By Steven C. Colburn
The Third Circuit Overturns the Tax Court
The land that James Gibbs senior owned when he died was valued for estate tax purposes as farmland under an exception to the "highest and best use" valuation requirement. Had the land been treated as potential development property, the value would have been much higher. A condition for using the lower value is this: If the heir to the property (in this case James junior) disposes of it within a ten-year period, the tax that would have been due based on the higher value will be recaptured.
Within the ten-year period, the state of New Jersey obtained an easement for the development rights from Gibbs junior in return for a payment substantially in excess of the value of the land in the estate. The easement ensures the use of the land as farmland as long as the state desires, effectively preserving it for farming purposes. It cannot be developed.
Gibbs junior dutifully notified the IRS of the transaction with the state of New Jersey, and the IRS assessed a recapture estate tax. He objected, and the matter was brought to the Tax Court, which ruled in his favor. But the IRS appealed, and Gibbs was not as fortunate in the Third Circuit. The main issue was whether the granting of the easement to New Jersey is a transfer of a property right or merely a contractual right. The answer has something to do with a bundle of sticks.
In a case of first impression, the Third Circuit, in Estate of Gibbs v. U.S., [82 AFTR 2d 98-7241 (3rd Cir. 1998), rev'g 81 AFTR 2d 98-891 (DC-NJ 1998)] reversed a district court's decision which granted a refund of recapture taxes to an heir who had sold the development rights on specially valued property, through a conservation easement, within the ten-year time limit. The sale of the easement to the state of New Jersey was held to constitute a disposition of a portion of the heir's interest in the property [within the meaning of IRC section 2032A(c)(1)(A)], triggering the estate tax recapture. The Third Circuit's ruling has implications for heirs of special use valuation property who may be contemplating the sale of certain rights on such property and provides guidance in helping to avoid the recapture tax of IRC section 2032A.
General Rules on Special Use Valuation
IRC section 2032A(a)(1) provides an exception to the general rule of section 2031(a) that property of a decedent must be valued for estate tax purposes at its highest and best use. Under section 2032A(a)(1), qualified real property may be valued based on its actual use at the date of the decedent's death provided certain conditions are met.
Qualified real property is defined by section 2032A(b) as real property which, at the date of the decedent's death, was located in the United States and was acquired from or passed from the decedent to a qualified heir of the decedent. In addition, the qualified property must have been owned and used by the decedent or a member of the decedent's family for a qualified use for at least five years out of the eight-year period ending on the date of the decedent's death.
A qualified use involves using the property 1) as a farm for farming purposes or 2) in a trade or business other than farming. Other requirements apply under section 2032A(b)(1)(A) regarding the percentage of the decedent's adjusted gross estate that must consist of the qualified property. The qualified real property valuation may be reduced by a maximum of $750,000 for estate tax purposes under section 2032A(a)(2). For decedents dying after 1998, this amount is adjusted for inflation.
Recapture of Estate Tax Savings
An additional estate tax will be imposed if the qualified heir disposes of any interest in qualified real property [other than to his or her family as defined in IRC section 2032A(e)(2)(A)-(D)] or ceases to use qualified real property for its qualified use within ten years of the decedent's death and before the death of the qualified heir. The qualified heir may wait up to two years after the date of death of the decedent to put the property to its qualified use; however, this will extend the recapture period as well.
Property which is specially valued ceases to be used for the qualified use if it is no longer used for the purpose under which it originally qualified. An example of such cessation of qualified use would be farmland converted to a business use other than farming.
The amount of the additional tax is the lesser of 1) the adjusted tax difference attributable to the property interest or 2) the excess of the amount realized for the interest over the special use value of the interest.
The Gibbs Case
At the time of his death on November 7, 1984, James C. Gibbs, Sr., owned and operated a dairy farm in the state of New Jersey. Based on its highest and best use, as potential development property, the farm was valued at $988,000. Its value for farming purposes was only $349,770.
As executor and sole heir of his father's estate, James C. Gibbs, Jr., filed an estate tax return on behalf of the senior Gibbs' estate in July 1985. On the return, Gibbs junior elected, pursuant to IRC section 2032A(a)(1), to value the real property of the farm at its lower, special use value. The election resulted in estate tax savings of $218,328 to the estate. As required by section 2032A(c), Gibbs junior agreed to be personally liable for any recapture tax due on the estate if, within ten years of his father's death, he disposed of any interest in the property.
In December 1993, Gibbs granted a "Deed of Easement" to the state of New Jersey in exchange for $1,433,494. The state received a development easement on the farm real property with the intent of preserving the property as farmland pursuant to New Jersey's Agricultural Retention and Development Act. The deed of easement specified Gibbs junior (acting as an individual and as executor of his father's estate) and his daughter, Diane Gibbs, as the grantors of the easement. The grantee was designated as the Warren County Board of Chosen Freeholders, acting on behalf of the state of New Jersey.
The deed clearly transferred the development rights on the property to New Jersey using the following language:
Grantor further transfer[s] and conveys to grantee all of the nonagricultural development rights and development credits appurtenant to the lands and premises described herein. Nothing contained herein shall preclude the conveyance or retention of said rights by the grantee as may be permitted by the laws of the state of New Jersey in the future.
The language of the deed was very specific in blocking any and all nonagricultural development of the land stating, "any development of the premises for nonagricultural use is expressly prohibited." It further stated that such restrictions "shall be construed as a restriction running with the land and shall be binding upon any person to whom title to the premises is transferred."
Gibbs junior filed IRS Form 706A, Additional Estate Tax Return, in March 1994 following his conveyance of the deed of easement to the state of New Jersey. The IRS assessed an additional estate tax of $159,823 to recapture tax savings realized by the estate due to the special use valuation elected for the farmland in 1985.
Taxpayer's Position. Gibbs claimed that his transfer of the conservation easement to New Jersey resulted in the imposition of contractual restrictions upon the future use of the farmland. The transfer was not a disposition of an "interest" in specially valued farmland, and the recapture provisions of section 2032A(c) would not apply.
IRS' Position. The IRS argued that Gibbs conveyed a developmental interest in the farmland to the state of New Jersey through the deed of easement. Through this device, Gibbs realized the value of the development rights of the property. As a result, Gibbs had disposed of an interest in qualified real property within the ten-year time limit.
District Court Decision. The district court held that Gibbs did not dispose of any interest in the farmland. It ruled that the deed of easement granted a conservation servitude to the state, ensuring that the property would be used as a farm forever. The court noted that the key question was whether the granting of the conservation servitude resulted in a disposition of Gibbs' specially valued farmland.
To answer this question, the court turned to New Jersey law and noted that the property was considered to be part of a farmland preservation program under New Jersey's Right to Farm Act. This program places restrictions, known as equitable servitudes, on the use of land owned by others, and such restrictions are covenants that run with the land. Such restrictions are enforceable only in equity. Contrary to most states, New Jersey views equitable servitudes as contract rights, rather than as property rights. This analysis led the court to conclude that a conservation or equitable servitude on land, under New Jersey law, results in restrictions on how the land may be used rather than an ownership interest in the land.
The IRS argued that the court should interpret the phrase "interest in land" more broadly and treat the unqualified right to develop the farm property given up by Gibbs as an interest in the real property. The court rejected this argument, stating that New Jersey law requires the transfer of such rights to be treated as a "contractual burdening" of the land, not a transfer of property rights. The court further noted as practical consequences of this transaction that the state of New Jersey did not acquire any rights 1) to use the land, 2) to direct its use, or 3) that could be sold or transferred to a third party.
The IRS also argued that Gibbs was the beneficiary of a windfall by purportedly receiving fair market value for the land and avoiding the recapture provisions of IRC section 2032A. The court rejected this argument, stating that it is irrelevant under section 2032A whether or not Gibbs received a windfall. The court noted that the recapture provisions of section 2032A(c) have the objective and effect of preventing an heir from realizing a double benefit on specially valued land. However, the court, citing Williamson v. Commissioner [70 AFTR 2d 92-6244 (9th Cir. 1992), aff'g 93 TC 242 (No. 23)(1989), also stated that such objectives could not be used as justification for ignoring the clear requirements of section 2032A(c). Instead, some event must occur, as described in section 2032A(c), which would trigger recapture of the estate tax savings.
The court maintained that New Jersey law clearly does not treat the burdening of land with a conservation or equitable servitude as an interest in land. In this respect, Gibbs did not dispose of an interest in his farmland when he granted the easement to the state of New Jersey. As a result, the recapture provisions of section 2032A(c) did not apply. Summary judgment was awarded in favor of Gibbs.
Ruling of the Third Circuit
The Third Circuit reviewed the position of the parties:
The IRS's Position. The IRS argued that it was immaterial whether New Jersey law classified the interest in the farmland created by the deed of easement as a "contract right" or a "real property interest." The district court had determined that the state of New Jersey recognized the rights in the farmland created by the deed of easement. Once the district court recognized that such rights existed, Federal law, not state law, determined whether the transfer of such rights constituted a disposition of qualified property resulting in the recapture of estate taxes under section 2032A(c)(1).
The Taxpayer's Position. Gibbs cited Treasury Regulations section 20.2032A-8(c)(2) as support for his contention that state law, not Federal law, determines whether a specific disposition of property triggers the recapture tax. He further argued that the regulation established a test to determine whether or not such a disposition would cause the recapture tax to apply.
Relevance of State Law
The Third Circuit noted that the IRC does not create rights in property. It reasoned that once New Jersey law defined the development easement as an interest in property, neither the classification of that interest nor the state law consequences of that definition were relevant in applying the recapture provisions of Federal tax law. As a result, the district court turned to Federal tax law at that point to determine if the recapture provisions of section 2032A(c)(1) applied.
The appellate court also rejected Gibbs' argument that Treasury Regulations section 20.2032A-8(c)(2) defines the events that trigger the recapture tax. Rather, the regulation specifies who must sign the agreement and be responsible for the recapture tax, if it is subsequently imposed (Estate of Lucas, 97 F.3d at 1407). Neither the district court nor the appellate court could find any authority for the taxpayer's interpretation of this regulation.
Bundle of Rights
Next, the appellate court turned its attention to the issue of whether Gibbs' transfer of the development easement on the farmland to the state of New Jersey was a disposition of "any interest" in qualified property that would trigger recapture of estate taxes under section 2032A(c)(1). The court noted that this was a case of first impression because there were no previous rulings on this issue. As a result, it relied on well-established principles of property law and estate taxation.
The court stated that owning property has often been compared by law to owning a "bundle of rights or sticks." It further noted that precedents exist for separating or breaking up such property rights for Federal tax purposes when taxpayers sever the rights incident to a fee simple interest in such property. Applying this reasoning, the court stated that the real property inherited by Gibbs may be viewed as consisting of two bundles of rights: 1) rights that relate to the agricultural or farming use of the property and 2) those relating to the additional or development value of the property.
According to the court, Gibbs' transfer of a development easement on the property to the state of New Jersey constituted a disposition of part of his interest in the property; namely, the second bundle of rights. The court noted that Gibbs had avoided paying estate taxes on this bundle of rights associated with the farm property by electing special use valuation on the property under section 2032A(a). One of the provisions to which Gibbs agreed was not to dispose of an interest in the property within the ten-year recapture period.
By executing the deed of easement and transferring the nonagricultural development rights to the farmland to the state of New Jersey, the court reasoned that Gibbs disposed of part of his interest in the property. Because this disposition occurred within the ten-year time limit, the recapture provisions of section 2032A(c)(1) applied.
Gibbs further argued that the deed of easement merely placed restrictions on how the land may be used. Therefore, he claimed that he did not dispose of an interest in the property because the deed conveyed "nothing to anyone."
The court also rejected this argument, noting the taxpayer's erroneous view of the development easement as a land-use restriction rather than an interest in the land. In addition, the court referred to the definition of a development easement by the New Jersey Agriculture Retention Act. This definition clearly refers to such an easement as "an interest in land" and also makes reference to the nonagricultural "bundle of rights" described previously.
Additional evidence to refute Gibbs' position was found in the wording of the deed of easement. The deed stated that Gibbs "grants and conveys to the Grantee a development easement ... for and
in consideration of the sum of $1,433,493.72." Next, the deed stated that Gibbs "transfer[s] and conveys to grantee all of the nonagricultural development rights and development credits appurtenant to the lands and premises described herein." Finally, the deed referred to the Agricultural Retention Act. The court noted that the language of the act was clear in that it contemplated the sale or other conveyance of development easements.
Gibbs noted that he could legally sell the farmland without the permission of the state of New Jersey. This fact, he asserted, proved that he had not disposed of any interest in the property. The court also rejected this argument, stating that the deed of easement provided that Gibbs could sell the property for agricultural purposes only. Anyone wanting to acquire development rights to the property would have to deal with New Jersey, not Gibbs. The court concluded that Gibbs, through the deed of easement, had disposed of part of his interest in the property to the state of New Jersey.
The Williamson Case
Gibbs cited the Tax Court's decision in Williamson [93 T.C. 242 (1989)] as support for the district court ruling. In Williamson, the heir to special use valuation property leased his farmland to his nephew. The IRS claimed that this was not a qualified use within the meaning of section 2032A(c)(1)(B), and therefore the recapture tax should apply. Alternatively, the taxpayer argued that the lease constituted a disposition of the farmland to a family member pursuant to section 2032A(c)(1)(A) which would not trigger the recapture provisions. The Tax Court held for the IRS, stating that a lease of property is not a disposition of property. Gibbs interpreted the ruling in Williamson to mean that section 2032A(c)(1)(A) should not be read literally and that Congress did not contemplate the granting of a development easement as "any" disposition of property that would trigger the recapture tax.
The appellate court disagreed with Gibbs' analysis. It stated that in Williamson the Tax Court gave no indication that it interpreted the phrase "any interest" of section 2032A(c)(1)(A) other than literally. Rather, the Tax Court held that granting the lease on the farmland was not a disposition of the land because the term "disposition" generally "refers to a sale, exchange, or gift." On appeal, the Ninth Circuit, distinguishing between a temporary lease and the conveyance of an easement, upheld the ruling of the Tax Court. The Ninth Circuit noted that a temporary lease was not a disposition due to its temporary nature, whereas an easement is a disposition of a property interest due to its permanence.
Finally, Gibbs argued that the legislative history of section 2032A supported the conclusion that the granting of a development easement should not trigger the recapture tax. He argued that Congress intended for the recapture tax to apply only in the event of a sale of the entire property, not a portion. This assertion was rejected for two reasons. First, the appellate court stated that it was not necessary to review the legislative history of section 2032A because the plain meaning of the statute makes it clear that the recapture tax does apply in this situation.
Furthermore, the court maintained that a review of the legislative history would yield the same result. The court noted that Congress could have worded the statute accordingly if it had intended for only the sale of the entire fee simple interest to trigger the recapture tax. Ample precedent exists in which courts have declined to interpret Congress' intent in cases where the meaning of a statute is clear.
New Jersey's Position
The Attorney General of New Jersey argued that the recapture tax should not be imposed, even if the court determined that the taxpayer had disposed of an interest in the property. The Attorney General reasoned that the express purposes of section 2032A and the Agricultural Retention Act of New Jersey were to preserve farmland. The imposition of a recapture tax in this situation would undermine New Jersey's efforts to conserve farmland by discouraging other farmers from selling development easements to the state.
The court answered these arguments by noting that New Jersey was asking the court to do something it does not have the authority to do: set aside express Federal tax law in order to further the policy objectives of a state.
The court held that the district court erred when it ruled that Gibbs did not dispose of an interest in property by granting a development easement to the state of New Jersey. As a result, the ruling of the district court was reversed, and Gibbs' petition for refund of the recapture tax was denied.
Taxpayers contemplating the granting or sale of development easements on their specially valued property should be warned to wait until the end of the mandatory ten-year time limit before doing so. It matters not whether the property will continue to be used for its original use.
As this is a case of first impression, it is possible that another court may reach a different result if faced with a similar issue. *
Steven C. Colburn is an associate professor of accounting at the Maine Business School, the University of Maine. He can be contacted at email@example.com.
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