In the current economic environment, landowners previously contemplating development or sale of their real property are seeking alternative ways to generate cash flow from their real property assets. Some savvy landowners realize that there may be significant financial benefit to be derived from subjecting their property to a conservation easement or creating a mitigation bank. This article will briefly discuss the financial benefits and issues related to a lender's lien subordination and substitution of collateral.

ConservationEasements
A conservation easement is effectively a covenant and restriction agreement between a landowner and the easement holder. The easement holder may be a governmental body or a qualified charity. In accepting the conservation easement, the easement holder assumes a trust responsibility to monitor future uses of the land and ensure compliance with the terms of the easement if a violation occurs.

The primary purpose of a conservation easement is to protect agricultural land, timber resources, historical sites, and other valuable natural resources such as wildlife habitat, clean water, or scenic open space by restricting future development. The decision to place a conservation easement on property is strictly voluntary, but the restrictions are forever binding on both the present and future landowners. The conservation easement may preserve certain rights, including the right to farm, harvest timber and hunt. Indeed, the conservation easement may also preserve the landowner's right to engage in mitigation projects on the property. A landowner and easement holder may agree in the deed granting the easement that the landowner may retain limited subdivision rights or the ability to build additional residential structures on the property. Landowners may receive substantial tax benefits from a conservation easement which are discussed in more detail below.

Mitigation Easements
A mitigation bank begins with a determination that the landowner's property has the correct environmental attributes to create, enhance, restore and preserve wetlands or streams. The landowner obtains bank/project approval from an Interagency Review Team ("IRT") comprised of the EPA, Army Corps of Engineers ("Corps") and a variety of state and federal environmental agencies. Unlike with a Conservation Easement, the landowner is not required to designate an easement holder and may, therefore, manage the property itself in a manner consistent with the IRT-approved Mitigation Banking Instrument ("MBI"). The regulations require that the MBI contain financial assurance provisions for monitoring the project for ten years and repairing and replacing the mitigation bank in the event of loss or destruction.

A landowner may consider conservation and/or mitigation in an effort to convert tax benefits and mitigation credits to cash more quickly and profitably than available development alternatives in a down market.

Tax Credits and Deductions
The federal government and many states offer property tax incentives, in the form of tax credits and deductions, to conservation easement donors based on the so-called "land use" value assessment of the Property. Virginia is among approximately a dozen states that offer a state income tax incentive. Virginia permits taxpayers to sell income tax credits that they cannot or do not want to use themselves. This enables landowners to get cash in hand soon after putting the easement to record. Virginia's Land Preservation Tax Credit ("LPTC") is based on 40% of the value of the conservation easement after approval by the Department of Taxation (the "Credit Value"). The value of the conservation easement is determined by an appraisal performed in accordance with § 170 of the Internal Revenue Code. LPTCs were capped at $106 million per year in 2009. Currently, Virginia permits each taxpayer to use up to $50,000.00 per year of tax credits for the year recorded with up to 12 years carried forward. There is an active market for LPTCs in Virginia. Yields on these credits range from $0.72/$1.00 to $0.80/$1.00 of the Credit Value.

Landowners who donate a qualifying conservation easement under § 170(h) of the Internal Revenue Code also may be eligible for a federal income tax deduction equal to the value of their donation. When a landowner donates an easement meeting the IRS rules, he may deduct the value of the gift at the rate of, currently, 30% of his adjusted gross income ("AGI") per year. Any amount of the donation remaining after the first year can be carried forward for five additional years or until the amount of the deduction has been used up, whichever comes first, allowing a maximum of six years within which the deduction may be utilized. This may result in sizable tax refunds that could be assigned to the lender.

Additionally, property taxes are lowered and for landowners who will leave sizable land holdings in their estates upon their death, the most important financial impact of a conservation easement may be a significant reduction in estate taxes.

The Business of Mitigation Banking
While financial benefits for conservation easements come from taxes, which can be forecasted based on the appraisal; mitigation banking is less regulated and based upon supply and demand. The landowner who engages in mitigation obtains credits which can be sold to parties developing land within that watershed ("service area") to offset unavoidable wetland or stream impacts, such as the need to develop in or around a stream or fill a wetland. Credits are released periodically upon the mitigation banks achievement of goals established by its MBI and in accordance with federal regulations. The current regulatory environment favors the purchase of credits by developers to offset environmental impacts, rather than on-site or off-site mitigation.

Stream credits sell generally in the range of $500 to $600 or more per credit (based on a linear foot of stream interruption) and wetland credits in the range of $40,000 to $60,000 per acre. The cost of creation, restoration and enhancement is not insignificant; however, there has been ample room for profit after costs. The lower rate of commercial and residential development and governmental budget shortfalls eliminating infrastructure projects are adversely affecting the absorption rate for mitigation credits and may create downward pressure on credit pricing.

A landowner can use both a conservation easement and mitigation easement on its property in order to obtain the tax credits and tax deductions and the income stream from the sale of mitigation credits. This is a relatively sophisticated process. The reservation of the mitigation rights may reduce the number of tax credits and tax deductions and it is important to engage professionals with knowledge of each of these types of easements, including the appraiser, the engineers and attorneys.

Subordination and Collateral Issues
The lender's decision to subordinate its lien to these "easements" markedly differs from the standard decision-making process for development easement subordination. The collateral value is likely to be significantly affected and a subsequent foreclosure of the real property would be subject to the easements and possibly related landowner obligations. However, an assignment of a significant tax refund and the proceeds of the sale of tax credits and/or mitigation credits, or some portion thereof, may represent sufficient value for the lender to consider these in substitution of the value of the developable real property as collateral for outstanding indebtedness.

The legal documentation for taking a security interest in these types of collateral is similar to that used in historic tax credit transactions in which the parties would enter collateral assignment agreements, including assignment of the interests of individuals to whom these benefits would flow in the case of an entity borrower. There are a number of risks to the lender in these transactions, among them, perfection risk, appraisal and challenge risk, legislative risk and "novelty" risk. There is scant authority regarding the nature of tax credits as general intangibles under the Uniform Commercial Code, although several Bankruptcy Courts applying the laws of certain states have held that tax refunds, such as the earned income tax credit, are general intangibles to which a security interest can attach. ¹On the other hand, the Appellate Court of Illinois determined that low income housing incentives were not intangible personal property which could be made subject to a security interest as these incentives were not to be transferable.² As previously indicated, Virginia LPTCs are freely transferable as are the mitigation credits derived from mitigation banking, and therefore, may be considered general intangibles that may be secured under the Uniform Commercial Code.

The tax benefits derived from conservation easements are based upon an appraisal and are susceptible to audit and challenge for a period of three years. During this time period, it is likely that LPTCs would have been sold to third parties. In the event a challenge results in a decrease in the number of credits registered, the landowner would be liable to the tax credit purchasers; for this reason, an escrow, letter of credit or similar credit enhancement may be required. Although the lender or secured party has no direct liability, the consequences of an early challenge could result in diminished value of the tax benefits assigned to the lender. There is no parallel issue with respect to the sale of mitigation credits.

The tax benefits and mitigation programs are subject to legislative change in any given year. The substitution of tax benefits, tax credits and mitigation credits and the proceeds thereof is a novel approach to restructure a troubled real estate loan and may be accomplished in a structure which minimizes the risks to the lender.

*Contributing authors: Lee Stephens, Deborah Fourness and Robert Allen. Lee is a shareholder in our Irvington office, Deborah Fourness is of counsel in the Richmond office and Robert Allen is an associate with the firm and works from the Irvington and Richmond offices. Each of their practices involves conservation law, including mitigation banking, as well as general corporate, real estate, banking and finance. 

1. See, e.g. In re Richardson, 216 B.R. 206 (Bankr. S.D. Ohio 1997), In re Palmetto Pump & Irrigation, Inc., 81 B.R. 109 (Bankr. M.D. Fla. 1987), and In re Kendrick & King Lumber, Inc., 14 B.R. 764 (Bankr. W.D. Okla. 1981)

2. See, e.g., Chicago v. Michigan Beach Hous. Coop., 242 Ill. App. 3d 636 (Ill. App. Ct. 1^st Dist. 1993).