Lessee cannot take deduction for facade easement contribution

By James A. Beavers, CPA, CGMA, J.D., LL.M.

The Tax Court held that a partnership that leased two buildings and, along with the owners of the buildings, contributed a facade easement on the buildings to a not-for-profit preservation corporation could not take a charitable deduction for the contribution.

Background

The Economic Development & Industrial Corporation of Lynn (the EDC), a not-for-profit development corporation, is the fee simple owner of the Daly Drug Building and the Vamp Building in Lynn, Mass. In 1979, Harbor Lofts Associates, a partnership, took a 61-year term lease on the buildings. Under the lease, Harbor Lofts is allowed to use the buildings for multifamily residential housing. Shortly after leasing the buildings, it renovated the buildings and converted them into apartments. Since the early 1980s the buildings have been listed on the National Register of Historic Places.

In 2009, the EDC and Harbor Lofts together transferred a facade easement to preserve the buildings' exteriors to the Essex National Heritage Commission Inc., a qualified organization under Sec. 170(h)(3). Under the easement agreement, Harbor Lofts and the EDC are responsible for all repairs and must maintain the buildings' facade in the condition and appearance existing on the date of the grant of the easement.

On the day the facade easement was recorded, Harbor Lofts and the EDC amended the lease term on the buildings until Dec. 31, 2056, and revised the rent payment schedule. In conjunction with these amendments, Harbor Lofts paid $4,500,000 to the EDC.

On its 2009 return, Harbor Lofts claimed a charitable contribution deduction of $4.458 million for its donation of the facade easement. The partnership claimed that the contribution of the easement was a contribution of a perpetual restriction on the use of the property that was a deductible qualified conservation contribution.

In 2016, the IRS issued a notice of final partnership administrative adjustment that disallowed the deduction for the contribution of the facade easement. Harbor Lofts challenged the IRS's determination in Tax Court.

The law

Under Sec. 170(f)(3)(A), a taxpayer generally cannot take a charitable contribution deduction for a contribution of a partial interest in property, but under Sec. 170(f)(3)(B), an exception is made for qualified charitable conservation contributions. A qualified conservation contribution is a contribution of a qualified real property interest to a qualified organization made exclusively for conservation purposes (Sec. 170(h)(1)). One form of a qualified real property interest is a restriction (granted in perpetuity) on the use that may be made of the real property (Sec. 170(h)(2)(C)). To be made exclusively for conservation purposes, the conservation purpose must be protected in perpetuity (Sec. 170(h)(5)(A)).

The parties' arguments

In Tax Court, Harbor Lofts filed a motion for partial summary judgment and the IRS filed a cross-motion for the same. The IRS argued that Harbor Lofts was not entitled to a charitable contribution deduction under Secs. 170(f)(3)(B)(iii) and (h) because the partnership was only a long-term lessee and did not hold a fee interest in the buildings, and thus the contribution did not qualify as a qualified conservation contribution because it did not meet the perpetuity requirements of Secs. 170(h)(2)(C) and (5)(A). Harbor Lofts countered that fee ownership of real property is not expressly required by Sec. 170(h) and that the contribution was similar to a facade easement granted by tenants in common. Alternatively, the partnership argued that it was the equitable owner of the buildings for tax purposes and therefore was eligible for deductions relating to the buildings.

The Tax Court's decision

The Tax Court granted the IRS's cross-motion for partial summary judgment. The court agreed that because Harbor Lofts did not have a fee interest in the buildings, the facade easement was not qualified real property under Sec. 170(h)(2)(C) and the contribution was not exclusively for conservation purposes as required by Sec. 170(h)(5)(A).

Nature of Harbor Lofts' property rights in the buildings: For purposes of charitable contributions, state law determines the nature of the property rights contributed, and federal law determines the tax treatment of those rights. Consequently, the Tax Court first considered the nature of Harbor Lofts' interests in the buildings under Massachusetts law. The Tax Court found that under Massachusetts law, Harbor Lofts had a leasehold interest for a term of years and that Massachusetts has traditionally found such an interest to be personal property. Thus, Harbor Lofts was not a fee owner, tenant in common, or joint tenant of the buildings.

Qualified real property interest: To be a qualified real property interest, a conservation easement must be "a restriction (granted in perpetuity) on the use which may be made of the real property."

Harbor Lofts argued that Sec. 170(h) does not explicitly require the taxpayer that transfers the property to have fee ownership of the real property. The court, however, concluded that Harbor Lofts, having a leasehold interest for a term of years, was incapable of granting a perpetual restriction on the use of the buildings because it did not hold perpetual property rights in the buildings. According to the court, "Harbor Lofts is correct that the Code does not specifically require a donor to hold a fee interest, but only the owner of real property or holder of a fee interest is able to grant a perpetual conservation restriction." The court found that Harbor Lofts had given up the rights to make improvements, alterations, and additions to the buildings, which were something of value, but the rights were contractual rights under a lease agreement, which are personal property rights.

In conjunction with its claim that it was not necessary for it to have a fee interest in the buildings, Harbor Lofts argued that because it granted the easement jointly with the EDC, it had made a Sec. 170(h) contribution similar to one made by tenants in common. The Tax Court brushed aside this argument. Besides noting that, because the partnership did not have a fee interest in the property, it was not a tenant in common in the buildings with the EDC, the court observed that the limited duration of a lease is far different from fee ownership as tenants in common.

Regarding the alternative claim of equitable ownership, the Tax Court explained that although Harbor Lofts took on many of the rights and obligations of ownership for the buildings, it took them on only for a finite period ending on the lease's expiration. Thus, even if it found that Harbor Lofts had equitable ownership, the facade easement grant could not satisfy the perpetuity requirements of Sec. 170(h)(2)(C).

Exclusively for conservation purposes: As the Tax Court had explained earlier in the opinion, a contribution is not made exclusively for conservation purposes unless the conservation purposes are protected in perpetuity. The court found that Harbor Lofts, as a lessee, was incapable of making a contribution protected in perpetuity, because it could only create a restriction that runs through the term of its lease, which was not perpetual. Only the EDC, which was the fee owner of the buildings, could create an easement that runs with the buildings that protects the conservation purpose in perpetuity.

Reflections

Because conservation and facade easements are one of the rare exceptions to the Sec. 170 rule that a taxpayer cannot take a deduction for a contribution of a partial interest in property, they are an area that attracts aggressive tax planning by some taxpayers. As numerous Tax Court cases have shown, some property owners are willing to claim a facade easement deduction for placing "restrictions" on property that, due to zoning or historical district rules, they have no right to alter anyway. Others will try to claim a deduction when they also receive a benefit from the contribution. Diluting the "in perpetuity" provision to allow leaseholders to take a facade easement deduction would only further encourage taxpayers that wish to take advantage of a deduction that is ripe for abuse.

Harbor Lofts Assocs., 151 T.C. No. 3 (2018)

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