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Conservation easements and façade easements have been the subject of many Tax Court cases in recent years. 1 A recent First Circuit decision 2 will affect how the tax benefits of certain façade easements are litigated in the First Circuit and may result in appeals of some of the Tax Court’s recent easement holdings. 3 The First Circuit held in Kaufman that the Tax Court had imposed an unreasonably restrictive interpretation of regulations 4 under Sec. 170(h) that “would appear to doom practically all donations of easements, which is surely contrary to the purpose of Congress.” 5
The Tax Court had held in Kaufman that a subordination agreement giving a lender priority on insurance and condemnation proceeds violated the Regs. Sec. 1.170A-14(g) “enforceable in perpetuity” requirement, particularly its “extinguishment” provisions. 6 The First Circuit rejected the Tax Court’s interpretation of the regulation as well as the IRS’s alternate theory that the easement should be rejected due to clear defects in its appraisal summary, finding that the defects didn’t necessarily “doom” the summary.
The case was remanded to the Tax Court on the issues of the valuation of the easement and recalculation of penalties. The First Circuit vacated the Tax Court’s decisions regarding the penalties associated with the easement deduction but did not disturb the Tax Court’s findings regarding partial deductions for, and penalties relating to, cash endowment contributions made in connection with the easement donation.
Facts
Kaufman concerned a mid-19th-century row house in the South End of Boston, an area known for its historic architecture and subject to local historic preservation restrictions. Lorna Kaufman purchased the house in 1999, and she and her husband, Gordon Kaufman, renovated it, including restoring its original façade. In 2003 the couple entered into a preservation restriction agreement supplied by the National Architectural Trust (later renamed the Trust for Architectural Easements) and made cash endowment contributions to the organization totaling $16,840. The Kaufmans selected an experienced, certified appraiser from two recommended by the Trust. After inspecting the property in January 2004, the appraiser submitted his report, estimating the fair market value (FMV) of the donated easement at $220,800.
The Kaufmans secured consent from their mortgage lender to an agreement subordinating the bank’s right in the property to the Trust to enforce the conservation and historic preservation purposes of the preservation restriction agreement in perpetuity. The lender agreement added several stipulations to the restriction agreement, one of which stated:
The Mortgagee/Lender and its assigns shall have a prior claim to all insurance proceeds as a result of any casualty, hazard or accident occurring to or about the Property and all proceeds of condemnation, and shall be entitled to same in preference to Grantee until the Mortgage is paid off and discharged, notwithstanding that the Mortgage is subordinate in priority to the [preservation restriction] Agreement. 7
On their 2003 tax return, the Kaufmans claimed a charitable contribution for the cash endowment donation of $16,840 8 and a noncash contribution of $220,800 for the façade easement donation as a qualified conservation contribution. The noncash contribution was limited by Sec. 170(b)(1) to $103,377 for 2003, with the remainder of $117,423 carried over. On their 2004 tax return, the Kaufmans claimed a charitable contribution of $3,032 for additional cash endowed to the Trust, and the remainder of the noncash contribution of the façade easement donation.
IRS Audit
On audit, the IRS disallowed the noncash deductions taken in 2003 and 2004 for the historic façade easement donations as well as the deductions for the cash endowment contributions, and in 2009 issued a notice of deficiency to the Kaufmans for the 2003 and 2004 tax years, citing three grounds for disallowing the noncash contribution:
- The Kaufmans had failed to establish that all of the requirements of Sec. 170 and all the regulations thereunder were satisfied;
- The contribution was made subject to subsequent events; and
- The Kaufmans had not established that the value of their contributed property interest was $220,800.
In addition, the IRS disallowed the Kaufman’s cash endowments to the Trust for 2003 because they were made subject to, or in contemplation of, subsequent events. The IRS assessed a deficiency for 2003 of $39,081 and for 2004 of $36,340, plus penalties for both years totaling $29,072.
Tax Court
The Tax Court granted summary judgment to the IRS on its disallowance of the façade easement deduction on the basis that, as a matter of law, the contribution to the Trust failed to comply with the Regs. Sec. 1.170A-14(g) “enforceability in perpetuity” requirements. The court explained that Regs. Sec. 1.170A-14(g)(6)(ii) requires a donee organization to possess a guaranteed right in perpetuity to a proportionate share of any future proceeds from the property in the event the easement is terminated as the result of an unexpected change in conditions that makes continued use of the property for conservation purposes impractical. Since, according to the stipulations placed on the agreement, the bank “retained a ‘prior claim’ to all proceeds of condemnation and to all insurance proceeds as a result of any casualty, hazard, or accident,” the mortgagee had a prior claim to any insurance proceeds in those instances, and the donee organization’s right to its proportionate share was uncertain. 9
In denying a reconsideration of its summary judgment, the Tax Court held that even if the preservation agreement had vested the Trust with a contractual right to its proportionate share of the proceeds from the sale of the property after judicial extinguishment of the façade easement, this right was insufficient to satisfy Regs. Sec. 1.170A-14(g)(6). According to that paragraph in the regulations, the Trust must not merely have had a contractual right against the property owner; it “must be entitled to a portion of the proceeds at least equal to that proportionate value of the perpetual conservation restriction.” 10
The Kaufmans argued for application of Regs. Sec. 1.170A-14(g)(3), under which an event will not cause a deduction to be disallowed even though it may defeat a donee organization’s interest, so long as it is “so remote as to be negligible.” The court found, however, that this standard was irrelevant to its analysis under the extinguishment provision of Regs. Sec. 1.170A-14(g)(6). Although the unexpected changes that can give rise to an extinguishment may include remote possibilities, the donee organization must still have an absolute right to receive a proportionate share of the proceeds from a sale or exchange, the court said. The court concluded that because the Kaufmans failed to grant the Trust an absolute right to a fixed share of the post-extinguishment proceeds, their gift failed to meet the requirements of Regs. Sec. 1.170A-14(g)(6).
However, the court found that the Kaufmans were entitled to a deduction for the cash contributions, but not until 2004, when the easement was completed. In addition, the court found that no accuracy-related penalties applied to any amounts other than the underpayment on the Kaufmans’ 2003 return arising from the disallowance of the cash contribution in that year. Both parties appealed to the First Circuit.
First Circuit
Before the First Circuit, the Kaufmans challenged the disallowance of the deduction for the façade easement. The IRS attacked the disallowance of most of the penalties but did not question the Tax Court’s allowance of the cash contribution deduction on the 2004 return.
Façade Easement Issue
The First Circuit focused its analysis primarily on paragraphs (g)(1) and (6) of Regs. Sec. 1.170A-14. Paragraph (g)(1), the enforceable-in-perpetuity requirement, states that “any interest in the property retained by the donor . . . must be subject to legally enforceable restrictions . . . that will prevent uses of the retained interest inconsistent with the conservation purposes of the donation.”
The agreement between the Kaufmans and the Trust provided that “nothing herein contained shall be construed to limit the [Trust’s] right to give its consent (e.g., to changes in the Façade) or to abandon some or all of its rights hereunder.” 11 The IRS argued that this provision would permit the Trust “to consent to any type of change, irrespective of its compatibility with the donation’s conservation purpose,” and that, consequently, the easement failed to prevent uses that would be inconsistent with the conservation purpose of the easement. 12
The First Circuit disagreed, referring to Simmons , 13 in which the D.C. Circuit considered and rejected the same argument, stating that “this type of clause is needed to allow a charitable organization that holds a conservation easement to accommodate such change as may become necessary to make a building livable or usable for future generations while still ensuring the change is consistent with the conservation purpose of the easement.” 14 The First Circuit added that to permit the reading that the IRS sought to ascribe to it “would be to deprive the donee organization of flexibility to deal with remote contingencies.” 15
The court focused most on Regs. Sec. 1.170A-14(g)(6)(ii), the extinguishment provision, which requires that:
[W]hen a change in conditions give[s] rise to the extinguishment of a perpetual conservation restriction [by judicial proceeding], . . . the donee organization, on a subsequent sale, exchange, or involuntary conversion of the subject property, must be entitled to a portion of the proceeds at least equal to that proportionate value of the perpetual conservation restriction, unless state law provides that the donor is entitled to the full proceeds from the conversion. 16
The Tax Court had held that, although the agreement entitled the Trust to a proportionate share of post-extinguishment proceeds, the lender agreement undercut this commitment, thereby defeating the deduction by stipulating that “[t]he Mortgagee/Lender and its assignees shall have a prior claim to all insurance proceeds . . . and all proceeds of condemnation, and shall be entitled to same in preference to [the Trust] until the Mortgage is paid off and discharged.” 17
The First Circuit reasoned that the Kaufmans lacked the power to compel the lender to “give up its own protection against fire or condemnation and, more striking, no power to defeat tax liens that [Boston] might use to reach the same insurance proceeds—tax liens being superior to most prior claims . . . including in Massachusetts the claims of the mortgage holder.” 18
Hence, to have the donee organization entitled to a “‘first bite’ as against the rest of the world” is not always practicable. 19 As a result, the IRS’s reading of the regulation
would appear to doom practically all donations of easements, which is surely contrary to the purpose of Congress. We normally defer to an agency’s reasonable reading of its own regulations . . . but cannot find reasonable an impromptu reading that is not compelled and would defeat the purpose of the statute, as we think is the case here. 20
Recordkeeping and Reporting Requirements
The IRS also argued that the Kaufmans had failed to comply with recordkeeping and reporting requirements in Sec. 170(f)(11) and associated regulations, which require a qualified appraisal report that explains the method and specific bases used to determine the FMV of the contribution. 21 They also require an appraisal summary to be attached to the taxpayer’s federal return that includes: 22
- A description of the property in sufficient detail for a person who is not generally familiar with the type of property to ascertain that the property that was appraised is the property that was contributed;
- The manner and date of the acquisition of the property by the donor;
- The cost or other basis of the property, adjusted as provided in the Code; and
- The appraised FMV of the property on the date of contribution.
Regs. Sec. 1.170A-13 explains at length the information required in a qualified appraisal and appraisal summary. Nonetheless, in Kaufman, the First Circuit forgave technical noncompliance with the requirements to show the date and manner of acquisition of the property. The Kaufmans explained that they did not acquire the preservation easement but created that property interest at the moment of its conveyance to the Trust. The First Circuit said that these defects in the completion of Form 8283, Noncash Charitable Contributions, were in no way prejudicial to the easement donation and did not “doom the appraisal summary.” 23
Overstatement of Value
The First Circuit remanded the case to the Tax Court, primarily to consider the proper value of the easement.
When the Kaufmans donated the easement, their home was already subject to South End Landmark District rules that severely restricted the alterations that property owners could make to the exteriors of historic buildings in the neighborhood. The rules also obligated owners to retain and repair all elements of the buildings’ façades and exteriors in keeping with the standards. The First Circuit stated that, “[g]iven these pre-existing legal obligations, the Tax Court might well find on remand that the Kaufmans’ easement was worth little or nothing.” 24
Such a holding on remand could leave the taxpayers little better off than under the 2011 Tax Court holding, including being held liable for penalties under Sec. 6662 for substantial understatement of income tax and substantial or gross valuation misstatements, unless they can show reasonable cause.
Similar Cases That May Be Affected
Wall
Following the same reasoning as in Kaufman, the IRS in Wall 25 disallowed a historic façade easement on the taxpayer’s home in Illinois. Two banks held mortgages on the property when the easement agreement was created, and both subordinated their mortgages to the Landmarks Preservation Council of Illinois (LPCI), an easement trust. However, the easement agreement allowed the mortgagees to retain a prior claim to any proceeds of condemnation proceedings or insured casualty, hazard, or accident.
The Tax Court granted the IRS summary judgment on the issue of the façade easement deduction. Citing its own holding in Kaufman (but before the First Circuit’s remand), the Tax Court reasoned that the LPCI did not have a guaranteed right to its proportionate share of its proceeds as required by Regs. Sec. 1.170A-14(g)(6), and the façade easement contribution failed as a matter of law to comply with the enforceability-in-perpetuity requirements of that regulation.
1982 East, LLC
At issue in 1982 East, LLC , 26 was a $6.57 million deduction for a contribution of a historic façade easement on a townhouse in a historic urban district in New York City. The building was owned by a limited liability company characterized for tax purposes as a partnership with a number of domestic and foreign members. The owners executed a deed in 2004 conveying the easement to the National Architectural Trust (the same organization as in Kaufman ). There was a mortgage on the property.
The Tax Court found that under the lender agreement, the bank retained a prior claim on all condemnation and insurance proceeds until the mortgage was satisfied. Relying on its reasoning in Kaufman (also before the First Circuit’s remand), the Tax Court held that the façade easement donation failed the enforceability-in-perpetuity requirement of Regs. Sec. 1.170A-14(g)(6)(ii) and that the taxpayers were not entitled to the deduction.
In light of the First Circuit’s holding in Kaufman, it remains to be seen whether the IRS and the Tax Court will revise their stance on lender agreements or whether the Seventh and/or Second Circuit will agree with the First Circuit if Wall or 1982 East, respectively, is appealed to them.
Footnotes
1 For a description of qualified conservation contributions, including façade easements, and their deductibility generally, see Durant, “The Changing Landscape of Conservation Easements,” 42 The Tax Adviser 166 (March 2011). The American Taxpayer Relief Act of 2012, P.L. 112-240, enacted Jan. 2, 2013, retroactively extended a higher deduction limitation for contributions of qualified conservation contributions by individuals under Sec. 170(b)(1)(E) and by certain corporate farmers and ranchers under Sec. 170(b)(2)(B) made in tax years beginning before Jan. 1, 2014. Under prior law, these provisions did not apply to contributions made in tax years beginning after Dec. 31, 2011.
2 Kaufman, 687 F.3d 21 (1st Cir. 2012), vacating and remanding 134 T.C. 182 (2010), reconsideration denied, 136 T.C. 293 (2011).
3 The First Circuit stated in Kaufman, slip op. at 24–25, “Judging from the amici, the present appeals have the hallmarks of a test case to settle larger issues between the industry and the IRS.”
4 Regs. Secs. 1.170A-13 and 1.170A-14(g).
5 Kaufman, 687 F.3d 21, slip op. at 13.
6 Kaufman, 136 T.C. 293 (2011), and 134 T.C. 182 (2010). See Regs. Sec. 1.170A-14(g)(6).
7 Kaufman, 687 F.3d 21, slip op. at 6.
8 The original amount on their return was $16,870, which the Kaufmans subsequently acknowledged was a “typographical error.”
10 Kaufman, 136 T.C. at 306, quoting Regs. Sec. 1.170A-14(g)(6)(ii).
11 Kaufman, 687 F.3d 21, slip op. at 14.
13 Simmons, 646 F.3d 6 (D.C. Cir. 2011), aff’g T.C. Memo. 2009-208.
14 Id., slip op. at 7 (internal quotation marks omitted), quoted in Kaufman, 687 F.3d 21, slip op. at 15.
15 Kaufman, 687 F.3d 21, slip op. at 15.
16 Regs. Sec. 1.170A-14(g)(6)(ii).
18 Kaufman, 687 F.3d 21, slip op. at 12 (citations omitted).
20 Id., slip op. at 13 (citations omitted).
21 Regs. Sec. 1.170A-13(c)(3).
22 Regs. Sec. 1.170A-13(c)(4)(ii).
23 Kaufman, 687 F.3d 21, slip op. at 18.
24 Kaufman, 687 F.3d 21, slip op. at 22.
26 1982 East, LLC, T.C. Memo. 2011-84.
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EditorNotes |
Monique Durant is an associate professor at Central Connecticut State University in New Britain, Conn. For more information about this article, contact Prof. Durant at durantmon@ccsu.edu. |
