Anyone for Tennis? Technical Foot Faults & the Conservation Easement Tax Deduction

TennisBallOnCourtWe just wrapped up the 2016 Wimbledon fortnight. Andy Murray took the Men’s bracket while the Williams sisters are once again making news.

We found the rules that govern the grass courts can be instructive in understanding the outcome of several recent conservation easement tax cases. We put together our thoughts for the new issue of the Bloomberg BNA Real Estate Journal. Most of the article discusses the surprising decisions being reached by the courts but we do manage to reference the ITF, the USTA, Serena Williams and one of Eric Clapton’s old bands.

You can see the article here: Anyone for Tennis? Technical Foot Faults & the Conservation Easement Tax Deduction

Understanding the Conservation Easement Tax Deduction (or Strawberry Fields Forever)

We’ve covered developments in the litigation of conversation and facade easement cases here for some time now.  We’ve recently taken that experience, added a little historical perspective, and put it together for an article in the Federal Lawyer.  (Yes, we mention the Beatles too).

Check it out here:  Understanding the Conservation Easement Tax Deduction (or Strawberry Fields Forever)

Timing is Everything in Easement Donations, or Is It?

“There is a tide in the affairs of men which when taken at the flood leads on to fortune.”

William Shakespeare

Shakespeare understood the importance of timing to success. Apparently, the Tax Court holds a similar view when it comes to charitable donations of conservation easements.

life_is_all_about_timing_481189800This is our third post on the Tax Court’s opinion in Bosque Canyon Ranch. The memorandum decision isn’t necessarily an important case; it didn’t establish any new precedents for the Court. However, there is quite a bit about modern conservation easements packed into a fairly short opinion, which gives us an opportunity to unpack some of what is there.

Today, we look at the Court’s conclusion that the property transfers between the two Bosque Canyon limited partnerships and their partners were disguised sales. (Click here for a more detailed case summary.)

A transfer of partnership property to a partner within two years of a cash (or other) contribution by that partner is presumed to be a disguised sale under IRC §707. The Bosque Canyon partnerships received cash and transferred property to partners within a two year window. That timing is not in question.

The presumption in IRC §707 may be refuted by facts and circumstances showing that the transfer did not constitute a sale. Treas. Reg. §1.707-3(b)(2) suggests 10 circumstances when a sale might be present. The Court identified five of those factors in its opinion.

  • the timing and amount of the distributions to the limited partners were determinable with reasonable certainty at the time the partnerships accepted the limited partners’ payments;
  • the limited partners had legally enforceable rights, pursuant to the LP agreements, to receive their Homesite parcels and the appurtenant rights;
  • the transactions effectuated exchanges of the benefits and burdens of ownership relating to the Homesite parcels;
  • the distributions to the partners were disproportionately large in relation to the limited partners’ interests in partnership profits; and
  • the limited partners received their Homesite parcels in fee simple without an obligation to return them to the partnerships.

When the transfers between the partnership and partners are not simultaneous, an additional rule provides that a disguised sale occurs only if “the subsequent transfer is not dependent on the entrepreneurial risks of partnership operations.” Treas. Reg. §1.707-3(b)(1)(ii). The timing of the transfers was not in dispute either. They were not simultaneous.

The timing issue, however, came in the context of entrepreneurial risk. The taxpayers argued that the limited partners’ contributions would be at risk if the anticipated conservation easements were not granted. The Court rejected this argument based on the timing of the easement grants. Unfortunately, the conservation easements for both partnerships were granted before the limited partnership agreements were executed. The Court found that the payments were not subject to the entrepreneurial risks of the partnership because the easements were secured before the partnerships were formed. In the case of Bosque Canyon Ranch I, the easement was granted just two days before the agreement execution, prompting us to recall Maxwell Smart’s famous line.

Given the Court’s determination on entrepreneurial risk, there was no need to parse the specific facts and circumstances of these transfers, or whether the five factors identified by the court were enough to warrant disguised sale treatment. It leaves open the question whether similar, or even slightly different, facts and circumstances would be sufficient to find a disguised sale. We don’t know. But with time, and another case, there’s a fair chance we will.

Fourth Circuit Affirms the Tax Court on Conservation Easement Donation

US-CourtOfAppeals-4thCircuit-SealOn December 16, 2014, the Fourth Circuit Court of Appeals affirmed the U.S. Tax Court’s ruling in Belk v. Commissioner, 140 T.C. No. 1 (2013).  We previously discussed the Tax Court’s decision here.

In Belk, the taxpayers donated a conservation easement over a 184 acre golf course and claimed a $10.5 million deduction on their 2004 tax return. The conservation easement agreement executed by the parties included a provision which allowed the taxpayers to substitute the property subject to the easement with “an area of land owned by Owner which is contiguous to the Conservation Area for an equal or lesser area of land comprising a portion of the Conservation Area.”

The IRS challenged the validity of the entire donation on the grounds that the real property interest (i.e., the golf course) was not donated in perpetuity because the substitution provision allowed it to be replaced by another property. The IRS argued that the substitution provision violated the requirement that the contribution be an interest in real property that is subject to a perpetual use restriction under IRC §170(h)(2)(C).

The Tax Court held that the donation made by the taxpayers did not constitute a “qualified real property interest” under §170(h)(2)(C) because the conservation easement agreement allowed for substitution of the contributed property. The Tax Court found that the donated property was not subject to a use restriction in perpetuity but in fact was subject to the restriction only so long as the substitution provision in the agreement was not exercised. Accordingly, the charitable donation did not meet the requirements of §170(h) and the deduction was denied in full.

The taxpayers appealed to the Fourth Circuit Court of Appeals to determine whether the easement agreement’s substitution provision prevented the easement from being a donation of “qualified real property interest” under § 170(h)(2)(C).  The taxpayers argued that IRC § 170(h)(2)(C) requires a restriction in perpetuity on some real property, not necessarily the real property considered in the original easement agreement.  They argued that easement satisfied this requirement because the substitution provision requires that any property removed from the easement must be replaced by property of equal value that is subject to the same use restrictions.

The Fourth Circuit considered the plain language of IRC § 170(h)(2)(C), specifically, that a “qualified real property interest” includes “a restriction (granted in perpetuity) on the use which may be made of the real property.”  The Court particularly focused on the use of “the” real property as opposed to “some” or “any” real property.

Relying on two recent taxpayer favorable decisions, Kaufman v. Shulman, 687 F.3d 21 (1st Cir. 2012) and Simmons v. Commissioner, T.C. Memo 2009-208 aff’d. 646 F.3d 6 (D.C. Cir. 2011), the taxpayers argued that courts have approved deductions for conservation easements that put the perpetuity requirement at “far greater risk” than the substitution clause considered here.  The Court distinguished this case from Kaufman and Simmons because they considered the requirement that the conservation purpose be protected in perpetuity under IRC § 170(h)(5)(A).  Here, IRC § 170(h)(2)(C) regulates the grant of the property itself, not its subsequent enforcement.

The Court also rejected other taxpayer arguments based on state law and a savings clause contained in the easement document that would negate the substitution clause if it would result in the conservation easement failing to qualify under IRC § 170(h).  Citing Procter v. Commissioner, 142 F.2d 824 (4th Cir. 1944), the Court held that “when a savings clause provides that a future event alters the tax consequences of a conveyance, the savings clause imposes a condition subsequent and will not be enforced.”

In the end, the Fourth Circuit held that while the conservation purpose of the easement was perpetual, the use restriction on “the” real property is not in perpetuity because the taxpayers could remove land from the defined parcel and replace it with other land. The Court held that allowing the taxpayers to substitute property would enable them to bypass several other requirements of IRC § 170, including IRC § 170(f)(11)(D) requiring the taxpayers to get a qualified appraisal prior to claiming the charitable deduction.

Read the full opinion here: Belk v. Commissioner, No. 13-2161 (4th Cir. 2014)

Record Your Easement: Tax Court Adjusts Timing & Valuation of New York Facade Easement

us_Tax_Court_fasces-with-red-ribbonIn Zarlengo v. Commissioner, T.C. Memo 2014-161, the Tax Court held that a New York facade easement is not protected in perpetuity under IRC § 170(h)(5)(A) until the easement is recorded.  The Court followed its decision in Rothman v. Commissioner, TC Memo 2012-163 and New York state law, specifically NY. Env. Law § 49-0305(4), requiring that a “conservation easement shall be duly recorded and indexed as such in the office of the recording officer for the county or counties where the land is situate in the manner prescribed by article nine of the real property law.”  The Court disallowed the charitable deduction taken in the year before the easement was properly recorded and all carryover deductions from that year.

The taxpayer found some success with their appraisal and valuation experts, as they were able to keep a portion of the charitable deduction claimed after the easement was properly recorded.  They were also able to avoid accuracy-related penalties for years prior to the Pension Protection Act of 2006 by presenting a successful reasonable cause defense.

Read the full opinion here: Zarlengo v. Commissioner, T.C. Memo 2014-161

Second Circuit Affirms Importance of Proper Valuations for Facade Easements

Second Circuit Court of AppealsOn Wednesday, June 18, 2014, the Second Circuit Court of Appeals affirmed the U.S. Tax Court’s ruling in Scheidelman v. Commissioner, TC Memo 2013-18.

This is Scheidelman’s second, and likely final, visit to the Second Circuit Court of Appeals. See our previous discussion of the Second Circuit’s decision to vacate and remand the case back to the U.S. Tax Court.

Read the full opinion here:  Scheidelman v. Commissioner, No. 13-2650 (2d. Cir., June 18, 2014).

Conservation Easement Yields New Rule on Reasonable Cause Penalty Defense

us_Tax_Court_fasces-with-red-ribbonThe Tax Court disallowed another charitable deduction for the donation of a façade easement in Boston’s South End Historic District. This time the decision was based on valuation principles, not technical foot faults, and the taxpayers were able to avoid certain penalties.

In Chandler v. Commissioner, 142 TC No. 16 (2014), the taxpayers owned two homes in Boston’s South End Historic District, the Claremont Property and the West Newton Property. The homes were purchased in 2003 and 2005, respectively. The taxpayers entered into an agreement in 2004 to grant the National Architectural Trust (“NAT”) a façade easement on the Claremont Property. They then executed a similar arrangement when they purchased the West Newton Property in 2005.

The taxpayers used an NAT recommended expert to value the easements. He valued the Claremont easement at $191,400 and the West Newton easement at $371,250. The taxpayers took charitable deductions related to the easements of more than $450,000 between 2004 and 2006.

The IRS did not challenge the easements’ compliance with §170(h). However, the IRS did allege that the easements had no value because they did not meaningfully restrict the taxpayers’ properties beyond the provisions under local law. The taxpayers’ countered that the easement restrictions were broader than local law because they limited construction on the entire exterior of the home and required the owners to make repairs. Local law only restricted construction on portions of the property visible from a public way and did not require owners to make repairs. The taxpayers’ also noted that the easement subjected the property to stricter monitoring and enforcement of the restrictions. The Tax Court, citing its recent opinion in Kaufman v. Commissioner, T.C. Memo 2014-52, (discussed below), rejected the taxpayers’ arguments because “buyers do not perceive any difference between the competing sets of restrictions.”

The only remaining issue was valuation. The taxpayers abandoned their original appraisals and presented new expert testimony at trial. The taxpayers’ new expert used the comparable sales approach to calculate a before value of $1,385,000 for the Claremont Property and $2,950,000 for the West Newton Property. The taxpayers’ expert chose seven properties for comparison: four properties in Boston and three properties in New York City. On the basis of data from these properties, he estimated that the taxpayers’ easements diminished the value of both properties by 16%.

The Tax Court found the taxpayers’ expert unpersuasive. The Court dismissed the three New York City comparables because they “tell us little about easement values in Boston’s unique market.” The court also found that three of the four Boston properties were “obviously flawed.” The Court took particular exception to the expert’s use of a comparable unencumbered property that was not actually unencumbered. The Court stated that the “error undermines [the expert’s] credibility concerning not only this comparison, but the entire report.”

The Tax Court also found the respondent’s expert report unpersuasive. The respondent’s expert examined nine encumbered Boston properties that sold between 2005 and 2011. He compared the sales prices immediately before and after the imposition of the easements. Each property sold for more after it had been encumbered by the easement. However, the expert failed to account for significant renovations that took place on many of the properties after they were encumbered. Thus, the Court found the expert’s analysis unpersuasive because “it does not isolate the effect of easements on the properties in his sample.” However, in the final analysis, the Court sided with the IRS and disallowed the taxpayer’s deductions.

However, the Court did accept the taxpayers’ reasonable cause defense for gross valuation misstatement penalties in 2004 and 2005. Unfortunately, the reasonable cause exception for gross valuation misstatements of charitable contribution property was eliminated with the Pension Protection Act of 2006, so the Court denied the taxpayers’ reasonable cause defense for the 2006 tax period.

Read the full opinion here: Chandler v. Commissioner, 142 T.C. No. 16

Tax Court Rejects Expert Value, Imposes Penalties

us_Tax_Court_fasces-with-red-ribbonIn what may be the last word on Kaufman v. Commissioner, the Tax Court sustained the IRS’s complete disallowance of charitable deductions claimed for the donation of a façade easement. The case returned to the Tax Court on remand from the First Circuit Court of Appeals to determine the value of the easement and the application of accuracy-related penalties.

The taxpayers’ owned a 150 year-old row house in a designated historic district in Boston, Massachusetts subject to the South End Landmark District Residential Standards (“South End Standards”). In 2003, taxpayers’ entered into an agreement with the NAT to donate a façade easement over the property. The taxpayers contacted an appraiser, recommended by NAT, who appraised the value of the easement. The appraisal concluded that the total loss of value, including the easement and the value of the unused development rights, was $220,800. The taxpayers deducted that amount on their 2004 and 2005 tax returns as a charitable donation of a qualified conservation easement. The Commissioner challenged the deductions with a statutory notice of deficiency.

In Kaufman v. Commissioner, 134 T.C. 182 (2010) (Kaufman I), the Tax Court ruled for the IRS in a motion for partial summary judgment. The Court held that the conservation easement failed to satisfy the “in perpetuity” requirements of the Treasury Regulations. The Court then issued a second opinion making additional findings, disallowing other items and imposing penalties on the remaining issues (Kaufman II). The taxpayers’ appealed. The U.S. Court of Appeals for the First Circuit rejected the Tax Court’s ruling that the taxpayers’ mortgage lender agreement undercut the regulation’s “in perpetuity” requirement as a matter of law (Kaufmann III) and remanded for further consideration of the taxpayers’ charitable contribution deductions under the facts.

The primary issue on remand was the proper valuation of the façade easement. The taxpayers’ valuation expert used a sales comparison analysis with data from three comparable properties. Using the before-and-after method, he determined that the value of the property was $1,840,000 before the grant of the easement. The expert used a “method unique to him and not a generally accepted appraisal or valuation method” to determine that the total value of the property was reduced by 12% or $220,800 when encumbered by the façade easement.

The IRS’s expert discredited the taxpayer’s valuation stating that it was “the fruit of an inappropriate valuation methodology employing a wholly unsupported adjustment factor.” Notably, both the IRS expert and the taxpayer’s expert agreed, “neither the preservation agreement nor the preexisting restrictions hamper the potential for developing the property to its highest and best use…as a single family home.”

The Tax Court gave no weight to the taxpayers’ expert because of his close relationship with NAT, his limited experience appraising façade easements, and his use of a “unique” valuation methodology. The Court also conducted its own comparison of the façade easement restrictions and the South End Standards. The Tax Court found that the agreements were “basically duplicative” and there were no significant additional restrictions placed on the property by the façade easement.

The Court held in favor of the IRS finding that the façade easement had no fair market value when conveyed to NAT. The Tax Court also upheld the IRS’s imposition of accuracy-related penalties.

Read the full opinion here: Kaufman v. Commissioner, T.C. Memo. 2014-52

Tax Court Reverses Itself on Qualified Appraisals for Façade Easements

UESThe proper standard for a qualified appraisal in the façade easement context has been vigorously contested by the IRS in recent years. In a rare reversal on reconsideration, the Tax Court adopted the Second Circuit Court of Appeals’ view of the necessary elements for a qualified appraisal in the context of these easement deductions. In short, the Court affirmed that the regulatory standard for a qualified appraisal requires only a method of valuation and a basis for valuation.

The decision under reconsideration was Friedberg v. Commissioner , TC Memo. 2011-238. In the reversal the Tax Court observed its practice of following the precedent of the U.S Court of Appeals to which a case may be appealed, first established in Golsen v. Commissioner, 54 T.C. 742 (1970).

In 2002, the taxpayers, Mr. Friedberg and Ms. Moss, purchased a townhouse in Manhattan’s Upper East Side Historic District for $9,400,000. In 2003, the National Architectural Trust (NAT) contacted Mr. Friedberg and asked him to donate a façade easement. Mr. Friedberg agreed and contacted an appraiser, recommended by NAT, who appraised the value of the easement. The appraisal concluded that the total loss of value, including the easement and the value of unused development rights, was $3,775,000. The taxpayers deducted that amount on their 2003 tax return as a charitable donation of a qualified conservation easement. The Commissioner challenged the deduction with a statutory notice of deficiency. The taxpayers filed a petition in the Tax Court.

The Tax Court issued an opinion following cross-motions on summary judgment. One of the questions decided in favor of respondent was that the taxpayers had failed to provide a qualified appraisal under Treas. Reg. §1.170A-13(c)(3)(ii). In reaching that determination, the Court followed its findings in Scheidelman v. Commissioner, T.C. Memo. 2010-151 (Scheidelman I) where it found that

“the mechanical application of a percentage diminution to the fair market value before donation of a façade easement does not constitute a method of valuation as contemplated under section 1.170A-13(c)(3)(ii).”

Though Friedberg and Moss lost on that issue, not all of the argued issues were decided, including whether the appraisal was “qualified” as to the valuation of the unused development rights. The parties continued discovery on that question.

Meanwhile, in Scheidelman v. Commissioner, 682 F.3d 189 (2d Cir. 2012) (Scheidelman II), the Second Circuit vacated the Tax Court on the qualified appraisal standard referenced in the Friedberg opinion. The Court of Appeals held that Huda Scheidelman had obtained a qualified appraisal under the regulations because her appraisal adequately specified the appraiser’s method of, and basis for, determining the easement’s fair market value.

Friedberg and Moss were still hashing out interrogatories and depositions when the Second Circuit decided Ms. Scheidelman’s case. They filed a motion for reconsideration of the Court’s earlier ruling under Tax Court Rule 161. The Tax Court granted the motion.

On reconsideration, the Tax Court found that the appellate opinion “specifically alter[ed] the underlying law” applied in the 2011 Friedberg decision. The Tax Court held that under Scheidelman II

“any evaluation of accuracy is irrelevant for purposes of deciding whether the appraisal is qualified pursuant to section 1.170A-13(c)(3)(ii)(J), Income Tax Regs.”

Accordingly, the Court re-examined the two elements necessary for a qualified appraisal under Treas. Reg. §1.170A-13(c)(3): (1) a method of valuation and (2) a specific basis for the valuation. With regard to the first element, the Court found that Mr. Freidberg’s appraiser provided sufficient information to enable the Commissioner to evaluate his underlying methodology. Thus it included a method of valuation. The Court then considered and found that the appraisal included “some research and analysis” which was enough to establish a specific basis for the appraisal. The legal standard met, the Court reversed its holding in favor of the government and granted summary judgment for the taxpayers on the question of whether they had obtained a qualified appraisal.

The case is hardly over for Friedberg and Moss though. The Court specifically did not opine on the reliability and accuracy of the appraisal, reserving that factual determination for trial. Nonetheless, the Court’s reconsideration reversed its legal ruling in favor of the government and re-established the appraisal as qualified under the regulations. Whether the merits of the appraisal will withstand the scrutiny of a trial remains to be determined.

Read the opinion here:
Friedberg v. Commissioner, TC Memo. 2013-224

Tax Court Reasserts Position on Conservation Easements

Opining on a motion for reconsideration, the Tax Court has reaffirmed the circumstances under which a conservation easement might be extinguished without violating the regulatory requirement that the donation be made in perpetuity. Asked to account for an intervening change in the law based on First Circuit Court of Appeals’ decision in Kaufman v. Shulman, the Court declined to change its earlier decision in Carpenter v. Commissioner, T.C. Memo. 2012-1.

In the matter under reconsideration, the parties reserved the right to extinguish the conservation easement by mutual agreement. Under those circumstances, the donee organization would have received its proportionate share of the proceeds following removal of the easement. The taxpayers argued that these circumstances met the in perpetuity “safe harbor” under Treas. Reg. Sec. 1.170A- 14(g)(6)(i) for terminated conservation easements.

The Court disagreed and emphasized that “extinguishment by judicial proceedings is necessary” to satisfy the regulation and that a proportionate share reserved for the donee organization is not an adequate substitute for guaranteeing the donation in perpetuity. The Court also reminded the taxpayers that in cases appealable to Federal Courts of Appeals that had not ruled on the issue – as was the case here – the First Circuit’s decision is not binding on the Tax Court.

Read the entire opinion here:
Carpenter v. Commissioner, T.C. Memo. 2013-172