Tax Court Denies Texas Conservation Easement

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.

BCRBosque 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.

Procedural History

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.”

Disguised Sale

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

Tax Court Denies Conservation Easement Donation on Qualified Appraisal

farms_ag_howard_countyQuality 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)

Reliance on Tax Attorney & Licensed Appraiser Helps Taxpayer Preserve Deductions & Avoid Penalties

us_tax_courtIn Palmer Ranch v. Commissioner, a TEFRA partnership avoided accuracy-related penalties even though the Tax Court reduced the fair market value of its conservation easement by $3.98 million.

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

Tax Court: No Penalties for Son of Boss Participants

In a memorandum opinion related to a division opinion we reported earlier this year, the Tax Court has found that underpayment and accuracy-related penalties asserted against investors in a “Son of Boss” tax shelter, did not apply to the participant taxpayers because they established reasonable cause under IRC § 6664(c)(1). However, the Court did sustain the government’s determination, which apparently was uncontested by the taxpayers, that they had underreported tax because of their involvement with the Son of Boss transactions.

The opinion offers a thorough discussion of the taxpayers’ conduct and the applicable standards for reasonable cause. The language and findings may provide useful guidance for taxpayers, and their counsel, seeking to avoid penalties by establishing reliance upon their advisors.

Read the entire opinion here:
Rawls v. Commissioner, T.C. Memo. 2012-340

Tax Court: Penalties Apply for Taxpayer Who Does Not Show Reliance on Tax Advice

In a reviewed opinion, the Tax Court has found that a sophisticated taxpayer (i.e., a hedge fund manager) could not avoid penalties by relying on the reasonable cause defense under Sec. 6664(c)(1) where the taxpayer presented no evidence that the omitted income was because he relied on advice given by the tax return preparer.

Read the opinion here:
Woodsum v. Commissioner, 136 T.C. No. 29 (2011)

Palmlund v. Commissioner

The Tax Court holds that a partnership can assert a reasonable cause defense to section 6662 penalties. However, reliance on a promoter, defined as an “advisor who participates in structuring the transaction”, is not reasonable cause for purposes of avoiding the penalty.

Palmlund v. Commissioner, 136 T.C. No. 3 (2011)