By David I. Kempler, Esq., and Elizabeth Carrott Minnigh, Esq.
Buchanan Ingersoll & Rooney PC, Washington, DC
In Scheidelman v. Comr. , the Second Circuit overturned a Tax Court ruling that the appraisal a taxpayer obtained insufficiently explained the method and basis of valuation, and thereby failed to comply with the qualified appraisal rules under Regs. §1.170A-13(c)(3). The Second Circuit also overturned a Tax Court ruling that a mandatory cash payment by taxpayers to a facade easement grantee was not a "contribution or gift" under §170 because taxpayers did not sustain their burden of proving either that the payment was not made as a quid pro or, if they did receive something of substantial value, that the payment exceeded the value of the benefits received. Accordingly, the Second Circuit vacated the decision of the Tax Court and remanded the case for further consideration of the value consistent with its opinion. This case is a significant setback for the IRS, which has been successful in several courts in disallowing a deduction for facade easements on the basis of faulty appraisals.
Under §170(f)(3)(A), a taxpayer may not take a deduction for the contribution of a partial interest in property. However, there is an exception under §170(h)(1) for "a qualified conservation contribution," which is defined by Regs. §1.170A-14(a) as a contribution of a "qualified real property interest" to a "qualified organization" that is made "exclusively for conservation purposes." Under §170(h)(4)(A)(iv), one permissible conservation purpose is "the preservation of a historically important land area or a certified historic structure," which encompasses facade conservation easements. In order to deduct the value of a donated facade conservation easement, §170(f)(11)(C) and Regs. §1.170A-13(c)(2)(i)(A) require that a taxpayer must obtain a "qualified appraisal" of the partial interest donated. As part of the qualified appraisal, Regs. §1.170A-13(c)(3)(ii)(J) and (K) require that the appraiser must disclose the method of valuation used to determine the fair market value, such as the income approach, the market-data approach, and the replacement-cost-less-depreciation approach, and the specific basis for the valuation, such as specific comparable sales or statistical sampling.
In 2003, the National Architectural Trust (NTA), an exempt organization under §501(c)(3), accepted Taxpayer's application to donate a facade conservation easement on the row house. NTA also required a cash donation of 10% of the easement's value. The two banks that held mortgages on the row house executed lender agreements for the donation. The National Park Service determined that the row house contributed to the significance of the historic district and was a "certified historic structure."
In 2004, Taxpayer hired Michael Drazner, a qualified real estate appraiser recommended by NTA to value the easement. Drazner estimated the unencumbered value of Taxpayer's property at $1,015,000. The report valued the facade easement at $115,000, approximately 11.33% of the total value, based in part on the range of easement values the IRS had found acceptable in the past. Taxpayer sent NTA a check for the required cash payment of $9,275, which was 10% of the value of the easement less certain adjustments. NTA confirmed receipt in a letter stating that Taxpayer had received no goods or services in return for her gifts, and a Form 8283, Noncash Charitable Contributions, signed by Drazner and NTA, reflecting a fair market value for the easement of $115,000.
Taxpayer claimed a $115,000 deduction on her federal tax return for the 2004 tax year, and carried over $63,083 to future years ($59,959 in 2005 and $3,124 in 2006). On audit, the IRS determined that she failed to establish a fair market value for the easement. Accordingly, the IRS notified her of resulting deficiencies in her taxes of $16,873, $17,537, and $1,015 for the years 2004 through 2006, respectively, and imposed a statutory penalty of $3,374.60, $3,507.40, and $203.00 for each year, respectively.
Taxpayer sought a redetermination of her tax liability from the Tax Court. In Scheidelman v. Comr., T.C. Memo 2010-151, the Tax Court found that Taxpayer was ineligible for the deduction because the Drazner appraisal was not a "qualified appraisal" because it failed to state the method of valuation and the basis of valuation, as required by Regs. §1.170A-13(c)(3)(ii)(J) and (K). The Tax Court also rejected Taxpayer's deduction of her cash contribution to the NTA. Noting that "a charitable gift or contribution must be a payment made for detached and disinterested motives," the Tax Court reasoned that Taxpayer had made the donation for the purpose of inducing NTA to accept her easement so that she could enjoy a tax benefit.
The Second Circuit, however, held that the Drazner appraisal was a qualified appraisal. The Second Circuit noted that the before-and-after method used by Drazner authorized by Regs. §1.170A-14(h)(3)(i) where no substantial record of market-place data is available. The Second Circuit concluded that Drazner explained at some length how he arrived at his numbers. The Second Circuit stated that, for the purpose of gauging compliance with the reporting requirement, it was irrelevant that the IRS believed the method employed was inaccurate or haphazardly applied as long as a method was described. The Second Circuit also stated that the regulation required only that the appraiser identify the valuation method "used" to enable the IRS to evaluate it, not that the method adopted be reliable.
Moreover, the Second Circuit concluded that Drazner sufficiently supplied the bases for the valuation, namely "IRS publications (since removed from circulation), tax court decisions, Drazner's past valuation experience, and the location of the house in the regulatory environment of New York City." The Second Circuit noted that this approach was nearly identical to that approved by the Tax Court in Simmons v. Comr., 98 T.C.M. 211 (2009), aff'd, 646 F.3d 6 (D.C. Cir. 2011). However, the Second Circuit noted that the existence of a qualified appraisal did not itself entitle Taxpayer to a deduction and, therefore, remanded the case for a determination of whether Taxpayer complied with other statutory and regulatory requirements, including that the contribution be exclusively for conservation purposes, as required by §170(h)(1)(C), and that it be protected into perpetuity as required by Regs. §1.170A-14(g)(6).
The Second Circuit then turned to whether the $9,275 contribution to the Trust was "charitable," and, therefore, deductible under §170. The Second Circuit noted that, while the donation might be described as a prerequisite of the Trust's acceptance of the easement donation, the Trust gave the taxpayer no "goods or services," or "benefit," or anything of value in return for her making the money gift. The Second Circuit further explained that a donee's agreement to accept a gift does not transfer anything of value to the donor, even though the donor may desire to have the gift accepted and may expect to derive benefit from the deductibility of the gift on her income taxes. Moreover, the Second Circuit noted that if the motivation to receive a tax benefit deprived a gift of its charitable nature under §170, virtually no charitable gifts would be deductible. Accordingly, citing Kaufman v. Comr., 136 T.C. 294 (2011), the Second Circuit held that a mandatory cash contribution was deductible.
This case is a significant setback for the IRS, which has been successful in several courts in disallowing a deduction for facade easements on the basis of technical issues regulating the appraisals, rather than the valuations themselves. By finding that the regulation only required that the appraiser identify the valuation method "used" to enable the IRS to evaluate it, the Second Circuit has forced the IRS to challenge the value itself. Litigation over valuation, rather than technical violations of the regulations, is generally more costly because it generally requires the IRS to hire outside appraisers.
For more information, in the Tax Management Portfolios, see Kirschten & Freitag, 863 T.M., Charitable Contributions: Income Tax Aspects, and in Tax Practice Series, see ¶2390, Charitable Contributions: Requirements for Deduction, and ¶2395, Charitable Contributions: Substantiation Requirements.
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