The deductibility of a charitable donation for a conservation easement or restriction on a real property interest is provided for under Sec. 170(h). Even with almost 13 pages of regulations (Regs. Sec. 1.170A-14), this provision is not straightforward, as evidenced by the number of taxpayers challenged by the IRS. Careful adherence to the regulations is necessary to avoid the risk of losing the charitable deduction (see “Charitable Contributions of Conservation Easements,” JofA, Nov. 2011, page 58, for more on relevant provisions on the types of property interests covered by the Code and regulations and considerations for taxpayers and their CPA advisers and return preparers in claiming deductions for charitable contributions). This article provides an overview of recent developments in the deductibility of conservation easements.
In several recent cases, the IRS has challenged the validity of the donation. Repeated IRS challenges are related to appraisals, substantiation, and compliance with the requirements of Regs. Sec. 1.170A-14(g) that the façade or conservation easement be enforceable in perpetuity.
SUBORDINATION BY THE MORTGAGEE
Under Regs. Sec. 1.170A-14(g)(2), if the donated property is subject to a mortgage, the rights of the mortgagee must be subordinated to those of the qualified donee to enforce the conservation purpose in perpetuity. In one recent case, Wall, T.C. Memo. 2012-169, the IRS denied a deduction, saying it was not clear that the mortgages on the property were actually subordinated to the interests of the charity.
The confusion arose over certain clauses in the preservation easement agreement. On Dec. 10, 2003, the petitioner entered into a preservation easement agreement with Landmarks Preservation Council of Illinois (LPCI). The contribution consisted of a preservation easement encumbering certain elements of his personal residence.
The Tax Court noted that under Secs. 170(h)(1)–(5), a qualified conservation contribution must be of a qualified real property interest to a qualified organization, made exclusively for conservation purposes, and that a contribution is not treated as exclusively for conservation purposes unless such purposes are protected in perpetuity. The court further explained:
If subsequent changes result in judicial extinguishment of the easement, the conservation purpose of the contribution is nonetheless treated as protected in perpetuity if the donee organization is entitled to a portion of the proceeds from a subsequent sale, exchange, or involuntary conversion of the subject property [that] is at least equal to the proportionate value of the perpetual conservation restriction, and it uses those proceeds in a manner consistent with the conservation purpose of the original contribution. Sec. 1.170A-14(g)(6)(i), Income Tax Regs.
Citing Kaufman, 134 T.C. 182 (2010), the court said this provision “is unconditional; if the donee organization is not entitled to a proportionate share of such proceeds, then the conservation purpose of the contribution is not protected in perpetuity.” (Emphasis in original.)
If the property on which an easement or restriction is made is subject to a mortgage and the mortgage holder’s interest is not subordinate to the interests of the charity, then the donation is not protected in perpetuity. The reason for this provision is that the organization is not otherwise guaranteed that it would receive a portion of the proceeds at least equal to the proportionate value of the perpetual conservation restriction in the case of a sale, exchange, or involuntary conversion.
The Wall easement agreement provided that each lienholder had agreed to subordinate its mortgage interest to the preservation easement. Representatives of the banks executed “Lender Acknowledgment–Preservation Easement” agreements that purported to subordinate the banks’ mortgage rights to those of LPCI. However, the lender acknowledgments also contained clauses that granted the banks a prior claim to insurance and condemnation proceeds in preference to LPCI. Consequently, the court found that “[a]s a result, LPCI does not have a guaranteed right to its proportionate share of such proceeds as required by section 1.170A-14(g)(6), Income Tax Regs.”
The court in Wall repeatedly relied on Kaufman, in which the Tax Court held that the taxpayers were not entitled to the charitable contribution deduction because the façade easement in that case did not meet the Sec. 170(h)(1) requirement that a qualified conservation contribution must grant a restriction on the property’s use in perpetuity: The bank holding the mortgage had a “prior claim” to insurance and condemnation proceeds. The Kaufman court concluded that the façade easement contribution thus “failed as a matter of law to comply with the enforceability-in-perpetuity requirement” of Regs. Sec. 1.170A-14(g).
However, the Kaufman case was subsequently overturned by the First Circuit (681 F.3d 21 (1st Cir. 2012)) and remanded to the Tax Court. The First Circuit held that the statute does not support “the stringent outcome that the IRS seeks to ascribe to it and the consequences of the reading would be to deprive the donee organization of flexibility to deal with remote contingencies” (see also “Tax Matters: Tax Court’s Denial of Easement Deduction Deemed Unreasonable,” JofA, Oct. 2012, page 62).
In Mitchell, 138 T.C. No. 16 (2012), the Tax Court found that the donor was not entitled to a charitable contribution deduction for a conservation easement because she failed to meet the subordination requirements. The donation occurred in 2003, when the property was subject to a deed of trust securing the debt to the previous owner, who was to be paid in installments. In 2005, a subordination agreement was entered into, but the court found that the agreement should have taken place at the time the gift was made. The taxpayer tried to rely on the “so-remote-as-to-be-negligible standard” of Regs. Sec. 1.170A-14(g)(3), but the court held that it did not apply. The Tax Court held that the subordination requirement of Regs. Sec. 1.170A-14(g)(2) “should not be read in tandem with the so-remote-as-to-be-negligible standard.” The court wrote, “The requirements of the subordination regulation are strict requirements that may not be avoided by use of the so-remote-as-to-be-negligible standard.”
In Minnick, T.C. Memo. 2012-345, the taxpayer tried to argue that a provision in the easement grant warranting that there were no interests in the property “that have not been expressly subordinated to the Easement,” demonstrated that he intended a mortgage to be subordinated to the donee’s rights. The court, however, denied the deduction because the mortgage was not actually subordinated.
Another frequent IRS challenge concerns the method used for valuing a noncash charitable donation. The Second Circuit in Scheidelman, 682 F.3d 189 (2d Cir. 2012), rev’g T.C. Memo. 2010-151, found in favor of the taxpayer. The Tax Court had ruled that the appraisal of a historic façade easement insufficiently explained the method and basis of valuation and thereby failed to comply with Treasury regulations, citing Regs. Sec. 1.170A-13(c)(3).
The Tax Court had found that Scheidelman was ineligible for the deduction because the appraisal was not a qualified appraisal. The appraisal failed to state the method of, and the basis for, the valuation, as required by Regs. Secs. 1.170A-13(c)(3)(ii)(J) and (K), the Tax Court had held.
Considering the method and basis used, the Second Circuit rejected the Tax Court’s conclusion that “the application of a percentage to the fair market value before conveyance of the façade easement, without explanation, cannot constitute a method of valuation.” The Second Circuit stated, “For the purpose of gauging compliance with the reporting requirement, it is irrelevant that the IRS believes the method employed was sloppy or inaccurate, or haphazardly applied—it remains a method. ... The regulation requires only that the appraiser identify the valuation method ‘used’; it does not require that the method adopted be reliable.” The court went on to state in a footnote, “In any event, the Commissioner’s interpretation, that an unreliable method is no method at all, goes beyond the wording of the regulation, which imposes only a reporting requirement.”
However, on remand, the Tax Court held that the façade easement had no value for purposes of the charitable deduction, accepting the IRS expert’s testimony that the façade easement did not affect the market value of the building (Scheidelman, T.C. Memo. 2013-18).
Four days before the appellate court sided with the taxpayers in Scheidelman, the Tax Court again denied a deduction for a charitable donation of a façade easement for the same reasons as in Scheidelman. The court in Rothman, T.C. Memo. 2012-163, rejected the taxpayer’s deduction, as the appraisal did not indicate the specific basis for the valuation. Additionally, the appraisal did not include a statement that the appraisal was made for income tax purposes, the terms of the donor/donee agreement, a description of the property, or a contribution date. The court also indicated that the appraisal did not adequately list the appraiser as being qualified under Regs. Sec. 1.170A-13(c)(3)(i)(B), nor was there a description of the appraiser’s background including his experience, education, and professional appraiser association memberships, as required under Regs. Sec. 1.170A-13(c)(3)(ii)(F). Also, the court said, the taxpayer incorrectly used market value versus fair market value, as required under Regs. Sec. 1.170A-13(c)(3)(ii)(I). On reconsideration after the Second Circuit’s decision in Scheidelman, the Tax Court in Rothman, T.C. Memo. 2012-218, determined that the appraisal in the latter case did meet the requirement of stating a method and specific basis for determining value. However, the court found that the appraisal still failed enough other requirements that it was not qualified.
In Dunlap, T.C. Memo. 2012-126, the Tax Court determined that seven owners of condominium units had failed to meet their burden of proof in demonstrating any value for their apportioned shares of a façade easement on the condominium building in which they owned units. The court determined that the unit owners’ two expert appraisals of the façade easement were not credible and identified various flaws in the experts’ valuation methods. These included using an income capitalization method for a hypothetical rental property otherwise identical to the condominiums, when the highest and best use for the property was as a condominium. The appraisals also used only comparable sales for years after the date of the easement, which oversampled sales in the worst year of the real estate market included (2009) and under-sampled them in the best year of the market (2007).
In addition, the court noted that the easement did not appear to impose more stringent restrictions on the property than those of a municipal agency, the New York City Landmarks Preservation Commission, undercutting the argument that the easement had any value.
In Averyt, T.C. Memo. 2012-198, the IRS claimed that Gayle and Margaret Averyt neglected to obtain substantiation from the donee of whether it provided any goods or services in consideration of the donation of a conservation easement. The lack of a contemporaneous written acknowledgment as required by Sec. 170(f)(8) was the basis for the IRS’s denial of the charitable contribution donation. The IRS relied upon Schrimsher, T.C. Memo. 2011-71, for its claim. The Averyts contended that the conservation deed constituted a contemporaneous written acknowledgment that complied with the requirements of Sec. 170(f)(8). The court agreed that the deed did satisfy all of the requirements of Sec. 170(f)(8), and the Averyts (and three other plaintiff couples whose cases were consolidated for trial) were entitled to partial summary judgment on this specific matter.
In Irby, 139 T.C. No. 14 (2012), the Tax Court allowed the taxpayers to satisfy the contemporaneous written acknowledgment requirement with a variety of documents, none of which individually met the requirement, but which taken together, the court held, constituted contemporaneous written acknowledgment.
The leniency that the taxpayers saw in Averyt and Irby was not evident in Mohamed, T.C. Memo. 2012-152. While the case concerned donation of an entire interest in real estate via a charitable remainder trust, the substantiation issues involved could occur in donations of conservation easements as well. Joseph Mohamed and his wife donated extremely valuable real estate to a charity in 2003 and 2004, but they did not follow IRS directions about how to document their donations. Mohamed, a real estate broker and certified real estate appraiser, prepared his own 2003 tax return including Form 8283, Noncash Charitable Contributions. In 2003, Mr. and Mrs. Mohamed donated five properties worth millions of dollars to a charitable remainder unitrust (CRUT). This type of trust allows a taxpayer an immediate deduction for a charitable contribution based on a portion of the value of the property settled in the trust.
Mohamed readily admitted that he did not read the instructions for Form 8283 because he thought it was so clear that he did not think he needed to. He did indicate he read the statement on the top of the form that indicated “See separate instructions.” Mohamed completed Section B of the Form 8283 reporting the properties and assigning a value based on his own appraisal. The Mohameds donated real estate to the CRUT in 2004 and self-prepared their tax return again.
Upon audit, the IRS challenged the valuation. An independent appraisal submitted by the taxpayers provided valuations of all of the properties that, combined, exceeded the Mohameds’ appraisal by more than $1.7 million. The CRUT sold some of the properties, and the sales prices were consistent with Mohamed’s self-appraised values. What appeared to become a battle between the taxpayers and the IRS on valuation turned out to be just a matter of tax return preparation compliance. The IRS realized that the Mohameds had made several mistakes on their 2003 and 2004 Forms 8283. The IRS asserted that these mistakes compelled denying the Mohameds any charitable deductions for their CRUT donations at all and moved for summary judgment.
The Tax Court agreed, noting that Sec. 170(a)(1) and associated regulations require verification and substantiation under IRS regulations of deductible charitable contributions. The taxpayers lost the benefit of the charitable contribution due to their failure to complete the Form 8283 accurately, along with noncompliance regarding the required statements and appraisals.
Taxpayers pursuing deductions for charitable donations associated with conservation easements and restrictions on real property need to be aware of the IRS’s high level of scrutiny in this area. In particular, recent cases have highlighted three major areas of challenge: preparation of the Form 8283 and compliance with the procedural rules regarding a conservation easement; the specific appraisal and valuation of the easement; and the ability to enforce the restriction and easement in perpetuity.
Charitable contributions of conservation easements have often been challenged by the IRS for issues of valuation, substantiation, and compliance with requirements that they be enforceable in perpetuity. Recent litigation suggests these are likely to continue to be significant areas of tax controversy.
In several recent Tax Court cases, the IRS contended that easement agreements assigning certain rights to mortgagees did not comply with regulations requiring a mortgagee’s rights to be subordinated to those of the charitable donee. Although one of these cases was subsequently overturned on appeal on that issue, the Tax Court on remand will consider valuation issues.
Valuation issues have included problems with qualified appraisals, including meeting the technical requirements for such appraisals specified in regulations. In one of these cases, an appellate court found for the taxpayer, but on remand the Tax Court again denied a deduction, finding that although the appraisal method may have been acceptable, its result failed to support the claimed value of the easement.
Substantiation of an easement or its value has proved problematic when taxpayers have failed to obtain contemporaneous written acknowledgements of their donation, although in two recent cases, the Tax Court held that taxpayers substantially complied with the requirement where other documents provided the same information. A failure to properly complete and file Form 8283, Noncash Charitable Contributions, may lead to disallowance of a claimed deduction, particularly where valuation is challenged.
Karl L. Fava ( firstname.lastname@example.org ) is a principal with Business Financial Consultants Inc. in Dearborn, Mich., and a member of the AICPA Tax Section Individual Income Tax Technical Resource Panel.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at email@example.com or 919-402-4434.
“Charitable Contributions of Conservation Easements,” Nov. 2011, page 58
The Tax Adviser articles
- “First Circuit Breathes New Life Into Façade Easement Deductions,” March 2013, page 154
- “The Changing Landscape of Conservation Easements,” March 2011, page 166
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