis of the entire property and only when the property’s basis is exhausted excess proceeds are recognized as gain. Furthermore, Rev. Rul. 77-414 confirms the property basis should be reduced by asset class (land or improvements) in proportion to their decrease in fair value as a result of the transaction.

In Costello, the parties agreed the basis in the transferable development rights could not be determined and the taxpayer was permitted to reduce his basis in the underlying property. It could be argued that the sale of development rights resulted in a direct decrease in the underlying land and not the existing improvement because the taxpayer’s right to use those improvements is unchanged.

While the headline in the Costello holding has been the disallowance of a charitable deduction in a quid pro quo exchange, the court applying guidance issued in Rev. Rul. 77-414 and determining the proceeds should first reduce basis in the underlying property is also an important clarification for the sale of development rights.

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