US Tax Court, 136 T.C. No. 13, April 4, 2011: On reconsideration, the US Tax Court affirms its previous decision saying that for a preservation easement to be eligible for a tax deduction, the holder of the easement must have an absolute right to a portion of proceeds from a sale after extinguishment of the easement. Priority on proceeds of condemnation and casualty insurance given to Kaufman’s lender by way of a conditional mortgage subordination was not in compliance with Tax Code requirements about what happens if an easement is ever extinguished, and therefore the Kaufman easement fails the Tax Code’s perpetuity requirement. The decision also lends some support to the practice of preservation organizations and land trusts of not accepting conservation easements or preservation easements without a stewardship contribution, though most of the taxpayer’s stewardship contribution here was denied.
Lorna Kaufman granted a historic preservation façade easement to National Architectural Trust (NAT). NAT obtained a subordination of Kaufman’s mortgage to the easement conditioned on the lender getting priority over Kaufman and NAT rights to any casualty insurance or condemnation proceeds until the mortgage was paid off. The IRS asserted that for an easement to be a “qualified conservation contribution” eligible for a tax deduction, it must give the donee the unconditional right to a proportionate share of future proceeds of a sale of the property following extinguishment of the easement. The IRS said the lender’s priority reserved by the subordination effectively violated that requirement and therefore also violated the requirement that the easement be granted in perpetuity. The Tax Court agreed (134 T.C. 182 (2010), “Kaufman I”).The IRS also claimed that the fact that NAT required the stewardship contribution, as wells as benefits Kaufman received in return, disqualified Kaufman’s tax deduction for the stewardship contribution. In Kaufman I, the Tax Court allowed that deduction. Both Kaufman and the IRS asked the Tax Court for reconsideration, leading to the current reconsideration decision, “Kaufman II”.
In Kaufman II the Court says that Kaufman’s arguments on reconsideration misunderstand Kaufman I’s reasoning. The Court says that it is a misreading of Kaufman I to think that it says that the facts in this case fail to meet the Code and Regulations’ subordination requirements, and that in fact what Kaufman I was saying that the failure was in not meeting the extinguishment requirements.
Kaufman had argued – as interpreted by the Court – that the subordination did not take away NAT’s rights to a portion of sale proceeds following extinguishment. Rather, Kaufman argued, NAT’s rights continued as a contractual claim against Kaufman or her successor owner personally. The Kaufman II Court notes that one section of the Treasury Regulations “requires that the donor [of an easement, i.e., Kaufman], at the time of the gift, must agree that the donation ‘gives rise to a property right … immediately vested in the donee organization’ [i.e., NAT].” (Income Tax Regs. 1.170A-14(g)(6)(ii).) The Court then says that although that requirement does not describe the property in which the donee must have a vested right (other than to say that the donee’s vested property right must have a value proportional to the value of the encumbered property), “we think it the intent of the drafters of [that section] that the donee have a right to a share of the proceeds and not merely a contractual claim against the owner of the previously servient estate.” In other words, the conditional subordination took away NAT’s rights in something bound up in the real estate – the proceeds of a future sale – and at best substituted something other than real estate rights.
“We did not base our grant of partial summary judgment for respondent [in Kaufman I],” the Court wrote, “on any consideration of the consequences of foreclosure of the bank’s mortgage. We based our grant solely on the fact, conceded by petitioners [Kaufman], that, because, following a judicial extinguishment of the facade easement, NAT might not receive its proportional share of any future proceeds, the agreement failed to satisfy the [extinguishment] requirements … and so failed to satisfy the enforceability-in-perpetuity requirements”.
Kaufman had also argued that chance of an eminent domain taking or casualty loss were so small that whatever rights the lender had in proceeds from such events should come under the Regulations’ allowance for risks of noncompliance that are “so remote as to be negligible”. The Kaufman II Court said that the “so remote as to be negligible” exception does not apply to the extinguishment requirements because the chances of extinguishment are always very remote. The easement must give the holder of the easement “an absolute right to compensation from the post-extinguishment proceeds for the restrictions judicially extinguished” [emphasis added] to satisfy the extinguishment provision. “It is Lorna Kaufman’s failure to accord NAT an absolute right to a fixed share of the post-extinguishment proceeds that causes her gift to fail the extinguishment provision. It is not a question as to the degree of improbability of the changed conditions that would justify judicial extinguishment of the restrictions. Nor is it a question of the probability that, in the case of judicial extinguishment following an unexpected change in conditions, the proceeds of a condemnation or other sale would be adequate to pay both the bank and NAT.”
The Kaufman II Court’s decision about the deductibility of the stewardship contribution was at least in part dependent on the facts of this case and who carried the burden of proof. NAT’s correspondence with Kaufman said NAT “requires that donors create an endowment that covers current operating costs and funds [NAT’s] long term Stewardship Endowment which is reserved for future monitoring and administration purposes.” Kaufman’s relationship with NAT before the easement was granted spanned 2003 and 2004. In December 2003 NAT told Kaufman they’d accept her easement subject to various conditions, including that an appraisal of the easement’s value be completed by February 2004 and that she make a contribution before the end of 2003 based on 8% percent of the anticipated appraised value (“the 2003 contribution”) with a second contribution to be given in 2004 based on the difference between the 2003 contribution and 10% of the actual appraised value of the easement (“the 2004 contribution”).
The Kaufman II Court disallowed the 2003 contribution but basically allowed the 2004 contribution. The IRS had argued that both contributions should be disallowed either (a) as conditional payments, because they were conditioned on the appraisal finding the value of the easement to be more than zero, or (b) as ineligible quid pro quos because they were required or because Kaufman received benefits from NAT.
The Court held that to get a deduction for the 2003 contribution, Kaufman had the burden of proving that, at the end of 2003, the possibility of a zero appraisal value was not so remote as to be negligible, and she did not offer sufficient proof. Therefore the 2003 contribution deduction was denied.
On the quid pro quo argument, the Kaufman II Court rejected both grounds asserted by the IRS. As to the “requirement,” the Court wrote, “Neither party, however, has provided us with any authority governing the deductibility of a payment to a charitable organization when the organization’s acceptance of a contribution of property is conditioned on the donor’s cash donation sufficient to maintain the property and contribute to operating costs. … Seeing no benefit to Lorna Kaufman other than facilitation of her contribution of the facade easement … and an increased charitable contribution deduction, we shall not deny petitioners’ deduction of the cash payments on the ground that the application required a ‘donor endowment’ to accompany the contribution of façade easement.”
As to the fee-for-services argument, the IRS had the burden of proof because of when it introduced this argument. The Court found the evidence ambiguous and so rejected this argument and allowed most of the 2004 contribution deduction.
The decision is available at http://www.ustaxcourt.gov/InOpHistoric/Kaufman2.TC.WPD.pdf.
Thanks to Shantia Anderheggen for bringing this decision to my attention so quickly.