Charitable Contributions
The Tax Court held that taxpayers were not entitled to a charitable deduction for conveying a land preservation easement on their farm to a county to secure the county's permission to sell development rights related to the property to a third party.
Background
In 2000, David and Barbara Costello purchased Rose Hill Farm (Rose Hill) in Cooksville, Howard County, Md., for $1,682,556. Rose Hill occupied 73.6 acres and included a working farm, a residence, and a three-car detached garage. The Costellos made numerous improvements to the property and, as a result, by 2006, their total cost basis in Rose Hill was $1,977,556.
In 1992, Howard County enacted a set of zoning provisions designed to conserve farmland and preserve rural and scenic landscapes, which created the Agricultural Land Preservation Program (ALPP). Through this program, the county acquires land preservation easements that restrict the exercise of development rights on qualified agricultural land. The objective of the ALPP is to keep county land available for farming and to cluster residential development elsewhere, minimizing its impact on agricultural areas.
Under the ALPP, the county can acquire land preservation easements in three ways. First, it can purchase from a landowner the development rights pertaining to property and then extinguish those rights. Second, a landowner can donate his or her development rights to the county. Third, a landowner can place an easement on his or her property in return for the county's allowing the landowner to sell the development rights to a third party, in what is called a density exchange.
A development right is, essentially, the right to build a residence on the land. In a density exchange, the third party can apply the purchased development rights to another parcel of land, thereby increasing the development density allowed on that land. However, Howard County must approve such a sale, and before the county will approve a sale of the development rights for a parcel of land, the landowner selling the rights must encumber the land with an easement that eliminates all future development potential for the land.
The Costellos, after purchasing Rose Hill, sought to participate in the ALPP. They entered into discussions about the program with Howard County in 2001, and the county offered to buy their rights for $375,000. The Costellos rejected this offer and instead began to look for a buyer for their development rights.
In 2005, the Costellos executed a contract to sell 16 of the 17 development rights associated with Rose Hill to Kennard Warfield, a developer, for $2.56 million. Warfield was required under the final contract to make a $1.2 million down payment toward the purchase price with the balance to be paid later. As required by the ALPP, the Costellos conveyed an easement to Howard County that severed the development rights from Rose Hill and prohibited all future development on the property.
The Tax Reporting of the Transaction
The appraisal: In 2007, before filing their return for 2006, the Costellos retained Bruce Dumler to appraise Rose Hill before and after a hypothetical sale of the development rights. He determined that the value of Rose Hill before the sale of the development rights was $7.69 million. After their sale, he found that its value for use as a working farm and residence was $2.1 million and, therefore, the development rights were worth $5.59 million.
Dumler listed Dec. 1, 2006, as the appraisal's effective date and based the appraisal on the assumption that Rose Hill was, as of Dec. 1, 2006, "free and clear of any or all liens or encumbrances." His appraisal did not mention the deed of easement, and it did not purport to value an easement. Rather, his appraisal stated that "the property rights appraised comprise the fee simple interest in the subject property," which he determined to be worth $5.59 million net of petitioners' residence. The appraisal did not take into account the payment the Costellos received from Warfield for the development rights, the easement that had been placed on the property, or that certain tests done on the land indicated that it would not support the number of dwelling units Dumler maintained would constitute its highest and best use.
The Costellos' 2006–2008 tax returns: On their 2006 tax return, the Costellos wished to take a charitable contribution deduction for the conveyance of the easement. To this end, they asked Howard County to sign a Form 8283, Noncash Charitable Contributions, as the recipient of the easement. The county refused to do so unless the Costellos gave it an opinion letter from a CPA stating they could take the deduction and confirmation that they had used a qualified appraiser for the appraisal of the easement.
A CPA prepared the Costellos' 2006 federal income tax return, and it was timely filed on Oct. 15, 2007. The return reported a noncash charitable contribution deduction of $5,543,309; in support of this deduction, the return included an unsigned Form 8283 referring to the easement and a copy of Dumler's appraisal. The return claimed no cost basis in the development rights sold to Warfield and reported a long-term capital gain of $1,029,441 on that sale. This reported gain corresponded to the cash petitioners got from Warfield; they claimed like-kind exchange treatment for the balance of the $2.56 million purchase price, consisting of land valued at $1,530,559.
After Howard County declined to sign the Form 8283, the Costellos had Dumler prepare an addendum to his original appraisal that took into account the conveyance of the easement. In the addendum, Dumler reduced the $5,543,309 value of the development rights by the $2.56 million paid by Warfield. On the basis of this and other changes, Dumler concluded that the easement should be valued at $3.03 million. The Costellos also obtained the requisite opinion letter from their CPA. After supplying the letter and the revised appraisal to Howard County, the county signed a Form 8283 for the easement.
The Costellos then filed an amended 2006 return, claiming a charitable contribution deduction for the easement of $3,004,692, with the Form 8283 and the appraisal with the addendum attached. The couple were unable, due to the charitable contribution limitation rules, to take the full charitable contribution deduction for the easement in 2006, and they carried forward and deducted the balance of the contribution on their 2007 and 2008 returns.
The IRS Demurs
In 2012, the IRS issued a notice of deficiency for the years 2006 through 2008 to the Costellos, claiming, among other things, that the couple were not entitled to a charitable contribution deduction in any of those years related to the conveyance of the easement. The Costellos challenged the IRS's determination in Tax Court.
The Tax Court's Decision
The Tax Court held that the Costellos were not entitled to a charitable deduction for conveying the land preservation easement to Howard County because they had not met the reporting requirements under Sec. 170 and the regulations by attaching a qualified appraisal for the contribution or a fully completed appraisal summary to their return. Although the failure to meet the reporting requirements was fatal to the Costellos' claim for a charitable deduction, the Tax Court also discussed (1) whether a deduction would also be disallowed because the conveyance of the easement was part of a quid pro quo exchange with Howard County and (2) the Costellos' alternate argument that the conveyance of the easement was a bargain sale.
The qualified appraisal requirement: For charitable deduction purposes, under Sec. 170(f)(11)(D), when the value of contributed property exceeds $500,000, no deduction is allowed unless the taxpayer obtains a "qualified appraisal" and attaches it to his or her return. Sec. 170(f)(11)(E)(i)(II) defines a qualified appraisal as "an appraisal of such property which . . . is conducted by a qualified appraiser in accordance with generally accepted appraisal standards and any regulations or other guidance prescribed" by the IRS. Under Regs. Sec. 1.170A-13(c)(3), the appraisal must be made no more than 60 days before the contribution of the property and no later than the due date, including extensions, of the return on which a deduction for the contribution is first claimed.
Because the Costellos first claimed the deduction for the easement conveyance on their original 2006 return, and the addendum to the original appraisal was made more than five months after the due date of the original return, the court only considered the original appraisal and not the addendum. The court found Dumler's original appraisal lacking because it was missing three of the required elements: an accurate description of the property contributed; the date of the contribution; and the salient terms of the agreements among the petitioners, Warfield, and Howard County.
Regarding the description of the property, the court noted that the purpose of the requirement was to ensure that the taxpayer provide the IRS with information sufficient to evaluate claimed deductions and assist it in detecting overvaluations of donated property. Because the original appraisal did not contain the words "conservation easement" or "land preservation easement" and stated that "the property rights appraised comprise the fee simple interest in the subject property," the court determined that this requirement had not been met.
As to the date of contribution, the court observed that this was required to determine whether the appraisal was timely performed. Because the effective date of the appraisal was not the date of execution of the easement or the date the Costellos conveyed it to Howard County, the appraisal did not meet this requirement.
The court explained that terms of the agreement are essential to the appraisal to enable the IRS to determine whether the donors have or will receive something in exchange for their donation. Since the appraisal was silent about the conveyance of the easement and the fact that it was required as a condition of selling the development rights to Warfield, the court found that the appraisal also failed to meet this requirement.
Appraisal summary: Per Regs. Sec. 1.170A-13(c)(2), any taxpayer claiming a deduction for a contribution of property the value of which exceeds $5,000 must also attach to his or her return a fully completed "appraisal summary." The appraisal summary requirement is met by filing Form 8283. Although the Costellos had attached a Form 8283 to their original return, according to the court, it was inadequate in two respects. First, it was not signed by the donee, Howard County, and this lack of a signature was not an accident or oversight. Second, it did not include a statement describing what the Costellos were receiving from Howard County for the easement conveyance (i.e., permission to sell the Rose Hill development rights) or the payment from Warfield for the development rights, so it did not comply with the requirement that the summary contain a statement explaining the amount of any consideration received from the donee for the contribution.
Substantial compliance: The Costellos claimed that, despite these problems with the appraisal and Form 8283, they had substantially complied with the charitable deduction reporting requirements. Citing a number of Tax Court cases, the court stated it had "declined to apply the substantial compliance doctrine where the taxpayer's reporting fails to meet substantive requirements set forth in the regulations or omits entire categories of required information" (Costello, at *24). The court found that the documents failed in both respects and the Costellos were not in substantial compliance with the reporting requirements, in particular because the appraisal, which valued the fee simple interest in Rose Hill and not the land preservation easement that the Costellos actually conveyed, was for the wrong asset.
Quid pro quo exchange: Although the Costellos' failure to meet the charitable deduction reporting requirements was fatal to their claim for a deduction for the conveyance of the land preservation easement, the Tax Court also addressed the issue of whether the easement was conveyed as part of a quid pro quo exchange. The court stated that in making this determination, it should look at the external features of the transaction and not the taxpayer's subjective motivations. The court found the external features of the Costellos' transaction with Howard County showed that the Costellos:
would not have conveyed the easement unless they received permission to sell their development rights; and they could not legally sell their development rights unless they executed the deed of easement. [The Costellos'] transaction thus bears the classic features of a quid pro quo exchange . . . [Costello, at *27]
Bargain sale: Finally, in the alternative, the Costellos argued that they had made a bargain sale of the easement to Howard County. The court rejected the idea that a sale had taken place, noting that one of the options under the ALPP, which the Costellos refused, was to sell the easement to the county outright. Since they did not opt to do this, it was not plausible for the Costellos to claim that they should be deemed to have done so. In addition, the court observed that under this theory, the Costellos were claiming that they donated the development potential in Rose Hill that was left after they sold the development rights to Warfield. However, because they sold all the development rights they had to Warfield, there was nothing left to convey to the county through a bargain sale.
Reflections
As the Tax Court mentions in its opinion, a qualified appraisal must be made by the due date of the first return on which the deduction for the property contributed is claimed. However, if the deduction is first claimed on an amended return, that date is changed to the filing date of the amended return. Thus, if a taxpayer has failed to obtain an appraisal by the due date, the chance for a deduction for a charitable contribution can be preserved by first claiming the deduction for the contribution on an amended return.
Costello, T.C. Memo. 2015-87
