Tax Court Denies Motion for Rehearing on Charitable Deduction for Conservation Contribution Disallowed Because of Failure to Subordinate Mortgage

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By David I. Kempler, Esq., and Elizabeth Carrott
Minnigh, Esq..…October 2013

Buchanon, Ingersoll & Rooney, PC, Washington, DC

In Mitchell v. Comissioner, T.C. Memo. 2013-204
("Mitchell II"), the Tax Court denied the taxpayer's
motion for reconsideration and supplemented its 2012 opinion in
Mitchell v. Commissioner, 138 T.C. No 16 (2012)
("Mitchell I"). In Mitchell I, the Tax Court held
that a taxpayer was not entitled to a charitable deduction for the
donation of a conservation easement over land that she owned, which
was subject to a mortgage, on the grounds that the contribution
failed the "exclusively for conservation purposes" requirement
because the mortgagee's deed of trust was not subordinated to
conservation easement deed until after donation.  In this
case, as well as a number of recent decisions regarding
conservation easements referenced herein, the IRS and the courts
have clearly articulated that taxpayers who claim conservation
easements must strictly comply with the rules under Regs.
§1.170A-14 or risk audit.

A taxpayer is generally allowed a deduction for any charitable
contribution made during the taxable year under §170(a)(1).
However, as a general rule, under §170(f)(3)(A) and (B)(iii), a
taxpayer is 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, which include
an exception for a "qualified conservation contribution." Section
170(h)(1) and Regs. §1.170A-14(a) provide that "qualified
conservation contribution" is a contribution of a "qualified real
property interest" to a "qualified organization" that is made
"exclusively for conservation purposes." Further, under
§170(h)(5)(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 down payment, Taxpayer executed a promissory note for the
remaining payments secured by a deed of trust on the undeveloped
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 equally to its two partners, Taxpayer and her husband. 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 sufficient
funds to pay off the promissory note at any time and all note
payments were made in a timely manner. The IRS issued a notice of
deficiency to 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).

In Mitchell I, Taxpayer argued that the conservation
purpose of the easement had been protected in perpetuity at the
time of the gift even without a subordination agreement because the
probability that FLP would have defaulted on the mortgage was so
remote as to be negligible. The Tax Court, however, rejected that
argument, holding that Taxpayer cannot avoid meeting the strict
subordination requirements of Regs. §1.170A-14(g)(2) by applying
the "so-remote-as-to-be-negligible standard" of Regs.
§1170A-14(g)(3).  Accordingly, in Mitchell I, the Tax
Court sustained the IRS's disallowance of the taxpayer's claimed
deduction for the donation, on the grounds that the mortgagee was
not subordinated at the time of the contribution as required by
Regs. §1.170A-14(g)(2).

In Mitchell II, Taxpayer argued that the decision of
the First Circuit in Kaufman v. Commissioner, 687 F.3d 21
(1st Cir. 2012), was an intervening change in the law that required
the Tax Court to reconsider its decision in Mitchell I,
because the First Circuit had vacated the Tax Court's 2011 decision
in Kaufman v. Commissioner, 134 T.C. 324 (2011), which the
Tax Court had relied on to reach its decision in Mitchell
I.
 The Tax Court disagreed, however, reasoning that
Kaufman addressed different legal issues.  The Tax
Court explained that Kaufman addressed post-extinguishment
proceeds under Regs. §1.170A-14(g); whereas, in Mitchell
I
, the Tax Court never reached the issue of the donee's right
to post-extinguishment proceeds because the Tax Court found that
Taxpayer failed to comply with the subordination requirements of
Regs. §1.170A-14(g)(2).  Accordingly, the Tax Court found that
the First Circuit's decision in Kaufman v.
Commissioner
 was not binding.

The Tax Court in Mitchell II then addressed and
rejected Taxpayer's specific arguments. Firstly, Taxpayer argued
that FLP's financial ability to pay the promissory note in full at
any time prior to the date on which the lender actually agreed to
the subordination "was the functional equivalent of a
subordination." The Tax Court, however, dismissed the argument on
the grounds that Regs. §1.170A-14(g)(2) required strict
compliance.

Secondly, Taxpayer argued that, since the Tax Court held in its
2012 decision in Carpenter v. Commissioner, T.C. Memo
2012-1, that Regs. §1.170A-14(g)(6) merely created "a safe harbor,"
all of the provisions of Regs. §1.170A-14 "should be read as a safe
harbor." The Tax Court rejected this argument, noting that it had
rejected a similar argument in its 2013 decision in Carpenter
v. Commissioner
, T.C. Memo. 2013-172.  The Tax Court also
expressly stated that all specific provisions of Regs. §1.170A-14
are mandatory.

Finally, Taxpayer argued that the Tax Court should reconsider
its decision in Mitchell I because "Colorado law creates
restrictions that protect the conservation easement." Citing
Estate of Quick v. Commissioner, 110 T.C. 440, 441-2
(1999), the Tax Court rejected this argument stating that a motion
for reconsideration was not the appropriate forum for raising new
legal theories.

Taxpayers who elect to establish conservation easements should
consult with appropriate tax advisers to ensure all formalities of
Regs. §1.170A-14 are strictly complied with in implementing the
transaction. Where a property is subject to a mortgage, this will
require that said mortgage be subordinated to the easement at the
time it was created. Because as a practical matter this will be
difficult, thereby making it difficult to ever place a qualified
conservation easement on mortgaged property.

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

Copyright©2013 by The Bureau of
National Affairs, Inc.