Table of Contents
Easy Reading on Easements Pg.1
|Overview of Tax Rules Pg.1|
|Tax Court Case — Valuation of Conservation Easement Gift: Donor Wins Pg.2|
|Tax Court Case — Valuation of Conservation Gift: The IRS Wins Pg.7|
|ACGA’s Recommended Gift Annuity Rates Pg.8|
|Charitable Gifts Encouraged — Nonbinding Sense-of-the Senate Resolution Pg.9|
|Insurance Policy Exchange — Charitable Giving|
Partial Interest Rule Pg.10
|Answers to Puzzlers — Taxwise Giving, June ‘09, |
|Reprobate Judge Pg.12|
|Charitable Mid-Term Federal Rates Pg. 12|
|Editor: Conrad Teitell, LL.B., LL.M. |
Sydney Prerau, Editor 1962-1967
EASY* READING ON EASEMENTS
What’s it all about, Alfie? First a quick overview of the tax rules on charitable gifts of conservation easements, followed by two Tax Court cases on the valuation of those gifts — one won by the donor** and the other by the IRS.
OVERVIEW OF TAX RULES
A qualified conservation contribution is a gift of a qualified real property interest to a qualified organization to be used only for conservation purposes. Let’s run down all these qualifieds.
Qualified organizations: governmental units; publicly supported charitable, religious, scientific, literary, educational, etc., organizations; and organizations that are controlled by, and operated for the exclusive benefit of, a governmental unit or a publicly supported charity. Key requirement: The organization also must have a commitment to protect the conservation purposes of the donation and must have the resources to enforce the restrictions.
Qualified real property interests — any of the following: Donor’s entire interest in real estate other than a mineral interest (subsurface oil, gas, or other minerals, and the right of access to these minerals); a remainder interest; or a restriction granted in perpetuity on the use that may be made of the real property.
Conservation purposes: preserving land areas for outdoor recreation by, or for the education of, the general public; protecting a relatively natural habitat of fish, wildlife, or plants, or a similar ecosystem; preserving open space, including farmland and forest land, if it yields a significant public benefit and must be either for the scenic enjoyment of the general public or under a clearly defined federal, state, or local governmental conservation policy; or preserving a historically important land area or a certified historic structure.
Building in a registered historic district. If a building in a registered historic district is a certified historic structure, a contribution of a qualified real property interest that is an easement or other restriction on the exterior of the building is deductible only if it meets all of the following three conditions:
1. The restriction must preserve the entire exterior of the building (including its front, sides, rear, and height) and must prohibit any change to the exterior of the building that is inconsistent with its historical character.
2. The donor and the organization receiving the contribution must enter into a written agreement certifying, under penalty of perjury, that the organization is a qualified organization with a purpose of environmental protection, land conservation, open space preservation, or historic preservation, and has the resources to manage and enforce the restriction and a commitment to do so.
3. The donor must include with his or her return: a qualified appraisal, photographs of the building’s entire exterior, and a description of all restrictions on development of the building, such as zoning laws and restrictive covenants.
Rehabilitation credit wrinkle. If the donor claimed the rehabilitation credit on Form 3468 for the building for any of the 5 years before the year of the contribution, his or her deduction is reduced. See IRC §170(f)(14).
Filing fee. If the donor claims a deduction of more than $10,000, the deduction will not be allowed unless he or she pays a $500 filing fee. See Form 8283-V, Payment Voucher for Filing Fee Under Section 170(f)(13), and its instructions.
TAX COURT CASE — VALUATION OF CONSERVATION EASEMENT GIFT: DONOR WINS
This conservation easement case is an excellent primer on valuation and appraisals. Kiva Dunes Conservation LLC (sometimes called “Kiva Dunes,” sometimes “Donor”) granted to the North American Land Trust a perpetual conservation easement covering a golf course that it owned. The IRS disallowed the $30,588,235 charitable deduction in its entirety; it also imposed an IRC §6662 accuracy-related penalty. Kiva Dunes appealed to the Tax Court.
After the trial (but before the court’s decision), the IRS conceded that Kiva Dunes was, after all, entitled to a charitable deduction — so the amount had to be determined by the court and whether an IRC §6662 accuracy-related penalty applied.
We’re not talking chopped liver. Kiva Dunes claimed a $30,588,235 charitable deduction for the easement based on an appraisal pre-pared by its expert, Claud Clark (more about him soon). Donor also claimed a $35,000 cash contribution. The IRS also disallowed that deduction, but we are not told why.
The Tax Court sets the stage for its decision by reciting some long-established rules for deductibility and valuation (case citations omitted):
• Deductions are a matter of legislative grace and a taxpayer bears the burden of proving entitlement to any claimed deductions.
• The IRS’s determination of value is normally presumed correct and the taxpayer bears the burden of proving that the determination is incorrect.
• Generally, the amount of a charitable contribution is the fair market value of the contributed property at the time it is contributed.
• Fair market value is the price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having a reasonable knowledge of relevant facts. Reg. §1.170A-1(c)(2). [That’s easy to recite, but not so easy to apply.]
• In determining the fair market value of property, not only the current use of the property must be taken into account, but also its highest and best use.
• A property's highest and best use is the highest and most profitable use for which it is adaptable and needed or likely to be needed in the reasonably near future.
• The highest and best use can be any realistic, objective potential use of the property.
• If there is a substantial record of sales of easements comparable to a donated easement, the fair market value of the donated easement is based on the sale prices of those comparable easements. Reg. §1.170A-14(h)(3)(i).
Where, as in this case, there was no established market for similar conservation easements and no record existed of sales of those easements, the regulations give a method for deter-mining fair market value:
If no substantial record of marketplace sales is available to use as a meaningful or valid comparison, as a general rule (but not necessarily in all cases) the fair market value of a perpetual conservation restriction is equal to the difference between the fair market value of the property it encumbers before the granting of the restriction and the fair market value of the encumbered property after the granting of the restriction. * * * Reg. §1.170A-14(h)(3)(i).
The IRS and Donor agreed that the before-and-after methodology was in this case the appropriate valuation method for determining fair market value.
Adjustment to before-and-after valuation (or any other valuation method). Any enhancement in the value of a donor's other property resulting from an easement contribution, or of property owned by certain related persons, reduces the value of the charitable deduction. Reg. §1.170A-14(h)(3)(i).
Enter the valuation gladiators — the appraisers. The court noted that valuation is not a precise science, and the fair market value of property on a given date is a question of fact to be resolved on the basis of the entire record. In this case, each party offered the report and testimony of an expert witness to establish the value of the easement.
What do courts look for in evaluating an expert’s opinion? For openers, an opinion is admissible if it assists the trier of fact to understand the evidence or to determine a fact at issue. An expert’s opinion is evaluated in the light of the expert's demonstrated qualifications. Where experts offer competing estimates of fair market value (this case), courts decide how to weigh those estimates by, among other things, examining the factors the experts considered in reaching their conclusions. Courts aren’t bound by the opinion of any expert witness, and may accept or reject expert testimony. A court may also reach a decision on the value of property that is based on its own examination of the evidence.
This conservation-easement case demonstrates the importance of selecting an expert who not only has excellent general qualifications, but also knows, as we shall see, the facts on the ground (pun intended?).
Donor’s expert. He is a professional real estate appraiser and has decades of experience in Baldwin County, Alabama, the location of the contributed easement. He has lived and worked in the immediate vicinity of the subject property for 22 years and owns and has owned property in the area. He performs more appraisals in Baldwin County than any other appraiser, and has a great depth of knowledge of the comparable properties used in valuing the easement and of the surrounding local real estate market.
The IRS’s expert. He is a member of the Appraisal Institute. He was in no way whatsoever a yokel, but he wasn’t a local. He had spent a substantial portion of his appraisal career in Atlanta. Although he recently moved to Alabama, his office is in Birmingham, 250 miles from Kiva Dunes Golf Course. In the Court’s words, he “has no particular expertise in Baldwin County, and he has been to the Baldwin County, Alabama, area only twice in connection with his appraisal of the easement.”
Valuation of the easement. Each expert determined before and after values of Kiva Dunes Golf Course and considered the issue of enhancement of other property owned by Kiva Dunes or related parties. Each expert's conclusions as to the fair market value of the easement were computed by subtracting his estimate of the after value and of any enhancement from his estimate of the before value.
Fair market value of Kiva Dunes Golf Course before the conservation easement. To reach their respective before value estimates, both experts used a discounted cash flow analysis of estimated revenues and costs associated with the development and sale of lots in a hypothetical subdivision. However, some of their assumptions differed in important ways — e.g., the number of lots available for sale, the average sale price of the lots, and the rate at which the lots would sell. The differences in their assumptions led to a dramatic difference in their respective before value estimates: The Kiva Dunes expert’s value was $31,938,985, and the IRS’s expert value was $10,018,000.
Tax Court’s determination of the before value. The IRS had conceded that Kiva Dunes expert’s testimony was credible and his assumptions were reasonable and amply supported by the evidence in his report. Thus, the court assigned a before value of $31,938,985.
Fair market value of Kiva Dunes Golf Course after the conservation easement. The experts agreed that immediately after the charitable contribution, the highest and best use of Kiva Dunes Golf Course was its continued operation as a golf course. However, in determining the after value of Kiva Dunes Golf Course, the experts used different methodologies. The IRS’s expert used an income approach. He divided a capitalization rate into a number that he represented was the 2002 net income of Kiva Dunes Golf Course. He determined the after value to be $8,808,000. In contrast, the Kiva Dunes expert concluded that the economic health of Kiva Dunes Golf Course during 2002 was too poor to support an income capitalization approach. Instead, he found sales of comparable properties that he analyzed and reached an after value of $1,050,750.
The court put the kibosh on the after value of the IRS’s expert. At trial, he admitted that the IRS provided him with Kiva Dune’s tax return before he submitted his appraisal. Therefore the court placed no reliance on his after value determination.
Donor’s expert, as noted, used the comparable sales method to reach his after value. That method, said the court, "is based upon the commonsense approach of taking the actual sales prices of properties similar to the subject property and then relating these prices to the subject property."
Under ideal circumstances, said the court, there is an abundance of sales of truly comparable properties made under similar conditions. Then only minor adjustments are required, and the value is easily derived. However, in this case, when such conditions do not exist, many factors come into play and more adjustments are required. As might be expected, the lack of sales of comparable properties results in a more subjective value, highly dependent on the independent judgment of the individual appraiser.
In reaching his after value, Donor’s expert identified five sales of properties he considered comparable. On the basis of the average price of his five comparables, adjusted for differences, Donor’s expert determined an after value of $1,050,750.
The Court said that it was “mindful of the fact that in reaching his after value, [Donor’s expert] did not take into consideration the highest and best use of his comparables in the traditional sense. He instead selected properties that were purchased for recreational uses that would be permitted on Kiva Dunes Golf Course. In other words, [he] considered the market forces in Baldwin County an accurate barometer of the highest and best use of a comparable property. We do not find [Donor’s expert’s] analysis in that regard to be ‘fatal,’ as [the IRS] contends.”
More adjustments. After adjusting Donor’s appraiser’s after value to account for improvements, the court determined that the after value for Kiva Dunes Golf Course was $2,982,981 ($1,070,980 comparable value + $1,912,001 depreciation adjustment).
Donor’s appraiser determined that the conservation easement enhanced other property owned by Donor by $300,000. And the IRS agreed. So the court adjusted the final value to reflect that enhancement.
Getting close to the end. “On the basis of our review of all the valuation evidence, giving due consideration to our observation at trial of the witnesses for both parties and to the testimony of the experts and their reports, we conclude that the fair market value of the easement is $28,656,004.” That reduced Donor’s claimed deduction by $1,932,231 ($30,588,235 minus $28,656,004). Remember that the IRS disallowed Donor’s entire deduction. So the Court allowed Donor to deduct $28,656,004 more than IRS’s initial zero, zip, nada valuation.
Penalty issue. The IRS had maintained that the Donor was liable for either a substantial or a gross valuation penalty pursuant to IRC §6662(b)(3) and (e) or (h). IRC §6662(a) and (b)(3) imposes a 20-percent penalty on that portion of an underpayment which results from a substantial valuation misstatement. There is a substantial valuation misstatement if the value of any property claimed on the return is 200 percent or more of the amount determined to be the correct amount. IRC §6662(e)(1)(A). IRC §6662(h) increases the penalty to 40 percent in the case of a gross valuation misstatement. There is a gross valuation misstatement if the value is 400 percent or more of the value determined to be the correct amount. IRC §6662(h)(2)(A)(i).
No penalties. “We corrected Kiva Dunes's reported value approximately 10 percent. Accordingly, Kiva Dunes is not subject to a valuation penalty.”
Kiva Dunes Conservation, LLC; T.C. Memo. 2009-145
Comment. In a fair tax world shouldn’t the IRS have to pay a penalty to Donor for putting it through the wringer (disallowing the deduction in its entirety and the court then allowing a $28,656,004 deduction)?
Sometimes (not often) a taxpayer who wins a lawsuit against the IRS can recover his, her or its reasonable litigation costs (e.g., expert witness expenses and legal fees). To qualify, the taxpayer’s income must be below specified ceilings and deadlines must be met. For the numerous requirements — plus the ifs, ands, and buts — see IRC §7430 and Reg. §301.7430-1 through 301.7430-6. And, of course, review the cases on the topic.
TAX COURT CASE — VALUATION OF CONSERVATION GIFT:
THE IRS WINS
What happened. Donor gave conservation easements to a qualified Colorado conservation organization and claimed a $3,100,000 charitable deduction. The IRS determined a deficiency on the basis that he overstated the value of his gift by $1,107,625. Donor appealed to the Tax Court.
The conservation easements. The “Deed of Conservation Easement In Gross” granted to the Valley Land Conservancy the development rights over two parcels. As a result, Donor and “his successors and assigns forever” were prohibited from, among other things, subdividing the parcels, constructing buildings or other structures except for a single-family residential dwelling on each parcel, and using the parcels for any commercial, residential, or industrial uses not specifically permitted.
In upholding the IRS’s valuation, the court first recited the applicable law:
Deductions are a matter of legislative grace, and a taxpayer bears the burden, etc.
Generally, a charitable contribution is the fair market value of the contributed property at the time it is contributed.
In determining the fair market value of property, not only the current use of the property is taken into account but also its highest and best use.
The amount of a charitable contribution of a conservation easement is generally the fair market value of the easement at the time it is contributed.
Enter the expert witnesses. The Donor and the IRS each had reports and testimony of an expert witness to establish the amount of Donor’s charitable contribution.
Donor’s expert. Using the before-and-after approach, he valued the conservation easements to total $2,926,700.
IRS’s expert also used the before-and-after approach and valued the conservation easements to total between $0 and $238,135.
Expert witness issues. Donor asserted that the IRS’s expert was biased, lacked appropriate qualifications, made numerous mistakes, and did not prepare his report in accordance with the Uniform Standards of Professional Appraisal Practice. The IRS countered that Donor’s expert is biased and made numerous mistakes.
The Tax Court holds for the IRS. After some criticisms of both experts, the court determined that the total fair market values of both parcels before Donor granted the conservation easements was $2,381,350. When Donor granted the conservation easements, the fair market values of the parcels diminished, entitling him to a deduction. They did not diminish so much, however, that the Donor is entitled to a deduction larger than that which the IRS had already allowed. Accordingly, the court sustained the deficiency determined by the IRS.
Hughes, T.C. Memo. 2009-94
*That’ll be the day.
**The court, in effect, said: Let’s win this one for the giver. And as you shall see, for good reason.
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