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).
“There is a tide in the affairs of men which when taken at the flood leads on to fortune.”
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.
This 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.
Last week we wrote about the Tax Court’s application of Belk v. Commissioner, 140 T.C. 1 (2013) in the Bosque Canyon Ranch case. Here’s a more detailed description of the case.
Bosque Canyon Ranch (“BCR”) is a 3,729 acre-tract in Bosque County, Texas. Petitioners formed BCR I, a Texas limited partnership, in July 2003. BCR I made $2.2 million in improvements to BC Ranch between 2003 and 2005.
In 2004, BCR I began marketing limited partnership interest (“LP units”) at $350,000 per unit. Each purchaser would become a limited partner in BCR I and the partnership would subsequently distribute a fee simple interest in a five-acre parcel of property (the “Homesite parcel”) to that limited partner. Each Homesite Parcel owner had the right to build a house on the parcel and use BC Ranch for various activities. The distribution of Homesite Parcels was conditioned on BCR I granting a conservation easement to the North American Land Trust (“NALT”) for 1,750 acres of BC Ranch.
BCR I granted the conservation easement to NALT on December 29, 2005. The land subject to the conservation easement could not be used for residential, commercial, institutional, industrial, or agricultural purposes. BCR I had 24 LP purchasers in 2005 with payments totaling $8,400,000. BCR I obtained a certified appraisal report effective November 28, 2005, valuing the conservation easement at $8,400,000.
BCR II was formed in December 2005 as a Texas limited partnership and BCR I deeded 1,866 acres of BC Ranch to BCR II. In 2006, BCR II began marketing Homesite parcels with offering documents were substantially similar to that of BCR I. BCR II granted NALT a conservation easement on September 14, 2007. BCR II collected payments of $9,957,500 from 23 purchasers and obtained an appraisal valuing the 2007 easement at $7,500,000.
After all of the transfers, the 47 limited partners of BCR I and BCR II owned approximately 235 acres and 3,482 of the remaining 3,509 acres were subject to the 2005 and 2007 NALT easements.
BCR I filed a 2005 Form 1065 reporting capital contributions of $8,400,000 and claiming an $8,400,000 charitable contribution deduction related to the 2005 NALT easement. The IRS sent petitioner a 2005 FPAA on December 29, 2008, determining that BCR I was not entitled to a charitable contribution deduction. The IRS also determined that petitioners were subject to either accuracy-related or gross valuation misstatement penalties. IRS counsel submitted an amended answer on April 26, 2010, contending that the BCR I transactions at issue were sales of real property.
BCR II filed a 2007 Form 1065 reporting capital contributions of $9,956,500 and claiming an $7,500,000 charitable contribution deduction related to the 2007 NALT easement. The IRS sent petitioner a 2007 FPAA on August 23, 2011, determining that BCR II was not entitled to a charitable contribution deduction and that petitioners were subject to either accuracy-related or gross valuation misstatement penalties. IRS counsel did not allege that the BCR II transactions were sales of real property. The Court consolidated petitioners’ cases for trial.
Charitable Contribution Deductions
The Homesite parcel owners and the NALT could, by mutual agreement, modify the Homesite boundaries. The deed forbids a decrease in “the overall property subject to the easement” and changes in the “exterior boundaries of the property subject to the easement.” The deed also provides that the boundary changes only occur between unburdened parcels (the Homesite lots).
The Court found that the property protected by the 2005 and 2007 easements could lose this protection as a result of boundary modifications allowed after the easements were granted. Citing Belk v. Commissioner, 140 T.C. 1 (2013), the Court held that the restrictions were not granted in perpetuity as required under IRC § 170(h)(2)(C) because the 2005 and 2007 deeds allow modifications between the Homesite parcels and the property subject to the easements. Thus, the easements are not qualified real property interests required under IRC § 170(h)(1)(A). (There are some distinct factual differences from Belk that we noted in an earlier post found here).
Judge Foley also took issue with the lack of documentation establishing the condition of the property provided by petitioners to NALT as required by Treas. Reg. § 1.170A-14(g)(5)(i). The Court found that the documentation was “unreliable, incomplete, and insufficient to establish the condition of the relevant property on the date the respective easements were granted.”
Judge Foley found that the partnerships deeded the Homesite properties to the limited partners within five months of the limited partners’ payments for the property. Under Treas. Reg. 1.707-3(c)(1) and 1.707-6(a) transfers between a partnership and a partner within a two-year period are presumed to be a sale of the property to the partner unless the facts and circumstances clearly establish that the transfers do not constitute a sale.
Petitioners argued that the partners’ payments would be at risk, pursuant to the terms of the LP agreements, if the easements were not granted. The Court rejected this argument based on its finding that the 2005 and 2007 easements were granted prior to the execution of the BCR I and BCR II LP agreements, respectively. Thus, the Court held that BCR I and BCR II were required to recognize income on any gains related to the 24 and 23 disguised sales by each limited partnership, respectively.
Gross Valuation Misstatement Penalties
Judge Foley held that the petitioners were liable for a 40% gross valuation misstatement penalty under IRC § 6662(h). Petitioner’s argued that they acted reasonably and in good faith by procuring a qualified appraisal from a qualified appraiser and by relying on a memorandum from their CPA. Judge Foley found that while these actions constituted a good faith investigation of the easement’s value, BCR I did not provide NALT with sufficient documentation of the condition of the property being donated and affirmed the 40% gross valuation misstatement penalty against BCR I for 2005.
For returns filed after August 17, 2006, the gross valuation misstatement penalty is modified by Treas. Reg. § 1.6662-5(g) when the determined value of the property is zero and the value claimed is greater than zero. Additionally, taxpayers who file returns after 2006 can no longer claim a reasonable cause defense for gross valuation misstatements relating to charitable contribution deductions. (Though reasonable cause is still a valid defense for substantial valuation misstatements. See, IRC § 6664(c)(3).) Thus, the Court held that BCR II is liable for the 40% gross valuation misstatement penalty relating to the 2007 tax year.
Read the full opinion here: Bosque Canyon Ranch L.P., v. Commissioner, TC-Memo. 2015-130
“Heads I win, tails you lose / to the never mind / when to draw the line”
– “Draw the Line” Aerosmith (1977)
The Tax Court continues to take a page from Steven Tyler’s songbook when it comes to property lines and conservation easements. In Bosque Canyon Ranch, L.P. v. Commissioner, the Tax Court rejected two related partnerships’ deductions for the donation of conservation easements. Among the shortcomings the Court found with the partnerships’ donations was a deed provision permitting “modifications to the boundaries between the Homesite parcels.” The Homesite parcels were not subject to the conservation restrictions placed over the remainder of the development property.
The potential post-donation modifications to the Homesite parcels were subject to the approval (within reasonable judgment) of the North American Land Trust; could not affect the exterior boundaries of the property subject to the easement; and the overall property subject to the easements could not be decreased. Despite these limitations, the Court, following Belk v. Commissioner, 140 T.C. 1 (2013), found that because the potential boundary modifications were in place at the time of the donation, the restrictions on the use of the property were not granted in perpetuity in violation of IRC 170(h)(2)(C).
The Belk court found that the perpetual donation requirement of IRC 170(h)(2)(C) was violated by a deed allowing the substitution of property subject to the original easement for continguous property of equal area and value after the donation of the easement. The Belk court seemed to be concerned with its ability to identify the specific real property interest subject to the easement at the date the easement was granted. Presumably, the Court felt it could not do that because the potential substitution of adjacent property could change the boundaries of the burdened parcel at any time. And because the specific real property interest had not been identified upon donation, it had not been burdened in perpetuity.
The Bosque Canyon opinion does not provide the detailed deed language that the Belk opinion did, but it does describe the deed as forbidding a decrease in “the overall property subject to the easement” and changes in the “exterior boundaries of the property subject to the easement.” It also suggests that the boundary changes only occur between unburdened parcels (the Homesite lots). These deed provisions – at least as characterized by the court – seem to be a bit different from those in Belk.
Under the Bosque Canyon provisions there could be no change in the borders of the burdened parcel, no diminution of the property subject to the easement and apparently no change in or substitution of property not originally identified. It seems that the Bosque Canyon deeds were limited to redrawing internal boundary lines between unburdened parcels in the same development that included the conservation easement.
If that is the case, then does the deed language in Bosque Canyon really raise the same identification of restricted real property interest subject to the conservation easement issue that concerned the Court in Belk? Is the redrawing of these lines of any real consequence to the identification of a real property interest subject to perpetual protection?
Unfortunately, the Court took issue with much more than the deed modifications in Bosque Canyon (which we will discuss in a future post) so the prospect of appellate review on this discreet deed modification issue is slim. It seems unlikely that the Tax Court intends to create a “heads I win/tails you lose” situation when it comes to deed modifications in conservation easement cases. Nonetheless, Belk might warrant a closer look if it is going to continue to guide the Court’s interpretation of IRC 170(h)(2)(C).
Read the opinion here: Bosque Canyon Ranch L.P., v. Commissioner, TC-Memo. 2015-130
Quality appraisals are still key to conservation easement donation deductions. In Costello v. Commissioner, T.C. Memo 2015-87, the Tax Court held that the taxpayers did not submit a “qualified appraisal” within the meaning of IRC § 170(f)(11)(E)(1) and upheld the substantial valuation misstatement penalties imposed on the taxpayers for the 2006, 2007, and 2008 tax years.
The taxpayers own a farm in Howard County, Maryland. Howard County uses a density exchange program in which each property has a certain number of development rights that may be sold to another developer of property, referred to as a “density exchange option.” Each development right essentially equates to one additional residence that a developer can build on a given property. In order to sell their development rights to a third party, the landowner must grant an easement to Howard County.
In 2006, the taxpayers granted the county a land preservation easement on their property. The taxpayers sold 16 of their 17 available development rights to a developer for a total purchase price of $2.56 million. Upon recordation of the deed of easement on October 17, 2006 all future development was prohibited on the taxpayers’ farm with the exception of farming.
The taxpayers obtained an appraisal on July 1, 2007. The appraisal assumed they could purchase eight additional development rights and the highest and best use of the subdivision would be a subdivision with 25 homes. The appraiser estimated a fair market value of $7.69 million before the sale of the development rights and gauged the fair market value of the property after the sale of the development rights at $2.1 million.
The taxpayers’ appraisal stated the assumption that the property was “free and clear of any and all liens or encumbrances” as of December 1, 2006. The appraisal did not account for the $2.56 million that the taxpayers received from the developer and the easement granted to the county in exchange for 16 of their 17 available development rights.
Additionally, the taxpayers’ 2007 appraisal omitted a number of required items, including an accurate description of the property contributed, the date of the contribution, or the terms of agreement. It also did not use the words “conservation easement” or “land preservation easement.” Judge Lauber concluded that the appraiser was not aware of the deed of easement that the taxpayer’s transferred to Howard County.
The donee (Howard County) did not sign the appraisal summary, as required under Treas. Reg. § 1.170A-13(c)(4)(i)(B), because it had serious doubts about the taxpayer’s ability to take a charitable contribution deduction. At the taxpayers’ request, the appraiser prepared an addendum on March 25, 2008 taking into account the $2.56 million that the taxpayer’s received for their development rights in 2006. The addendum reduced the taxpayers’ noncash charitable contribution to $3,004,692.
An official from Howard County signed off on the addendum and the taxpayers filed an amended 2006 return on May 16, 2008. The taxpayers’ claimed a charitable contribution deduction of $1,058,643 on their amended 2006 return, $1,666,528 on their 2007 return, and the remaining $278,521 on their 2008 return.
The IRS issued a notice of deficiency for all three years on July 13, 2012 disallowing the charitable contribution deductions in full and assessing accuracy-related penalties. The notice of deficiency also disallowed like-kind exchange treatment on the sale of the development rights and deductions claimed for business use of the home. The taxpayers’ timely petitioned the Tax Court challenging the disallowance of the charitable contribution deductions, asserting a higher basis on the sale of the development rights, and disputing the accuracy-related penalties.
At trial, Judge Lauber did not consider the taxpayer’s addendum to the appraisal because it was made more than five months after the due date (including extensions) of the taxpayer’s 2006 return. Under Treas. Reg. § 1.170A-13(c)(3)(i)(A) to be “qualified” an appraisal must be made no more than 60 days before the contribution and no later than the due date (including extensions) of the return on which the charitable deduction is first claimed.
The taxpayers argued for application of the substantial compliance doctrine under Bond v. Commissioner, 100 T.C. 32 (1993) and Hewitt v. Commissioner, 109 T.C. 258 (1997). Judge Lauber held that the numerous defects and missing categories in the taxpayers’ appraisal prevented the taxpayers’ from successfully asserting substantial compliance. Judge Lauber further opined that even if the court assumed substantial compliance, the contribution was part of a quid pro quo exchange as defined in Hernandez v. Commissioner, 490 U.S. 680 (1989), because the taxpayers could not legally sell the development rights without first granting an easement to Howard County.
The Court also dismissed the taxpayers’ contention that the transaction was a bargain sale because once the taxpayers signed the contract to sell their development rights, they had no excess development potential to grant Howard County through a bargain sale.
In sum, the Court held that the appraisal “failed to inform the IRS of the essence of the transaction in which petitioner’s engaged.” Thus, the appraisal was not a qualified appraisal under Treas. Reg. § 1.170A-13(c)(3)(i).
Judge Lauber also denied the taxpayers’ reasonable cause defense to the application of the 20% substantial valuation misstatement penalties under IRC § 6662(b)(3) for all three-tax years because the taxpayers did not get a qualified appraisal under IRC § 170(f)(11)(E)(1).
Read the full opinion here: Costello v. Commissioner, T.C. Memo 2015-87 (2015)
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)
In 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
The 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
The taxpayer claimed a $23.94 million charitable contribution deduction on its 2006 partnership return. The IRS disallowed $16.97 million of the value under exam. At trial, the parties presented valuation experts who relied upon the comparable sales method to set the before and after value of the property. The taxpayer’s expert valued the land at $307,000 per acre, while the IRS expert came in at at $94,000 per acre. The Tax Court reviewed the four properties used by both experts and compared the property’s then-current use with its highest and best use. The taxpayers’ contended that 360 multifamily dwelling units could be developed on the 82-acre parcel. The IRS disagreed, emphasizing: a failed rezoning history; environmental concerns; limited access to outside roads; and neighborhood opposition. The Court rejected each of these arguments and found that “there is a reasonable probability that [the parcel] could have been successfully rezoned to allow for the development of multifamily dwellings.”
The IRS also argued that the real estate market was softening in 2006. Judge Goeke accepted the idea of a declining real estate market and reduced the taxpayer’s pre-encumbrance appraisal of the land from $25.2 million to $21 million. Using the same “after” value percentage (5% of the unencumbered property) the Court found that the fair market value of the conservation easement was $19.96 million.
Following the framework set forth in the U.S. Supreme Court’s recent decision in United States v. Woods, the Court determined that it had jurisdiction to consider the IRC § 6662 penalties. The Court then accepted the taxpayers’ reasonable cause defense and disallowed the 20% penalty because the taxpayer: retained a tax attorney to advise them on the tax aspects of the easement donation; hired a credible, licensed appraiser, and made a good-faith attempt to determine the easement value.
Read the Tax Court opinion here: Palmer Ranch v. Commissioner, T.C. Memo. 2014-79
In 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