CONSERVATION CONTRIBUTIONS: WHEN SAVING FACE IS A CHARITABLE EVENT

Substantiation and valuation rules gain importance for deducting donations of qualified conservation easements in light of increased IRS scrutiny.
Author: MARK A. TURNER and RAMON FERNANDEZ

MARK A. TURNER, DBA, CPA, CMA, is an associate professor, and RAMON FERNANDEZ, MBA, CPA, CFP, CMA, CIA, is an assistant professor at the University of St Thomas—Houston in Texas.

Driving through a historic district draws attention to the style and grace that was in vogue in generations past. Today the tax Code helps preserve that past by enabling property owners to trade the facades of their homes and buildings for a deduction. While the basic provision ( Section 170(h) —qualified conservation contribution) has been around for decades, recent legislative changes, judicial decisions, and IRS concerns about possible tax avoidance schemes invite additional examination. Tax advisors need to be aware of the judge-made concept of “substantial compliance” in the context of whether taxpayers must substantially meet, or strictly meet, regulations that spell out requirements for the deduction. Additionally, because taxpayers and the IRS often dispute the value assigned to the donation, valuation methodology should be considered.

Conservation real property donations

Section 170(h)(1) permits a deduction for conservation contributions of real property interests if donated to qualified organizations. Qualifying for the deduction requires that donated property be either:

Listed in the National Register of Historic Places.
Certified by the National Park Service to be of historical significance to the registered historic district where it is located. 1
“Listed” property can be any “building, structure or land.” The term structure includes personal residences. Only “buildings” (excluding personal residences) may qualify for the “certified” deduction.

According to the National Register of Historic Places website, the nomination process for listing property starts with each state's historic preservation officer. Nominations submitted to that state officer may come from a variety of sources, including property owners, historical societies, and governmental agencies. Generally, the state agency will identify the required documentation and screen proposals for eligibility. Once the state agency gives its approval, it forwards the nomination to the National Park Service, which subsequently posts it to the Federal Register. Certification follows an application process as outlined by the National Park Service, which makes a determination as to the building's historical significance to the district.

For buildings located in registered historic districts and certified by the National Park Service, Section 170(h)(4)(B) , added by the Pension Protection Act of 2006, requires preservation of the entire exterior (i.e., front, sides, rear, and height) and prohibits changes that are inconsistent with the exterior's historical character. Furthermore, when the donation is made, the donor and donee must sign a written agreement certifying that the donee is a qualified organization and has resources sufficient to manage and enforce restrictions. The taxpayer must also include with his or her tax return:

A qualified appraisal.
Photographs of the building's exterior.
A description of all restrictions on the development of the building.
These particular requirements are not imposed on listed property.

A National Register listing or National Park Service certification itself places no obligations on private property owners. Any obligations assumed by owners are those imposed by local or state authorities that are focused on historic preservation.

Facade easements

Section 170(f) generally disallows a deduction for a gift of less than a donor's entire interest in the donated property. Section 170(f)(3)(B)(iii) provides an exception for a qualified conservation contribution where the property is a qualified real property interest, the donee is a qualified organization, and the contribution is exclusively for conservation purposes.

A qualified real property interest, according to Section 170(h)(2)(C) includes a restriction (such as an easement) that is granted in perpetuity on the use made of the real property. Easements are non-possessory interests in the use of real property in the possession of another person for a stated purpose and thus qualify for the charitable contribution deduction. Such restrictions must be legally enforceable and must prevent the retained property interest from being used in a manner inconsistent with the conservation purpose. Furthermore, a conservation purpose includes the preservation of a historically important area or structure. 2 If future development is permitted on the site, a deduction is allowed only if the terms of the restriction require that the development conform to local, state, and federal standards for construction or rehabilitation within the historic district.

Substantiation requirements

Noncash contributions in excess of $5,000 must be substantiated according to the requirements of Reg. 1.170A-13(c)(2)(i) . That regulation requires that taxpayers must:

(1) Obtain a qualified appraisal.
(2) Attach a fully completed appraisal summary to the tax return.
(3) Maintain records containing the information required by Reg. 1.170A-13(b)(2)(ii) , including:
Name and address of the donee organization.
Date of contributions.
Location and description of the property.
Fair market value on date of contribution.
Method of valuation.
Terms of any agreement or understanding entered by the taxpayer in relation to the sale, use, or other disposition of the property contributed.
A qualified appraisal must: 3

(1) Be made no earlier than 60 days prior to the date of contribution or later than the due date of the return, including extensions, on which a deduction is first claimed or reported.
(2) Be prepared, signed, and dated by a qualified appraiser
(3) Contain the name, address, identification number, and qualifications of the qualified appraiser.
If the appraiser is acting in his or her capacity as a partner in a partnership, an employee of any person, or an independent contractor engaged by a person other than the donor, then the name, address, and taxpayer identification number of the partnership or the person who employs or engages the qualified appraiser must be provided.
The qualifications of the appraiser who signs the appraisal, including the appraiser's background, experience, education, and membership, if any, in professional appraisal organizations, must be provided.
(4) Contain a statement that the appraisal is prepared for income tax purposes.
(5) Contain a description of the property sufficient in 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.
(6) Include the terms of any agreement of understanding entered into or expected to be entered into by or on behalf of the donor or donee that relates to the use, sale, other disposition of the property, including an agreement that restricts temporarily or permanently a donee's right to dispose of the property.
(7) Show the date on which the property was contributed.
(8) Show the fair market value of the property on the date of contribution.
(9) Show the method of valuation and the specific bases for the valuation.
Valuation methods might include the income approach, the market data approach, and the replacement-cost-less-depreciation approach.
The specific basis for the valuation might include specific comparable sales transactions or statistical sampling, including a justification for using sampling and an explanation of the sampling procedure employed.
(10) Show the date on which the appraisal was made.
Tax Court's view

The detailed requirements listed by the regulations beg the question of whether they are to be strictly, or merely substantially complied with, to qualify for the charitable deduction. On the one hand, a strict compliance would leave no doubt in the mind of the taxpayer regarding compliance. Alternatively, substantial compliance could more efficiently achieve the objectives of the statute, eliminating undue burden. So, are these regulations absolute rules to conform to or just guidelines?

American Air Filter Company.

In American Air Filter Company, 4 the Tax Court summarized a line of cases that differentiated between regulatory requirements that relate to the substance of a statute and must be strictly complied with, versus regulations that are procedural in nature and substantial compliance is sufficient. American Air considered whether the taxpayer made an effective election concerning minimum distributions from controlled foreign corporations when it failed to file the required statement to make such an election, but in other ways, did indicate its intention to make such an election. Factors cited to determine whether strict versus substantial compliance is required are:

(1) Whether the taxpayer's failure to comply fully defeats the purpose of the statute.
(2) Whether the taxpayer attempts to benefit from hindsight by adopting a position inconsistent with his original action or omission.
(3) Whether the IRS is prejudiced by the untimely election.
(4) Whether the sanction imposed on the taxpayer for the failure is excessive and out of proportion to the default.
(5) Whether the regulation provided with detailed specificity the manner in which an election was to be made.
In American Air the Tax Court found for the taxpayer. Failing to indicate that a particular election was made relating to subpart F income was an important oversight, but insufficient to offset other details indicating intent to make the election and a belief that an election had been made. The Tax Court concluded that the taxpayer had substantially complied with the requirements of the election.

Simmons.

Substantial compliance was the taxpayer's argument in the recently decided Simmons 5 case, allowing the taxpayer to deduct the charitable contribution of a facade easement validly donated to a nonprofit corporation under Section 170(h)(1) . The IRS sought to deny the deduction on the basis of failure to comply with the reporting requirements of Section 170 and related regulations. The IRS argued that the appraisals did not contain an explicit statement that they were prepared for income tax purposes, failed to adequately describe the property, failed to adequately identify the method of valuation, and did not provide the dates of the contributions. The taxpayer argued that although the appraisals did not satisfy all of the requirements of a qualified appraisal, the requirements had been substantially met. The Tax Court agreed with the taxpayer and so concluded that substantial compliance was sufficient.

Bond.

In support of its decision, the Tax Court cited two of its own decisions. Bond, 6 decided in 1993, involved the donation of two blimps to an organization qualified under Section 170(c)(2) . The basis for determining the case turned on whether the regulatory requirements of Section 170 are “mandatory or directory with respect to its statutory purpose.” On the one hand, Section 170 is intended to allow taxpayers a deduction for contributions to certain organizations. On the other hand, the regulations are intended to help the IRS process and audit returns on which contributions are made and do not relate to the substance of whether the contributions were in fact made. The regulations therefore are directory and not mandatory. In Bond, the taxpayer—

met all of the elements required to establish the substance or essence of a charitable contribution, but merely failed to obtain and attach to their return a separate written appraisal containing the information specified in respondent's regulations even though substantially all of the specified information except the qualifications of the appraiser appeared in the Form 8283 attached to the return.
Hewitt.

In Hewitt, 7 taxpayers claimed a deduction for a donation of shares of stock that was not publicly traded. Failure to obtain a qualified appraisal before filing the returns doomed the deduction. Here, the court stated:

[P]etitioners herein furnished practically none of the information required by either the statute or the regulations. Given the statutory language and the thrust of the concerns about the need of respondent to be provided with appropriate information in order to alert respondent to potential overvaluations ... petitioners simply do not fall within the permissible boundaries of Bond v. Commissioner, supra, where an appraisal summary, which was completed by a qualified appraiser, contained most of the required information and could therefore be treated as a written appraisal, was attached to the return.
In the Tax Court's view, Simmons looked more like Bond and less like Hewitt.

Fifth Circuits' view

In a case involving an election to forego a net operating loss carryback, Young, 8 the taxpayers argued that they substantially complied with the statute on the basis that an election was merely procedural. To the contrary, the Fifth Circuit reasoned that the plain language of the statute that entitles taxpayers to a carryback necessarily requires they make an “irrevocable” election “to relinquish the entire carryback period with respect to a net operating loss.” Affirmative steps must be made, as there is no automatic compliance. Additionally, the conclusion here does not mean that there can never be substantial compliance absent a literal adherence to the requirements of the Code and regulations. When a finding of substantial compliance would contravene the will of Congress and would create an incentive for ambiguity on returns, substantial compliance is not in play. An irrevocable election to forego the carryback is not merely procedural.

Seventh Circuit's view

The Seventh Circuit decision in Prussner 9 took issue with the Tax Court's five-factor test for substantial versus strict compliance:

Reading the Tax Court's decision on the subject of substantial compliance is enough to make one's head swim. Tax lawyers can have no confidence concerning the consequences in which noncompliance with regulations governing the election of favorable tax treatment will or will not work a forfeiture... We think the doctrine should be interpreted narrowly and point out that the courts of appeals owe no special deference to the Tax Court's legal views.... The common law doctrine of substantial compliance should not be allowed to spread beyond cases in which the taxpayer had a good excuse (though not a legal justification) for failing to comply with either an unimportant requirement or one unclearly or confusingly stated in the regulations or the statute.
In Prussner, an estate was permitted a special use valuation election even though it failed to attach a recapture agreement to its estate tax return. The estate had supplied substantially all the necessary information on its tax return and subsequently submitted a required agreement.

Bruzewicz 10 considered whether the doctrine of substantial compliance could be used to excuse taxpayers who argued they had substantially but not strictly complied with regulations governing a charitable deduction for the preservation of the facade easement of their home. Because this case was appealable to the Seventh Circuit, the district court adopted the circuit's tougher standard for applying the doctrine of substantial compliance.

Section 170(f)(8)(A) requires taxpayers to obtain a contemporaneous written acknowledgement from the receiving exempt organization that no goods or services were given to donors in consideration for the preservation easement donation. In Bruzewicz, the donee provided only an acknowledgement of two cash amounts and the word “easement” as the type of donation. That limited wording was inadequate to meet the statutory requirement of a written acknowledgement, according to the court. Such a document is essential to the application of a statute that clearly states no deduction is allowed “unless the taxpayer substantiates the contribution.”

Reg. 170A-13(c)(3)(ii)(F) establishes requirements for appraisals. The Bruzewicz appraisals contained only each real estate appraiser's license numbers. No details regarding the appraiser's backgrounds, qualifications, or experience were provided. The court viewed this detail as critical to the process of validating the contribution, falling far short of substantial compliance, and farther still from strict compliance.

Substantiation of a preservation easement should include a description of the donated property as required by Reg. 170A-13(c)(3)(ii)(A) . While the appraisal did describe the residence in detail, it failed to describe those parts of the house that were the subject of the facade easement. Absent that description, the court considered the appraisal and its valuation of the donated property to be meaningless.

The taxpayer in Bruzewicz took a poke at the IRS in the case, stating “that by disallowing their deduction for the preservation easement, the Government is trying to do indirectly what others have been unable to do directly.” By “invalidating such deductions through an inappropriately restrictive reading of the Code and its regulations,” the IRS is indirectly siding with those critics who have tried unsuccessfully to persuade Congress to repeal the deduction for preservation easements. The district court—which had the last word in this case—noted that the taxpayers could have avoided the IRS's disallowance if they “simply complied with the clear requirements set forth in the governing statutes and regulations.”

Valuation requirements

Valuation of a facade easement is not a simple task. To start, taxpayers must select a qualified appraiser. The essential elements of a real estate appraiser's competency include his knowledge of the property and of the real estate market in which it is situated, and his or her skill and experience in evaluating property. As each property is unique, particularly when only the facade of a building located in a historical area is the item to be valued, finding a suitable appraiser may be difficult. In Whitehouse Hotel Limited Partnership, 11 the taxpayer sought to challenge the IRS's expert witness who testified as to the value of a facade easement.

The IRS appraiser had over 25 years of experience appraising real estate in the same geographic area, including buildings similar to the one in this case, had presented a seminar on commercial real estate appraising, and on more than one occasion, albeit for a different purpose, had appraised this building. The taxpayer argued that despite the appraiser's experience, little of it related to facade easements. The court, however, noted that there is no real difference in valuing property encumbered by a conservation easement donated to charity than any other property encumbered by some other restriction or burden. It boils down to determining a before and an after value, that is, what is the value of the property before donation of the facade and what is its value after the donation. The value is the contribution.

In 1995, Whitehouse Hotel Limited Partnership acquired a parcel of real property in New Orleans' famed French Quarter. The building was located in the Vieux Carre National Historic District and was to be renovated and operated as a hotel. Prior to any construction, in 1997 the partnership conveyed certain of its rights in the building to the Preservation Alliance of New Orleans, a nonprofit Louisiana corporation. This charitable donation of the facade easement eventually led to a dispute with the IRS over the value of the donation.

In Whitehouse Hotel, the taxpayer's expert appraiser used three methods of valuing the real estate to determine the value before and after the facade easement was donated and the donee's restrictions became applicable. To determine a “before” value, these methods were used:

(1) Cost approach.
(2) Adjusted income approach.
(3) Comparable sales approach.
The first two of those methods were used to compute an “after” value. The expert was unable to determine an after value using the comparable sales method as no comparable sales could be identified. Through imaginations that are not completely clear—as is the nature of this type of appraising—the appraiser determined the lost value due to encumbrances resulting from the donation was $10 million. The IRS appraiser, on the other hand, relied exclusively on a comparable sales approach and assessed the diminished value at zero.

In valuing property, experts take into account the highest and best use of that property on the relevant valuation date. In Whitehouse Hotel, the experts differed on whether the conveyance changed the highest and best use of the property. Resolving that issue was an important step in deciding the value of the conveyance. The court decided in favor of the IRS expert's view of the highest and best use.

In its decision as to value, the court considered the analysis offered by each appraiser. Most apparent in the analysis by all parties, including the court, is the difficulty in making an objective assessment. Choosing what values to assign to each of the gains and losses attributable to taking alternative courses of action has as many opinions as there are experts available to offer one. No specific algorithm produces an indisputable answer. As the court noted, “valuation is not a precise science, and determining the fair market value of property on a given date is a question of fact to be resolved on the basis of the entire record.” Furthermore, “expert testimony may assist the Court to understand areas requiring scientific, technical, or other specialized knowledge.”

The court is, of course, not bound by any expert witness opinion and is free to divine its own conclusion using its own assessment of how all the facts should be weighted. In the end, taxpayers and the IRS alike are subject to the judgment of the court even though the court must mingle the same facts and circumstances as the expert appraisers in arriving at a conclusion. In Whitehouse Hotel, the court rejected both experts' valuations and arrived at its own value, although one that leaned closer to the IRS expert's value.

Recently, the IRS reviewed its position on easement valuation in CCA 200947053. In particular, it said “the fair market value of an easement should not be determined by applying a percentage reduction to the value of the underlying property before the easement.” Moreover, “the IRS does not accept this percentage reduction as a method of valuing an easement.” In fact, easement grants may not affect property value at all if the easement is not more restrictive than local ordinances already in effect.

Do easements change fair market value?

Property that qualifies for the facade easement contribution is often located in an area that is already subject to substantial property restrictions. In Simmons, the IRS argued that the easements granted to the donor did not affect the fair market value of the property because the property was already subject to D.C. historic district preservation laws. The Tax Court noted that existing preservation laws did not automatically negate any charitable contribution deductions and dismissed this argument:

Although the easements were duplicative in some respects, it is important to note that granted easements to L'Enfant meant that the petitioner would be subject to a higher level of enforcement than provided by the District of Columbia. L'Enfant actively enforces its easements in a way that the District of Columbia does not. Ms. Goldman credibly testified that in previous situations the District of Columbia had consented to changes to a historic building only to have L'Enfant later intervene and prevent those changes. L'Enfant could also dictate what types of supplies and materials had to be used when work was being done on a donated easement.
It is, therefore, hard to fathom that a donated easement has no value, particularly one that is actively enforced by the recipient organization.

Penalty for overvaluation

One consequence of an excessive valuation of charitable contributions is a penalty for substantial underpayment of tax. Section 6662 imposes a penalty for either negligence or disregard for the rules or regulation; or a substantial understatement of income. Therefore, a failure to strictly or substantially comply with the rules and regulations related to preservation compliance possibly could result in the penalty. In the alternative, as a result of the lost charitable contribution, a taxpayer's tax liability may be substantially understated. In Bruzewicz, the taxpayer did not offer any reply to this penalty claim. With nothing offered in defense, the court permitted the penalty to stand.

In Whitehouse Hotel, a 400% reduction in the partnership's claimed contribution invited the Section 6662(a) accuracy-related penalty. Section 6662(e)(1)(A) describes this as a gross valuation misstatement and Temp. Reg. 301.6221-1T(c) applies the penalty at the partnership level.

The taxpayer sought to avoid this penalty under the reasonable cause exception of Section 6664(c)(1) , requiring a showing that the claimed value of the property was based on a qualified appraisal by a qualified appraiser, and the taxpayer made a good faith investigation of the value of the contributed property. The IRS conceded the first requirement, but challenged whether the taxpayer made a good-faith investigation. The taxpayer bore the burden of proof and supported its position by arguing the partnership's sole general partner relied on a good-faith professional valuation and the claimed lost value was significantly lower than amounts affirmed by previous Tax Court decisions.

The court was unconvinced. The general partner, in fact, became the general partner only after the partnership return was signed. More importantly, the good-faith investigation should be directed to the lost value, rather than the value of the property itself. The overvaluation penalty was, therefore, assessed on the basis of gross valuation misstatement.

The Pension Protection Act of 2006 added Section 6695A , which imposes a penalty on the appraiser if a substantial or gross valuation misstatement is attributable to an incorrect appraisal. A penalty may be imposed on any person who prepared the appraisal and who knew, or reasonably should have known, that the appraisal would be used in connection with a tax return or claim of refund. The penalty is the lesser of two amounts:

(1) The greater of $1,000 or 125% of the gross income received by the appraiser.
(2) 10% of the underpayment attributable to the misstatement. The appraiser must make a written declaration that he or she is aware of this penalty provision.
IRS concerns

In IRM 7.20-6.2.1 (01/01/07), the IRS presented its case that some tax-exempt organizations are directly involved in abusive tax avoidance transactions. “Because they are tax-indifferent, tax-exempt organizations are, at times, used by for-profit entities as accommodations parties in these transactions.”

These for-profit enterprises move assets to tax-exempt supporting organizations but maintain control over the assets and obtain a charitable deduction without transferring a commensurate benefit to charity. Specifically, the IRS identified the donation of facade easements to tax-exempt organizations that merely duplicate existing local historic preservation laws. The IRS view was issued prior to the outcome in Simmons, where the court determined that additional organizational requirements might in fact impose an additional burden on the facade contributor, and thus the contribution had value. It remains to be seen how far the IRS will pursue its line of reasoning on the issue of facade contributions.

Conclusion

The Code allows a charitable contribution deduction for the donation of a qualified real property interest, such as a facade easement to a qualified charity for the exclusive purpose of conservation. The property must be listed or certified as a historic property. The substantiation requirements in the Code and the Regulations must be met, although the courts have disagreed on whether compliance with these rules should be strict or just substantial. The Tax Court has been more lenient than the circuit courts, which have advocated a more strict compliance standard.

Valuation of a facade easement requires valuing the property before and after the donation of the easement. The difference in value becomes the amount of the contribution. Not surprisingly, the taxpayer's appraiser tends to value the difference high, while the IRS appraiser tends to shoot low, even zero. In Whitehouse Hotel, the court rejected both valuations and arrived at its own compromise value, albeit much closer to the IRS appraiser's value. Even though valuation of property is a tricky, subjective process, an excessive valuation may result in an accuracy-related penalty assessed on both the taxpayer and the appraiser.

The recent volume of court cases in this area suggests that the IRS is aggressively pursuing tax returns with easement contributions. In its own Internal Revenue Manual, the IRS seems to view some of these deductions as abusive tax avoidance schemes with tax-exempt organizations complicit in the transactions. Taxpayers and their advisors contemplating taking an easement contribution deduction should tread cautiously and comply strictly with all aspects of the Code and Regulations in order to withstand any possible IRS challenge to the deduction.

1
Section 170(h) (4(C).
2
Section 170(h) ((4)(A)(iv).
3
Regs. 1.170A-13(c)(3)(i) and (ii).
4
81 TC 709 (1983).
5
TC Memo 2009-208 , RIA TC Memo ¶2009-208 , 98 CCH TCM 211 .
6
100 TC 32 (1993).
7
109 TC 258 (1997).
8
57 AFTR 2d 86-911 , 783 F2d 1201 , 86-1 USTC ¶9255 (CA-5, 1986).
9
65 AFTR 2d 90-1222 , 896 F2d 218 , 90-1 USTC ¶60007 (CA-7, 1990).
10
103 AFTR 2d 2009-1428 , 2009-1 USTC ¶50317 , 604 F Supp 2d 1197 (DC Ill., 2009).
11
131 TC 112 (2008).
© 2010 Thomson Reuters/RIA. All rights reserved.