Mitchell v. Comr.: Tax Court Disallows Charitable Deduction for Conservation Contribution Because of Failure to Subordinate Mortgage

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By David I. Kempler, Esq. and Elizabeth Carrott Minnigh, Esq.  

Buchanan Ingersoll & Rooney PC, Washington, DC

In Mitchell v. Comr., 138 T.C. No. 16 (2012), the Tax Court held that a taxpayer was not entitled to a charitable deduction for the donation of a conservation easement over land she owned that was subject to a mortgage on the grounds that the contribution failed the "exclusively for conservation purposes" requirement because mortgagee's deed of trust was not subordinated to conservation easement deed until after donation.  In this case of first impression, the Tax Court found that Regs. §1.170A-14(g)(3), which states that a deduction should not be disallowed because of the possibility of a remote event, could not be applied to overrule the strict requirement of subordination in Regs. §1.170A-14(g)(2).

Under §170(a)(1), a taxpayer is generally allowed a deduction for any charitable contribution made during the taxable year. However, a taxpayer is generally not allowed a charitable contribution deduction for a gift of property consisting of less than an entire interest in that property, unless it falls within certain exceptions including a "qualified conservation contribution" under §170(f)(3)(A) and (B)(iii). Pursuant to §170(h)(1) and Regs. §1.170A-14(a), a "qualified conservation contribution" is a contribution of a "qualified real property interest" to a "qualified organization" that is made "exclusively for conservation purposes." Pursuant to §170(h)(5)(A), a contribution is made exclusively for conservation purposes only if "the conservation purpose is protected in perpetuity."

With respect to property subject to a mortgage, Regs. §1.170A-14(g)(2) provides that no deduction will be permitted "unless the mortgagee subordinates its rights in the property to the right of the … [donee] organization to enforce the conservation purposes of the gift in perpetuity." However, under Regs. §1.170A-14(g)(2), a deduction will not be disallowed merely because on the date of the gift there is the possibility that the interest will be defeated so long as on that date the possibility of defeat is so remote as to be negligible.

In 2000, Taxpayer and her husband (who died in 2006) purchased 351 acres of undeveloped land. The purchase was seller-financed. After a downpayment, Taxpayer executed a promissory note for the remaining payments secured by a deed of trust on the unimproved land. In 2002, Taxpayer and her husband formed a family limited partnership (FLP) to which they transferred the land, subject to the deed of trust. On December 31, 2003, FLP contributed a conservation easement over 180 acres to a land conservancy, which was a qualified charitable organization. On its 2003 tax return, FLP claimed a $504,000 charitable contribution deduction, which flowed to its two partners, Taxpayer and her husband, equally. At the time that the conservation easement was granted, the deed of trust securing the debt to the seller was not subordinated to the easement and, in fact, Taxpayer failed to have the mortgagee subordinate the deed of trust to the conservation easement deed until December 22, 2005. From 2003 through 2005, FLP had the money to pay off the promissory note at any time and all payments were made in a timely manner. The IRS issued a notice of deficiency to the taxpayer in 2010, disallowing the 2003 charitable contribution deduction on the grounds that Taxpayer did not satisfy the subordination requirements of Regs. §1.170A-14(g)(2).

The Tax Court first looked at whether Taxpayer obtaining a subordination agreement in 2005 satisfied the subordination requirement. The Taxpayer argued that it was irrelevant that the subordination agreement was signed almost two years after the grant of the conservation easement because the regulation has no requirement as to when the mortgagee must subordinate its claim to that of the donee organization. The Tax Court found that, while the subordination regulation is silent as to when a taxpayer must subordinate a preexisting mortgage on donated property, the regulation requires that a subordination be in place at the time of the gift in order to meet all the requirements of §170(h) and the underlying regulations at that time. Moreover, the Tax Court noted that if Taxpayer had defaulted on the promissory note prior to the date of actual subordination, the seller could have instituted foreclosure proceedings and eliminated the conservation easement and, therefore, the conservation easement was not protected in perpetuity at the time of the gift. Accordingly, the Tax Court held that Taxpayer failed to meet the requirements of §170(h) and the underlying regulations for 2003.

The Tax Court then turned to the question of whether, notwithstanding the fact that the deed of trust took priority over the conservation easement until December 22, 2005, the easement was protected in perpetuity because the probability of Taxpayer's defaulting on December 31, 2003 on her promissory note was so remote as to be negligible. Taxpayer asserted that the subordination regulation must be read in conjunction with the so-remote-as-to-be-negligible standard. The Tax Court noted that, while it had previously decided in Kaufman v. Comr., 136 T.C. 294 (2011), and Carpenter v. Comr., T.C. Memo 2012-1, that the so-remote-as-to-be-negligible standard in Regs. §1.170A-14(g)(3) should not be applied when determining whether a taxpayer has met the requirements of other subsections of Regs. §1.170A-14(g), it was a matter of first impression whether the so-remote-as-to-be-negligible standard must be considered in determining whether the taxpayer satisfied the subordination requirements of Reg. §1.170A-14(g)(2).  The Tax Court also acknowledged, however, that the D.C. Circuit in Simmons v. Comr., 107 AFTR 2d 2011-2632 (6th Cir. 2011), aff'g T.C. Memo 2009-238, applied the so-remote-as-to-be-negligible standard to find that a gift of a facade easement was protected in perpetuity. However, the Tax Court distinguished the D.C. Circuit case because, there, the standard was used to defeat a general argument made by the IRS as to the conservation easement's grant in perpetuity and not to defeat a specific subparagraph of Regs. §1.170A-14(g).  Given the Tax Court's prior rulings under the other subsections, the Tax Court held that the subordination regulation should not be read in tandem with the so-remote-as-to-be-negligible standard.

Finally, Taxpayer argued that she and her husband had an oral agreement with the seller that they would not subdivide or develop the property. Taxpayer claimed that, since these were the same rights relinquished under the conservation easement, the oral agreement protected the conservation easement's purpose in perpetuity as required by §170(h)(1)(C) and (5). However, the Tax Court concluded that the oral agreement had no effect on the seller's ability to foreclose the property and extinguish the conservation easement if Taxpayer had defaulted on the promissory note. Therefore, the Tax Court held that the oral agreement also failed to comply with the requirements of Regs. §1.170A-14(g)(2). Accordingly, the Tax Court disallowed the charitable deduction.

The decision of the Tax Court makes clear that, even after the Simmons decision, the so-remote-as-to-be-negligible rule in Regs. §1.170A-14(g)(3) may not be used to excuse noncompliance with one of the specific requirements set forth in Regs. §1.170A-14(g), which an easement must satisfy in order for a taxpayer to qualify for a charitable contribution deduction. In making a conservation easement, taxpayers should take care to closely adhere to the requirements set forth in the regulations.

For more information, in the Tax Management Portfolios, see Kirschten & Freitag, 863 T.M., Charitable Contributions: Requirements for Deduction,  and in Tax Practice Series, see ¶2390, Charitable Contributions: Requirements for Deduction, and ¶2395, Charitable Contributions: Substantiation Requirements.