Dunlap v. Commissioner of Internal Revenue

U.S. Tax Court, T.C. Memo, 2012-126, May 1, 2012: Tax Court finds taxpayers’ appraisals not credible to rebut IRS appraisal, resulting in zero value for tax deduction purposes to historic preservation easement to NAT. Deductions were allowed for “required” cash contributions and accuracy-related penalties were disallowed.

The unit owners of a condominium building (Cobblestone) in a New York historic district granted a historic preservation façade easement to National Architectural Trust (now known as the Trust for Architectural Easements) in 2004. Because the easement affected a common element of the condominium, it was granted by the treasurer of the condominium board on behalf of the unit owners. The building was subject to the preservation regulations of the New York City Landmarks Protection Commission (LPC) as well as (1) a “sound, first-class condition” designation under LPC regulations which, the court wrote, is a “special designation applied to approximately 150 of the 26,000 properties subject to LPC regulations and results in designated properties’ being subject to a higher standard of preservation than the normal LPC standard”, and (2) a “Continuing Maintenance Agreement” (CMA) with LPC. According to the court the CMA is perpetual, requires inspection every 5 years, “cover[s] various elements of both the interior and the exterior of the building”, may result in a requirement for the condominium to perform “work which should be completed to maintain the building in sound, first-class condition” at the condominium’s expense unless the need for such work is contested by the condominium, and “[o]ther provisions of the continuing maintenance agreement imposed reporting obligations on [the condominium] in case of fire or other damage to the property.”


The IRS presented appraisals by two expert witnesses that valued the easement at zero for a variety of reasons, including that the facade easement’s restrictions “were substantially similar to restrictions already imposed by the LPC” and that the condominium bylaws “already required unit owners to seek approval from the … board for changes to [the] façade”. The Petitioners (several unit owners) presented appraisals by two expert witnesses each of which gave different but substantial values to the easement. Under section 7491(a)(1) of the Tax Code, “If, in any court proceeding, a taxpayer introduces credible evidence with respect to any factual issue relevant to ascertaining the liability of the taxpayer for any tax imposed …, the [IRS] shall have the burden of proof with respect to such issue.”  The court had to decide whether the unit owners’ appraisals were credible evidence to place the burden of proof on the IRS. For various reasons the court found the unit owners’ appraisals were not credible (although the appraisers were “qualified”), and thus they not only did not shift the burden of proof to the IRS but they did not prove that the easement had a value other than what the IRS said: zero.

The court dismissed each appraisal from the taxpayers for different reasons but as to each did not accept the appraisals method for determining the value of the building after donation of the façade easement. (The value of the easement may be determined by comparing the value of the building “before”, i.e., without the easement, and “after”, i.e., with the easement; the “before and after method”.)

The higher of the two appraisals for the unit owners arrived at a “before” value using comparable sales data for condominium units and aggregating the value of all the units as the value of the entire building. It then arrived at an “after” value using the income approach in two steps. First, it applied a capitalization rate (cap rate) to the net operating income the appraiser calculated the units would have had as rental units (not owner occupied) given the condominium’s past typical operating expenses without a façade easement. Next, it applied a higher cap rate to the projected net operating income given a higher level of operating expenses which the appraisal said would be incurred with a façade easement. That process resulted in a change in value, which the appraisal expressed as a percent. Then the appraisal took the percent arrived at using the income approach and applied it to the “before” value derived from the comparable sales approach to find an “after” value for the condominium building as owner occupied condominium units, not as rentals.

The court said this was mixing apples and oranges, not because the appraisal switched from a comparable sales “before” approach to an income “after” approach, but because it used a different “highest and best use” – i.e., an owner-occupied condominium – for the “before” value than it used for the “after” value – i.e., as rental apartments. The court did not cite any source for the proposition that there can be only one highest and best use, but in another part of the opinion quoted the portion of the opinion in Hilborn v. Commissioner, 85 T.C. 677, at 689-690 (1985), that explains the before and after approach as requiring a determination of the highest and best use, and cited without quoting Treas. Regs. sec. 1.170A-14(h)(3)(ii).

The court also criticized this appraisal for treating the façade easement as more restrictive than “the LPC regulations and enforcement”. The opinion does not go into the details of the LPC regulations or the CMA other than to characterize the LPC regulations as “slightly less rigorous” than the Secretary of the Interior’s standards built into the easement. Instead the court focuses considerably on enforcement. After writing positively of LPC enforcement procedures, the court lambasts NAT enforcement. (See the post “Trust for Architectural Easements Barred from Certain Easement Activities”.) [Editorial comment: the opinion could be read to suggest that in valuing the easement the appraisal should have taken into account NAT’s record of enforcement or lack thereof, or that the appraisal’s credibility was damaged by the failure to consider NAT’s enforcement record.]

As to the lower of the two appraisals presented for the taxpayers, the court found its “method of discounting sales data in this case improperly skewed the resale data and that no proper comparison of sale prices took place,” but pointedly did not decide whether the methodology itself is “improper per se”. This appraisal stated that it used only the comparable sales approach and looked at sales between 2004 and 2009, a period that included the severe recession. The appraiser testified that “because he was dealing with multiyear sales he used the discounted cashflow approach in part, which straddles the fence between the comparable sales approach and the income capitalization approach.” The appraisal said that to compare sales over a multi-year period it was necessary to “discount” all prices to a net present value as of the appraisal date. The IRS expert asserted that, “discounting created a ‘huge distortion’ in [the appraisal’s] discounted sales figures and that ‘it’s never clear why discounting needs to be applied at all,” and that the preponderance of prices from sales later in the 2004-2009 period skewed the results significantly because discounting weights later data more heavily. The tax court agreed with the IRS. “As a result of the spacing of the data,” the court wrote, the condominium’s “discounted sale values were negatively affected by an undersampling of sales in the best real estate year (2007) and an oversampling of sales in the worst real estate year (2009). That effect was not accounted for by [the] appraisal report.”

Cash Contribution

The court also reviewed the IRS denial of a deduction for the cash contribution unit owners made to NAT together with the façade easement. The issues were several.

As to all unit owners, the court rejected the IRS argument that because NAT required the contributions there was no charitable intent. Citing Kaufman v. Commissioner 136 T.C. 294, at 318-319, the court said that if the cash contribution made possible the easement contribution, the potential tax benefit to the unit owners of the easement contribution is “acceptable” as compatible with charitable intent.

The court also rejected the IRS’s argument that the cash was a commercial quid pro quo for services from NAT. The court said for there to be a quid pro quo there must be reciprocity in cash paid in return for services performed, i.e., where “the taxpayer’s money will not pass to the charitable organization unless the taxpayer receives a specific benefit in return and where the taxpayer cannot receive the benefit unless he pays the required price”. The court found that the services performed by NAT were of insignificant value to the unit owners or that unit owners were unaware of the benefits conferred by NAT on the condo board and manager.

The IRS assertion that the cash contribution was conditional based on the appraised value of the easement failed for lack of evidence that any of the cash contribution would have been refunded had an appraisal subsequent to the cash payment found a lower value for the easement. (See Treas. Regs. section 1.170A-1(e).)

Another issue was “substantiation”: whether NAT’s letter acknowledging the contribution should have reduced the acknowledged contribution by the value of certain services performed by NAT or by the small portion of the contribution that was funneled by NAT to the condo board and manager. The court found “(1) any administrative work completed by NAT was done so that NAT would be assured of holding an enforceable facade easement in perpetuity and that any benefits accruing to unit owners as a result of such work were incidental and insignificant; (2) NAT’s referral of [an appraiser] had either no value or an insignificant value; and (3) [the unit owners] were not aware that a small part of their cash contribution made to NAT was later paid to” the condo board and manager.

Lastly, the court rejected accuracy-related penalties against the taxpayers under Code sections 6662(a) and (b)(2) related to their “gross” or “substantial” misstatement of the value of the easement, since the easement turns out to be valueless.  The court agreed with the taxpayers that they satisfied the “reasonable cause defense”: they “(1) had reasonable cause; and (2) acted in good faith” because “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 property.” The court did not find that the taxpayers were reasonable in their reliance on the advice of the condominium’s attorney or their individual tax advisers, in part because those advisers were not called as trial witnesses and the taxpayers’ testimony about their reliance was “self-serving”. The court nevertheless found good faith because their reliance on the original appraisal was reasonable, they “disclosed the contribution of the facade easement on their tax returns”, and they attached to their returns the appraisal and the required Form 8283 substantially complete. The court found the original appraiser “qualified” despite his lack of experience appraising conservation easements. It found the appraisal “qualified” because it said the appraisal requirements of Treas. Regs. (sections 1.170A-13(c)(3)(i) and (ii)) are “directory rather than mandatory” and “substantially all of the information required had been provided”. The court disagreed with the IRS about various faults the IRS found in the appraisal.

The decision is available at http://www.ustaxcourt.gov/InOpHistoric/Dunlap.TCM.WPD.pdf.

1 comment to Dunlap v. Commissioner of Internal Revenue

  • [...] On the subject of value, although the valuation issues were not in dispute on appeal, because they were not reached in the Tax Court decision, the Court saw fit to comment. Specifically, the Court offered dictum on the issue of whether the easement had any value given the municipal restrictions on facades in the historic district in which the Kaufmans’ home is located. Those restrictions were characterized by the Court as “severely restrict[ing] the alterations that property owners can make to the exteriors of historic buildings in the neighborhood.” The Court volunteered that, “Given these pre-existing legal obligations the Tax Court might well find on remand that the Kaufmans’ easement was worth little or nothing.” The appraisal had made distinctions between the preservation easement and the municipal restrictions. The Court said, “Whether any of the offered distinctions justify any deduction is a matter for the remand.” This same issue also came up when the Tax Court rejected the appraisals in Dunlap v. Commissioner, T.C. Memo, 2012-126 (May 1, 2012). [...]