On January 9, 2019, Hoover real estate businessman Kenneth Lewis pled guilty in Jefferson County Circuit Court to securities fraud.[i] Lewis was indicted in November 2017 for offering and selling investments through his real estate firm for a property “flipping” enterprise where he pocketed some of the investment funds and failed to transfer proceeds from one of the sales to his client.[ii] 

Lewis’ plan was to flip three different residences, but according to the ASC, Lewis did not purchase one of the properties and pocketed funds received from the investors for personal use. In addition, one of the properties was flipped, but Lewis did not pay the investor from the proceeds of the sale. Finally, Lewis violated the Alabama Securities Act by failing to register himself with the ASC as a securities broker, and failing to register the investments he sold as well.[iii]

The AAR Public Policy Team will continue to monitor activities of the ASC for their impacts on the real estate industry.
 

On December 18, 2018, the United States Department of Justice (DOJ) filed a complaint in the U.S. District Court for the Northern District of Georgia, seeking an injunction and disgorgement of funds from a conservation easement investment group based out of Atlanta.[iv] The DOJ claims that the group operates an “abusive conservation easement syndication tax scheme” by using donations of conservation easements and corresponding tax benefits, overvalued appraisals of the easements, and “sham” limited liability entities to “transfer overvalued and otherwise improper federal tax deductions to customers.”[v] Before explaining the DOJ’s complaint, we will review conservation easements and syndicated conservation easement groups.

Background on Conservation Easements

The Internal Revenue Code (“the Code”) allows a taxpayer to take a tax deduction for placing a conservation easement on property. To receive a conservation easement tax credit, taxpayers make a “qualified conservation contribution,” defined as a contribution of a “qualified real property interest” (i.e., a permanent restriction on development or use of the land) to a “qualified organization,” typically a nonprofit organization which manages the property, for conservation purposes.[vi] Internal Revenue Service (IRS) regulations provide four permissible purposes in order to obtain tax benefits as a conservation easement:

1. preserving land for outdoor recreation or education,
2. protection of fish, wildlife, or plants,
3. preserving open space, or
4. preserving a historically important land area or structure (otherwise known as a “façade easement”).[vii]

How the process typically works is that a taxpayer will donate a piece of property to an approved entity like a government body or, more frequently, a nonprofit organization which restricts further development on the property, and the taxpayer can then claim a tax deduction for the fair market value of the property interest he or she donated. The resulting development-restricted area is known as a conservation easement.

The value of the donation is determined by examining the easement’s fair market value at the time of the donation, which the taxpayer can deduct from his or her Adjusted Gross Income (AGI), in an amount up to 50% of the taxpayer’s AGI.[viii] To obtain a deduction for an easement valued over $5,000, documentation must be submitted to the IRS demonstrating that the easement’s value was calculated by a “qualified appraiser” using permissible valuation methods.[ix] 

Determining the Fair Market Value of a Conservation Easement

The fair market value of a conservation easement can be difficult to calculate and has been the subject of various litigation and enforcement actions by the IRS.[x] That difficulty is shown by examining a version of the frequently-used “Before and After Method”[xi] for easement valuation. In particular, use of that method can cause legal trouble where an appraiser does not calculate the “before” value of the property (i.e., prior to the easement’s placement) using a comparison of similar properties sold on the open market, perhaps because a reference to a comparable property is unavailable. This method is known as the “income approach” or “income capitalization approach,” and basically means a calculation of the value of the property pre-easement that is the “most probable price” a buyer would be willing to pay based on the “present value of the future income” the property’s owners could expect to realize without the easement.[xii]

Assume property owner Jane Doe has a conservation easement on a parcel of her ranch property. A company called the X Corporation previously approached Jane and expressed interest in the parcel, stating that it would be a perfect site for its factory, and even made an offer to buy the property. Jane refused because she wanted to keep the property preserved as she likes watching the wildlife on the property. However, Jane did not want the monetary potential of the land to go to waste, so she made the easement donation.

In this scenario, an appraiser utilizing the “Before and After” valuation method could calculate the value of the ranch parcel prior to placing the easement on it by including what the parcel would have been worth had the X Corporation purchased it. Arguably, such a calculation would initially meet the IRS’ “highest and best use” requirement (meaning that in calculating the “before” value a person can consider what the most objectively valuable use of the property would have been), as long as X Corporation’s offer to purchase the property was “close in time” to when Jane made the easement donation, and it was “reasonably probable” that the factory would have been built.[xiii]  

Once the parcel’s “highest and best use” has been determined, its fair market value for calculation of the tax deduction must then be specifically calculated using an approved methodology. Typically, the IRS and the U.S. Tax Court (the federal court which directly oversees the IRS) look favorably on comparing the property to “similar” properties sold on the open market.[xiv] So in this example, Jane would want to ensure her appraiser (assuming the parcel is worth over $5,000) compares her parcel to similar parcels being sold on the open market nationwide.

Issues with the “Income Approach”

However, assume the appraiser calculates the value of Jane’s parcel simply by making an estimate of the cash flow Jane would have obtained and would currently be enjoying if she had sold the property to X Corporation; in that scenario, the appraiser would use a series of factors and variables not necessarily demonstrated by objective market data. Under this method - the “income approach” - the value of the pre-easement parcel could be higher (and thus adding to the value of the tax deduction), but its reliability is more suspect and more likely to incur scrutiny from the federal government.

That is what happened in the case of various “syndicated” conservation easements developed by the company sued by the U.S. Department of Justice for tax fraud as discussed below.

Background on Syndicated Conservation Easements

Recently, the IRS has stepped up its enforcement efforts against organizations thought to be engaging in abusive tax-avoidance practices. In an official notice released in 2017, the IRS named “syndicated” conservation easement transactions as “listed transactions,” meaning such transactions are subject to extra reporting requirements and scrutiny by the IRS, violations of which can incur significant financial and even criminal penalties.[xv] These transactions are not presumptively illegal but are now being treated as enforcement priorities by the IRS and, at the very least, heavily discouraged by the federal government.

Syndicated conservation easement transactions typically involve an investment organization that promotes and facilitates the creation of a partnership or LLC and pools a group of investors to the partnership or LLC, which in turn purchases a piece of property and then donates the property as a conservation easement. The benefit of contributing to the partnership or LLC is a tax deduction for the conservation easement in an amount that “significantly exceeds the amount invested.”[xvi] According to the IRS, the main issue with these arrangements is that the properties are typically being appraised at “greatly inflated” levels.[xvii] That value inflation in turn allows these entities to claim inflated deductions, based on “unreasonable conclusions about the development potential” of the property that is being foregone due to the conservation easement’s establishment.[xviii]

DOJ Enforcement Action Against Atlanta-Based Syndicated Conservation Easement Group

The DOJ is the federal agency primarily tasked with enforcement of the federal tax laws in courts around the country. The DOJ filed a civil complaint in federal court against the leadership and primary organizers of EcoVest Capital, Inc., an Atlanta investment firm specializing in syndicated conservation easement transactions. The DOJ is seeking an injunction prohibiting the defendants (including EcoVest’s president and several senior officers, the group’s promotor, and the Alabama-based property appraiser retained by the group) from engaging in any more syndicated conservation easement transactions and disgorgement of the funds obtained “from any source” as a result of the syndication operation.

According to the DOJ, the defendants operated a conservation easement syndication “scheme” that is “nothing more than a thinly veiled sale of grossly overvalued federal tax deductions” under the “guise of investing in a partnership.”[xix] The DOJ claims that the easements owned by the LLCs are heavily overvalued by the appraiser,[xx] and that the investors are using those valuations to claim “highly inflated and overvalued tax deductions in the form of noncash charitable contribution deductions on their individual tax returns.”[xxi]

The “income approach” used by the Alabama appraiser which resulted in the high valuations of the easements at issue is not presumptively illegal, as discussed above.[xxii] However, the DOJ’s suit may be due in part to the seemingly unrealistic valuations and the resulting amount of tax benefits that investors obtained here. Specifically, the DOJ asserts that the scheme has resulted in the sale or promotion of “at least 96 conservation easement syndicates,” with a value of over $2 billion of federal tax deductions. At this time, no criminal charges have been brought against the defendants by the DOJ.

Several major cities and counties have recently passed laws governing short-term rental booking platforms like Airbnb, Home Away, and VRBO. Some of these laws have placed significant regulatory burdens on those platforms, and as a result, Airbnb and others have filed suit to overturn them.

District of Columbia

The District of Columbia’s city council recently passed one of the more restrictive ordinances in the country on November 13, 2018.[xxiii] That ordinance prohibits the listing of a property for a short-term rental if it is not the host’s primary residence. It imposes extensive licensing and recordkeeping requirements on hosts, and also requires third party platforms to report information about listings.

Due to its prohibition of many short-term rentals that currently operate in Washington, D.C., Mayor Muriel Bowser issued an official statement on January 15, 2019 to the city council refusing to sign the bill, citing her concerns with lost revenues to the city.[xxiv] She did not veto the bill, however, since the council has a veto-proof majority in favor of the bill. The ordinance may be vulnerable to a court challenge, as Mayor Bowser mentioned in her statement, because some of the bill’s reporting requirements may violate the Fourth Amendment to the U.S. Constitution’s prohibition on unreasonable searches and seizures.

New York City

The Fourth Amendment violation was the reason a federal court recently stayed enforcement of New York City’s short-term rental ordinance.[xxv] That order temporarily prevents the city from enforcing its ordinance requiring Airbnb and similar booking platforms to send reports on their users to the city’s Office of Special Enforcement, the city agency which regulates hotels.[xxvi]

The city’s ordinance was geared in part to ensure the state’s law prohibiting short-term rental of most apartments[xxvii] is not skirted by short-term rental service users. The ordinance requires booking platforms to report (among other things) the full names and addresses of users who rent their dwellings out, the type of dwelling units listed, fees received, and total days rented for every listing on the platform. The reports must be provided monthly to the regulatory agency, and significant financial penalties may be incurred if the booking platform fails to file a report.

Airbnb and Home Away sued New York City in federal court to prevent enforcement of the ordinance. They claimed that the ordinance violated the Fourth Amendment’s prohibition on unreasonable searches and seizures, the First Amendment’s protection against compelled speech, and privacy protections under the federal Stored Communications Act (SCA).[xxviii] The court upheld the companies’ Fourth Amendment claim as likely to succeed because the city was essentially operating a massive seizure of business records without first obtaining a warrant or court approval to obtain the records.[xxix] However, the court did not find in the companies’ favor on the First Amendment or SCA claims. The court held that the SCA claim would likely fail at trial because Airbnb and Home Away obtained user consent to searches of records in their terms of service.[xxx] The court did not substantively address the companies’ First Amendment claim, but also found it unlikely to succeed on the merits.[xxxi]

The case will now proceed to discovery (a process where both sides obtain evidence from each other), pending an appeal of the court’s order. At this time, the city has not filed an appeal.

Boston  

Airbnb has also filed a lawsuit seeking to overturn the City of Boston’s short-term rental ordinance, citing similar violations of the U.S. Constitution, federal, and state laws as its New York City lawsuit. Among other things, Boston’s ordinance requires Airbnb to screen user advertisements and to actively police its website for violations of the ordinance’s limitations on the types of residences that may be listed or exceed the maximum number of days a unit may be listed. The ordinance imposes significant penalties on booking services that do not ensure their websites are complying with the law.

Of note, in this lawsuit, Airbnb is also claiming Boston’s ordinance violates the federal Communications Decency Act (CDA), an argument not advanced in the New York City suit. The CDA generally prohibits holding websites liable as publishers or speakers of material for content published by a third party (i.e., a user of the website). Congress passed this law in part to “protect and nurture the Internet as a forum for communication.”[xxxii] Airbnb claims that Boston’s ordinance impermissibly holds it liable for content posted by Airbnb users, burdening the company with extensive monitoring requirements to ensure users are complying with the city’s law.

The ordinance was set to take effect on January 1, 2019, but the city has stated it will delay enforcement of parts of the ordinance while the lawsuit is pending.[xxxiii]

Other Recent Developments

The City Council of Los Angeles enacted an ordinance regulating short-term rentals on December 11, 2018. Similar to other such ordinances, it prohibits users from renting properties besides their primary residences, requires registration with the city, and requires booking websites to extensively monitor listings to ensure compliance with the ordinance. At this time, Airbnb has not filed a lawsuit to overturn that law.

In Texas, the City of Austin and the City of Grapevine (in between Dallas and Fort Worth) both have ordinances regulating short-term rentals that are in the middle of litigation. In addition, on January 4, 2019 Airbnb sued the City of Miami Beach, FL over its short-term rental law.

The AAR Public Policy Team will continue to monitor the nationwide litigation regarding state and local efforts to regulate short-term rental booking companies like Airbnb.