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By David I. Kempler, Esq., and Elizabeth Carrott Minnigh, Esq.
Buchanan Ingersoll & Rooney PC, Washington, DC
In Rolfs v. Comr. , No. 11-2078 (7th Cir. 2/1/12), the Seventh Circuit affirmed a Tax Court decision holding that taxpayers who donated their home to the fire department in exchange for the demolition of their house by the fire department received value in exchange for the property that exceeded the value of the gift and, therefore, could not take a charitable deduction for the donation. The valuation method for donations of property for demolition as a training exercise set forth by the Seventh Circuit make it virtually impossible for a charitable deduction to ever be taken with respect to that type of donation.
Under §170(a)(1), taxpayers may take as a deduction on their federal income tax returns the verifiable amount of charitable contributions made to qualified organizations. The Supreme Court stated in Hernandez v. Comr., 490 U.S. 680, 690 (1989), that to qualify for this deduction, contributions must be made with "no expectation of a financial return commensurate with the amount of the gift." To determine whether a gift was intended or whether a commensurate return could be expected as part of a quid pro quo exchange, the IRS and the courts look to the objective features of the transaction, not the subjective motives of the donor. Regs. §1.170A-1(c) provides that the value of any charitable gift is equal to the fair market value as of the time of the contribution as determined under the hypothetical willing buyer/willing seller rule, wherein both parties to the imagined transaction are assumed to be aware of relevant facts and free from external compulsion to buy or sell. The Supreme Court further stated in U.S. v. Am. Bar Endowment, 477 U.S. 105, 116-8 (1986), that if some consideration or other tangible benefit is received, the charitable deduction is limited to the excess of the fair market value of the donation over the fair market value of the benefit received.
Taxpayers purchased a three-acre lakefront property in Wisconsin. Taxpayers decided to demolish the home located on the property and construct a new home on the property. To accomplish the demolition, Taxpayers donated the house to the local fire department to be burned down in a firefighter training exercise. Taxpayers claimed a $76,000 charitable deduction on their 1998 federal income tax return for the value of their donated and destroyed house. The IRS disallowed the deduction, and that decision was upheld by the Tax Court in Rolfs v. Comr., 135 T.C. 471 (2010).
To support their claimed deduction, Taxpayers needed to show a value for their donation that exceeded the substantial benefit they received in return. In support thereof, Taxpayers relied primarily on an appraiser's before-and-after approach, valuing their entire property both before and after destruction of the house. The Tax Court, however, found that Taxpayers' before-and-after valuation method failed to account for the condition placed on the gift requiring that the house be destroyed. Moreover, the Tax Court found that Taxpayers received a substantial benefit from their donation because the cost of demolishing the house would have been approximately $10,000. The Tax Court then concluded that any valuation that did account for the destruction requirement would certainly be less than the value of the returned benefit.
In its review, the Seventh Circuit noted that, while it was common-sense for the fair market valuation of donated property to take into account conditions on the donation that affect the market value of the donated property, it was not clear what effect those conditions would have on value. The Seventh Circuit rejected Taxpayers' before-and-after approach on the grounds that while it was clear that a $76,000 home had been destroyed, it was not clear that any of this value had been transferred to the fire department, stating that "[b]y deciding to destroy the house and then making that demolition a condition of their gift, the taxpayers themselves became responsible for that decrease in value, even if the fire department provided the mechanism to accomplish it. None of the value of the house, as a house, was actually given away."
The Seventh Circuit determined that there was no actual market for, and thus no real or hypothetical willing buyers of, houses to be used as firefighter training sites. As there were no market comparables, the Seventh Circuit determined that the house should be valued at the higher of two alternatives: (i) the value of the house if it were immediately burned down and sold for scrap, or (ii) the amount someone would pay for the house if they were required to uproot it and move it elsewhere. The IRS presented two experts. Both experts determined that the salvage value of the component materials of the house was minimal and would be offset by the labor cost of hauling them away and, if moved in intact, the cost of moving the house would exceed the value of the house itself. Based on this testimony, the Seventh Circuit concluded that the Tax Court had correctly concluded that a house severed from the land had no substantial value, either for moving off-site or for salvage.
The Seventh Circuit then turned to the fair market value of the benefit received by Taxpayers. The Seventh Circuit noted that Taxpayers and the expert witnesses for the IRS all agreed that the costs of demolishing the house would be upwards of $10,000. The Seventh Circuit rejected Taxpayers' claim that they actually received no real value because, even after the house was burned, they had to pay $10,000 to $15,000 for debris clearing and foundation removal, noting that "[c]ommon sense tells us that whatever destruction was caused by the fire would have cost money if performed by workers with sledgehammers or a wrecking ball, even if additional clean-up was required." Accordingly, the Seventh Circuit found no error in the Tax Court's factual determination, based on the available evidence and testimony, that Taxpayers received a benefit worth at least $10,000.
The Seventh Circuit held that when property is donated to a charity on the condition that it be destroyed, that condition must be taken into account when valuing the gift. In light of that condition, the Seventh Circuit determined that the value of the gift did not exceed the fair market value of the benefit that Taxpayers received in return.
In reaching its determination, the Seventh Circuit expressly approved the Tax Court's ruling that the holding in the case of Scharf v. Comr., T.C. Memo 1973-265, that allowed a charitable deduction for property donated to a fire department to be burned, "has no vitality" after the decision of the Supreme Court in U.S. v. Am. Bar Endowment. Accordingly, this decision effectively settles the uncertainty in the circuits regarding whether this type of donation that has existed since the 1973 ruling in Scharf. Moreover, the valuation approach set forth by the Seventh Circuit make it virtually impossible for a charitable deduction to ever be taken with respect to a donation of this type.
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.
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