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)

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 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

Tax Court Denies Conservation Easement that Allowed Substitution of Property

us_tax_courtAs the IRS continues to challenge charitable deductions for the contribution of conservation and facade easements, the Tax Court is considering the details of these arrangements with greater scrutiny. In doing so, the Court is refining the law governing these transactions. In its most recent opinion on this issue, the Court clarified yet another requirement for taxpayers who wish to claim this charitable deduction.

In Belk v. Commissioner, 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 owner of the property (i.e., 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 use restriction granted in perpetuity under IRC §170(h)(2)(C).

The IRS previously had argued that certain facade easements violated the “in perpetuity” requirement. See, Kaufman v. Commissioner, 134 T.C. 182 (2010) (Kaufman I) and Kaufman v. Commissioner, 136 T.C. 294 (2011) (Kaufman II). The Kaufman argument, however, was based on the language of IRC §170(h)(5) which requires that the conservation purpose of the easement be protected in perpetuity. Though the IRS prevailed in the Tax Court, Kaufman and the §170(h)(5) argument was overturned by the First Circuit Court of Appeals. Kaufman v. Shulman, 687 F.3d 21 (1st Cir. 2012).

In Belk, the IRS, and apparently the taxpayers (see footnote 17), combined the two provisions of §170 while making the perpetuity argument. Judge Vasquez, writing for the Court, parsed the issue more carefully. He noted that §170(h)(2)(C) requires that the property must be subject to a perpetual restriction on use as distinguished from § 170(h)(5) which requires that the conservation purpose be protected in perpetuity. The Court made it clear that the two provisions were separate and distinct and based its decision on the former.

The Court held that the donation made by the Belk’s 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 court found that the contributed property was not subject to a use restriction in perpetuity but in fact 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 Court did not reach the question of conservation purpose or valuation.

Read the entire opinion here:
Belk v. Commissioner, 140 T.C. No. 1 (2013)