US Tax Court, 139 T.C. No. 13, October 23, 2012: On remand from Appeals Court, historic preservation deduction reduced, penalty imposed.
The US Tax Court took another look at the objections of the Whitehouse Limited Partnership (Petitioner) to the IRS’ reduction of Whitehouse’s claimed charitable deduction for donation of a historic preservation easement, and the imposition of an accuracy penalty for gross valuation misstatement. The case was heard on remand from the U.S. Court of Appeals for the Fifth Circuit, per its opinion in Whitehouse Hotel Ltd. P’ship v. Commissioner, 615 F.3d 321 (5th Cir. 2010) (Whitehouse II), vacating and remanding 131 T.C. 112 (2008) (Whitehouse I). Whitehouse II was reported in Preservation Law Digest, but Whitehouse I was decided before PLD began publication.
The matter was remanded to the Tax Court for it take another look at several issues as to which the Court of Appeals overruled its decision or that required further adjudication because of the overruling.
Easement’s affect on Kress Building Value: The preservation easement was imposed on the Maison Blanche building but not on the Kress building, two contiguous buildings owned by Whitehouse. The day after Whitehouse donated the easement, it converted the Maison Blanche and Kress buildings into a single condominium. The Appeals Court wrote, “… as a matter of valuation, the tax court erred by not considering the effect on market value of the [two] buildings’ pending combination….” Therefore the Tax Court’s new decision takes into account the effect on both buildings.
Highest and Best Use: The appraisal of the easement’s value as it affected the value of the property before and after the donation had to include a conclusion about the property’s highest and best use. If the property’s value was determined by looking at so-called comparable sales, the appraiser’s decision about which properties are comparable would be determined by selecting the appropriate use of the property being appraised. The Tax Court therefore addressed this question in Whitehouse I but the Appeals Court found the Tax Court’s consideration “ambiguous” and ordered the Tax Court to reconsider it.
The Tax Court in Whitehouse III repeated that it did not need to decide whether the highest and best use was as the Whitehouse’s appraiser said (a luxury hotel) or as the IRS’ appraiser said (a nonluxury hotel) because “the determination of fair market value incorporates the highest and best use of a piece of property only if the demand for that use will affect the market price… The point to be taken is that, although the highest and best use of property may determine a ceiling on how much a willing buyer would pay for the property, it does not necessarily determine a floor on how little a willing seller would accept”. Citing Van Zelst v. Commissioner, 100 F.3d 1259 (7th Cir. 1996), aff’g T.C. Memo. 1995-396, the Court said that “the equilibrium price at which the willing buyer and the willing seller would meet would be somewhere between the value of the property taking into account its most productive use (i.e., its highest and best use) and the value of the property taking into account its second most profitable use”. The value would depend on demand: greater the demand for the property would skew value to the highest and best use; low demand would skew value to the second most profitable use.
In this case, the Court found no evidence that demand for the property at the date of donation was higher than it had been at the time of Whitehouse’s purchase of the property three years before, and the burden of proof was on Whitehouse to show otherwise. Significantly, at both dates the buildings were unrenovated shells. (This point also was significant in the Court’s weighing of Whitehouse’s appraisal and the accuracy-related penalty, discussed below.) Accordingly, the Court decided, “we are accepting …[the IRS’ appraiser’s] view that the value of the subject property under the comparable-sales approach is to be determined on the basis of sales of buildings suitable for conversion into hotels — luxury or not…. We do not need to choose between the two experts’ opinions of highest and best use, since, even if we were to agree with … [the Whitehouse’s appraiser], it would make no difference.”
Rejecting Replacement Cost and Income Valuation Methods: In Whitehouse I the Tax Court rejected the income and replacement-cost valuation methods and said comparable sales should be used. The Appeals Court did not decide whether the Tax Court was wrong but ordered reconsideration of all three easement valuation methods. The Tax Court in Whitehouse III again rejected the Whitehouse appraiser’s use of the reproduction cost method as inappropriate for this type of historic structure (in part because of the unlikelihood that anyone would reproduce it if it were destroyed), citing United States v. Benning Housing Corp., 276 F.2d 248, 250 (5th Cir. 1960) and Estate of Palmer v. Commissioner, 839 F.2d 420, 424 (8th Cir. 1988). The Court also rejected the income method for this property. It noted, “Certainly, we are not hostile to the income approach to determining value, and we have accepted (and applied) it in determining the value of conservation easements, see, e.g., id. (subdivision method), although it is not favored if comparable-sales data are available… We have no difficulty with the process [whereby Whitehouse’s appraiser used a computer model employing a discounted cashflow analysis to arrive at both before- and after-restriction present values for the Maison Blanche-Kress parcel]. Where we have difficulty is with petitioner’s call to trust on their face … [Whitehouse’s appraiser’s] judgments as to values to be input to his model.”
Comparable-sales Valuation Method: The Court again rejected the Whitehouse appraisal’s reduction by 10% of each comparable’s price to reflect the effect of the easement in the “after” because it was supported only by the appraiser’s opinion, which the Court did not find persuasive. The Court also rejected that appraisal’s use of nonlocal properties as comparables, in part because it found local comparables were available and because the adjusted values the Whitehouse appraisal calculated for nonlocal properties were significantly higher than the adjusted values that appraisal determined for local properties.
Extent of the Easement, Affect on Value: Whitehouse claimed that the historic preservation easement included the Kress building by prohibiting an increase in its height that otherwise could have been changed to allow 60 additional rooms atop that building. Whitehouse said that prohibition negatively affected the Kress building’s value and had to be taken into account in the easement’s value. Although the Court opined that the promise not to increase the height of the Kress building was not a qualified conservation contribution under the Internal Revenue Code and Treasury Regulations because under Louisiana law it was not a preservation easement enforceable in perpetuity – and therefore did not affect the value of the contributed easement – nevertheless the Court thought it should recalculate the value of the easement (which it referred to as a servitude) “on the assumptions that, in fact, it does obligate the partnership not to build atop the Kress Building and that separate ownership of the Maison Blanche and Kress Buildings is unlikely”. (The Court may have been trying to avoid an appeal on this point.)
(As a drafting point, it’s worthwhile to report that Whitehouse’s argument in support of its position was based in part on language in the preamble of the easement, one of “whereas” paragraphs. The Court noted, “Petitioner’s reliance on the preamble of the conveyance is misplaced. ‘Generally, a preamble does not create rights beyond those conveyed by the contract’s operative terms.’ Chevron U.S.A., Inc. v. Santa Fe Snyder Corp., 69 Fed. Appx. 658 (5th Cir. 2003) (citing Grynberg v. FERC, 71 F.3d 413, 416 (D.C. Cir. 1995)”. But the Court went on to say that even if the preamble had an affect on how the body of the easement should be understood, “it must be that the preamble does so by implication, since neither the term ‘servitude of view’ nor any description of a servitude of view appears in the preamble. To accept that a servitude of view (a predial servitude) is established by implication, however, is prohibited.”)
Valuation: The Court used the comparable-sales method of valuation. Whitehouse had claimed a charitable deduction of $7.445 million. Its appraisal had valued the easement at $10 million, relying primarily on the replacement cost approach. Although Whitehouse paid $11 million for the property in 1995, the 1997 appraisal calculated a “before” value of $41 million. The IRS would have reduced the deduction $1.15 million. The Court calculated the “before” value of the combined Maison Blanche-Kress property at $12.473 million, and the “after” value as $10.615 million, resulting in a value of the easement and deduction at $1.858 million.
Accuracy-Related Penalty: The deduction claimed by Whitehouse was 401% more than the deduction allowed by the Court. If a taxpayer overstates the value of a property claimed as a deduction by 400% or more, it’s a “gross valuation misstatement” for which a penalty may be imposed under section 6662(a) of the Code of 40% of any underpayment of tax. Whitehouse argued that the penalty should not be imposed, under the “reasonable cause” exception of section 6664(c) of the Code. To claim the reasonable cause exception the taxpayer must show that it acted with good faith to assess the proper tax liability, and for a substantial or gross valuation misstatement the exception also requires the taxpayer to show that the claimed value was based on “a qualified appraisal made by a qualified appraiser” and that “the taxpayer made a good-faith investigation of the value of the contributed property” [emphasis added]. Here the issue was whether Whitehouse made a good faith investigation. Whitehouse argued that it satisfied that burden because it relied on a qualified appraisal and professional tax advice it received from its accountants and lawyers.
The Court found that the reliance on the appraisal could not be considered as having been done in good faith and did not demonstrate a good faith investigation where that appraisal gave a before value of $96 million on a building purchased not long before for $9 million, and which valued it as if fully developed and not as the shell that it actually was. The Court wrote, “a reasonably prudent taxpayer attempting to assess its proper tax liability would no doubt have further investigated [the appraiser’s] methodology and conclusions. Lack of further investigation would be counterindicative that the partnership acted with reasonable cause and in good faith in the face of the facts before it.” The Court gave no weight to Whitehouse’s comparison of that appraisal to another appraisal because the other appraisal appraised the property and not the easement. While there was testimony in the record that Whitehouse relied on the advice of its accountant and lawyer, that testimony did not show what that advice was or whether it was based on an investigation into the value of the easement. (The Court said it was not implying a duty on the part of an accountant who prepares a tax return to conduct such an investigation or to ensure that the taxpayer had done so “unless the information furnished it appeared incorrect, incomplete, or inconsistent”.) Accordingly the court imposed the 40% accuracy related penalty.
Decision available at http://www.ustaxcourt.gov/InOpHistoric/WhitehouseDiv.TC.WPD.pdf.