The Fourth Circuit upheld the IRS's disallowance of a deduction for the full value of all the building components of a house that was donated to a charitable organization for deconstruction in the organization's job training program.
Background
Linda and Lawrence Mann purchased a house in Bethesda, Md., in 2011. They initially planned to renovate the house, but after learning about water issues in its basement and the high cost of the changes they wanted to make to it, they decided to tear down the house and build a new one on the lot. Accordingly, the couple hired a home builder to demolish the house, clear the site, and build a new house on the site.
Before this work began, other builders the Manns knew suggested they work with Second Chance, a charitable organization that offers what are known as "deconstruction" services, in which an unwanted building is dismantled in order to remove building components and other items that can be reused. Second Chance undertakes the deconstruction work to provide job training to disadvantaged members of the community and also to prevent salvageable material from ending up in landfills.
Second Chance keeps the salvageable building components and other items it takes from a property it deconstructs and resells them to raise money to carry out its training programs. A property owner that transfers a property to Second Chance for deconstruction benefits by being able to take a charitable contribution deduction for the value of the building components and other items removed from the property that are donated to Second Chance for resale if the various requirements for a charitable contribution deduction are met.
In Second Chance's deconstruction work, some components of a house, such as drywall, tile, and roofing materials, that are not being salvaged are necessarily destroyed as part of the deconstruction process or as part of the training of Second Chance employees working on the project. However, Second Chance explicitly states when taking on a deconstruction project that it does not provide demolition services, and the organization advises house donors that they must hire a demolition contractor at their own expense to complete the demolition of the donated house after the deconstruction work is done and clear the site.
The Manns decided to have Second Chance deconstruct the house before it was demolished by the Manns' builder. Linda Mann (who was the sole owner of the home) signed a two-page "Agreement for Charitable Contribution" with Second Chance, dated Dec. 1, 2011. Per the agreement, Linda conveyed to Second Chance "all of [her] right, title and interest in the improvements, building and fixtures located [at the house]," as described in an appraisal "prepared by NoVaStar Appraisal, Inc."
Before the deconstruction began, the Manns engaged NoVaStar to provide an appraisal to establish the value of the house donation for tax purposes. The NoVaStar appraiser concluded that the highest and best use for the house was moving it to another lot to use as a residence and therefore appraised the value of the house "without disassembly." The appraiser determined the fair market value (FMV) of the home and land together ($1,875,000) and then the FMV of the land only ($1,200,000). Subtracting the value of the latter from the value of the former, the appraiser determined that the value of the house without the land was $675,000.
Second Chance performed its deconstruction work on the house in two phases: The first, which involved the removal of nonstructural elements, occurring during December 2011 and January 2012, and the second, involving the deconstruction of exterior and structural elements, occurring in June and July 2012. Second Chance did not maintain a complete inventory of the items that it removed from the house, although it did create a list of items that it took from the house during the first phase of the project. After Second Chance finished its deconstruction work on the house on July 6, 2012, the Manns' building contractor demolished the house and removed the remaining structural elements.
On their 2011 joint return, relying on the appraisal by NoVaStar, the Manns claimed a charitable contribution deduction of $675,000 for the house. The IRS audited the Manns' return for 2011 and disallowed the deduction, finding that Linda had not donated her entire interest in the house and had not provided an accurate appraisal of what she did donate to Second Chance.
After denying an administrative appeal by the Manns, the IRS calculated an amount due of $191,638 for 2011. The Manns paid the tax due but in November 2015 filed a refund claim and a request for abatement. In August 2016, the couple filed an amended return for 2011. On that return, "for settlement purposes only," they adjusted the charitable contribution deduction for the house to $313,353, based on a new appraisal from NoVaStar.
The second appraisal based the FMV of the house on the value of all of the house's building components on the secondhand market. Not all of the building components had a well-established secondhand market, so the NoVaStar appraiser used "the cost approach to value" by estimating the cost of all materials as new and then accounting for depreciation. The appraisal provided an estimate of all of the house's building components without regard to (1) which components would be removed by Second Chance for resale; (2) which would be destroyed during the course of deconstruction; and (3) which would remain on-site for demolition and removal by the Manns' contractor.
After reviewing the amended return, the IRS again disallowed the claimed charitable contribution deduction for the house. Undaunted, the Manns filed a refund suit in district court, seeking a determination that the charitable contribution deduction for the value of the house was valid. The Manns and the IRS filed cross-motions for summary judgment.
The court, agreeing with both the IRS's reasons for disallowing the charitable contribution deduction for the house, granted the IRS's motion. It concluded that the Manns had not made "a valid transfer of an entire interest in real property," as required by Sec. 170(f)(3) because they did not record the transaction in the public land records, as required by Maryland law. The court also determined that even if the Manns had effectively donated the house to Second Chance, they would not be entitled to a deduction for $675,000 or $313,353, because neither of their appraisals were qualified appraisals that properly substantiated their claimed deduction.
The Manns filed an appeal with the Fourth Circuit. Giving up on the original deduction they claimed of $675,000, on appeal the Manns only challenged the district court's ruling in upholding the government's disallowance of their amended claimed charitable contribution deduction of $313,353 for the house.
Arguments on appeal
The Manns contended that they were entitled to the $313,353 deduction for the value of all the house's components because (1) they effectively severed the house from the real property by their written donation agreement; (2) they donated their entire interest in the house to Second Chance; and (3) the value of the house was properly appraised in the $313,353 appraisal. They argued that their donation agreement "constructively" severed the house from the underlying land and that, under Maryland law, severance does not require recordation of the transfer. Also, because they donated the entire house, they argued the second appraisal appropriately included all the components of the house in the determination of the donation's value.
The IRS again maintained that the Manns did not donate their entire interest in the house because the transfer of the house was not recorded in the public land records, as required by Maryland law to transfer record ownership. It also argued that although the agreement purported to transfer the entire house, in substance the Manns only donated the right to use the house for specific purposes (deconstruction training and salvage) and, consequently, they donated a partial interest in the house, which is not deductible under Sec. 170(f)(3). Finally, the IRS contended that the appraisal was not a qualified appraisal as required by Sec. 170(f)(11)(C) because the appraisal included all the house's components, including those that were not salvaged.
The Fourth Circuit's decision
The Fourth Circuit, affirming the district court, held that the Manns were not entitled to a charitable contribution deduction for the donation of the house to Second Chance. It found that the Manns had only donated a nondeductible partial interest in the home and that the appraisal of the home was not a qualified appraisal.
Interest in house donated: Under Maryland law, real property includes both land and the improvements to the land. Thus, the house and the land that it sat on were a single piece of property, so for the Manns to contribute their entire interest in the house, it had to be severed from the land. The Manns argued that Maryland did not require the recordation of an agreement that constructively severed an improvement from its underlying land; rather, only a writing sufficient to satisfy the statute of frauds was required. They contended the contribution agreement with Second Chance met this requirement, so they had converted the house from real property to personal property and conveyed their entire interest in the house by the agreement.
Citing Supervisor of Assessments of Baltimore County v. Greater Baltimore Med. Ctr. (GBMC), 32 A.3d 174 (Md. Ct. Spec. App. 2011), and Townsend Baltimore Garage, LLC v. Supervisor of Assessments of Baltimore City, 79 A.3d 960, 967 (Md. Ct. Spec. App. 2013), the Fourth Circuit found that while the contribution agreement may have made Second Chance the contractual owner of the house, because the agreement was not recorded in the public land records, Linda Mann retained record ownership of the house. Consequently, the house had not been severed from the land, and the Manns had not conveyed their entire interest in the property they owned, or even an undivided portion of their entire interest in the property.
The Manns claimed that the GBMC and Townsend cases did not apply because neither case involved Maryland's constructive severance doctrine. While acknowledging that this was true, the Fourth Circuit found they did apply because the Maryland Court of Special Appeals specifically recognized in those cases that "contractual ownership" of an improvement does not, without more, establish "title or record ownership" for real-estate-tax purposes. Thus, even if the donation agreement constructively severed the house from the land and conveyed contractual ownership of the house, Linda Mann was still the record owner of the house, and therefore the entire interest in the house had not been transferred.
Applying the substance-over-form doctrine, the Fourth Circuit further determined that the substance of the transaction showed that the Manns had failed to transfer their entire interest in the house to Second Chance. The court noted that in the transaction, although Linda Mann donated some components of the house to Second Chance to sell to fund its operations and some of the components of the house were destroyed for training purposes or in removing the components that were donated to Second Chance, she continued to have the benefits and burdens of the remaining components of the house, which she paid her builder to demolish. Thus, in substance, the Manns did not donate as personal property the entire interest in the house to Second Chance, and consequently they were not entitled to a charitable contribution deduction for the entire value of the house.
Qualified appraisal: In determining the $313,353 appraisal amount used by the Manns to support their charitable contribution deduction, the appraiser had assumed that every component of the house would be severed and donated to Second Chance for its use. Because every component of the house was not donated to Second Chance, the court concluded that the appraisal failed to provide the value of the property the Manns actually contributed. Therefore, the appraisal did not meet the qualified appraisal requirement in Sec. 170(f)(11)(C), which, according to the court, provided another reason for finding the IRS had properly denied the Manns' claimed charitable deduction.
Reflections
The Manns were out more than just the amount of the disallowed deduction for the donation for the house. To get Second Chance to do the deconstruction work, the Manns had to agree to donate $20,000 in cash (although they eventually only donated $11,500) and presumably had to pay for the appraisals by NoVaStar. Additionally, they had to take the time, trouble, and expense of challenging the IRS determination administratively and through the court system.
The IRS does not object to a deduction for a charitable donation of building components from a home deconstruction, but, as this case indicates, if it has doubts about the propriety of such a deduction, it will scrutinize it to make sure that its amount is not overstated and it is substantiated as required by the Code and regulations. Thus, taxpayers undertaking such a project should be careful to ensure that they have proper documentation of the components actually donated to charity and a qualified appraisal of their value.
Mann, No. 19-1793 (4th Cir. 1/6/21)
Contributor James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information about this column, contact thetaxadviser@aicpa.org.
