Palmolive Building Investors v. Commissioner

U.S. Tax Court, 149 T.C. No. 18, October 10, 2017: Outside 1st Circuit, full subordination of mortgagee’s right to insurance proceeds is required to qualify for charitable deduction.

Contrary to the ruling of the U.S. Court of Appeals for the 1st Circuit in Kaufman v. Shulman, 687 F.3d 21 (2012) (Kaufman III), the Tax Court holds in this case that donation of a historic preservation easement or conservation easement does not qualify for a federal charitable tax deduction if a mortgagee’s rights to the property’s insurance proceeds are not fully subordinate to the easement. A mortgagee retention of any rights to the insurance proceeds fails the perpetuity requirement of Treasury Regulations Section 1.170A-14(g)(6) which requires that the donee receive a “property right” that entitles it to receive proceeds from any disposition of the property after extinguishment of the easement.

Palmolive Building Investors donated a historic preservation facade easement on a property in Chicago to a qualified organization. At the time of the donation the property was subject to two mortgages. Although the mortgagees each granted a subordination of their mortgage to the easement, the subordinations stated that they were subject to the terms of the easement. The easement provided that in the event the facade easement were extinguished, the mortgage holders would have claims prior to that of the donee organization to any proceeds received from the condemnation proceedings, until the mortgage is satisfied.

The Kaufman III decision had overruled the Tax Court (Kaufman I and Kaufman II) in circumstances very similar to the Palmolive facts. Kaufman III held that the mortgagee’s reservation of rights in insurance proceeds did not disqualify the easement as long as the donee had a contractual right against the property owner for insurance and sale proceeds after extinguishment of the easement. The Tax Court explained that because this Palmolive case is appealable to a U.S. Court of Appeals (the 7th Circuit for this Chicago property) other than the 1st Circuit in which Kaufman III was decided, the court does not consider itself bound in this case by the Kaufman III opinion. Perhaps in deference to the 1st Circuit, the court went to some length to explain why in its understanding of the law the reservation of mortgagee rights fails the perpetuity requirement and Kaufman III was wrongly decided.

The court gave the example of a mortgage debt of $87 million on a property worth $100 million at the time of easement donation where the mortgage was superior to the donee’s easement right: “if the value of the property decreased to $87 million by the time of a condemnation or forced sale, then the mortgagee could be made whole upon foreclosure, but the donee’s subordinate right to the easement would be worth nothing. The presence of a mortgage can thus threaten the perpetuity of the donee’s interest in the property.”

To quote at length from the Opinion:

“If the property (along with the facade) were destroyed by fire or otherwise, the unsubordinated mortgagees would stand at the head of the line to receive insurance proceeds; and if the proceeds were not adequate to pay off the loans, then [the donee] might in the end receive nothing. [The donee’s] supposedly perpetual interest in the facade would in fact have served [the donor] and the mortgagees (by serving as collateral and supporting insurance coverage) but would result in no benefit to [the donee].

“Where an owner of property subject to a mortgage and covered by insurance would seek to donate a perpetual easement interest in a facade, the owner may not surreptitiously hold back an interest in the facade by using it as collateral for mortgage loans and exploiting insurance coverage on it to repay the owner’s mortgage debt. Rather, the mortgagee’s “rights in the property” (as collateral for its loans and as predicate for insurance proceeds) must be subordinated to the interests of the donee.

“Receiving proceeds in the event of a condemnation is a critical right and interest of the mortgagee; and if that right and interest is not subordinated, then the donee’s ‘property right’ to proceeds is undermined. Palmolive’s arrangement does not reflect the actual subordination of the mortgage.”

Palmolive also argued that a “savings clause” in the easement had the effect of preempting the insurance proceeds provision and curing whatever defect might be found there. The savings clause said that any provision of the easement that conflicts or is inconsistent with or otherwise doesn’t comply with tax law requirements “shall be deemed to be amended to the extent necessary to eliminate such conflict or inconsistency.”  The provision went on, however, to say that any such change “which materially adversely affects a Mortgagee’s rights under this Conservation Right … shall require the consent of any Mortgagee so affected.” The court rejected Palmolive’s argument, saying that the exception for mortgagee’s rights undoes whatever benefit the savings provision conferred and, besides, the clause purports to retroactively amend the deed, while the requirements of the Code and Treasury Regulations must be satisfied at the time of the gift.

For practitioners, it’s worth reading the court’s decision to see the exact language of the easement that reserved the mortgagee’s rights to insurance proceeds.

Decision available at http://www.ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=11415.

Thanks to Leslie Ratley-Beach for bringing this decision to my attention so quickly.

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