The donation of conservation easements remains a highly litigated area between the IRS and donors. Done correctly, these easements further important charitable goals, including slowing the impact of development on fragile ecosystems, preserving important scenery and protecting endangered wildlife. alliantgroup is assisting donors in correctly planning and implementing these gifts. Unfortunately, we have also been called in later in the process when the IRS has raised varied issues relating to the creation and documentation of the easement. Most often, we are asked to help in controversies over how the easement was valued.
Valuation was the key aspect in the Whitehouse Hotel case. On June 11, the Fifth Circuit Court of Appeals entered a decision affirming the Tax Court’s revised valuation of a partnership’s conservation easement but reversing the court’s imposition of a gross valuation misstatement penalty. Whitehouse Hotel v. Commissioner of Internal Revenue, No. 13-60131.
By way of background, the Internal Revenue Code allows taxpayers to claim a deduction for the contribution of a qualified real property interest to a qualified organization to be used strictly for conservation purposes. I.R.C. § 170(h). A conservation easement includes the donation in perpetuity of an interest in real property that, among other possible charitable purposes, ensures that the taxpayer will maintain the historic appearance of the property. The regulations state that absent a substantial record of sales of comparable easements, the taxpayer must value the conservation easement by taking the difference between the fair market value of the property, according to its highest and best use, before and after the easement contribution. 26 C.F.R. § 1.170A-14. The Conservation Easement Audit Techniques Guide outlines three valuation approaches that should be considered in every conservation easement appraisal: the comparable sales approach, the reproduction cost approach and the income approach. Properly valuing the easement is important because a taxpayer who grossly overstates (by 400% or more) the value of a conservation easement may be subject to a 40% gross valuation misstatement penalty. I.R.C. § 6662(h). A taxpayer may rebut the penalty by showing the easement was valued based on a qualified appraisal made by a qualified appraiser and the taxpayer made a good faith investigation of the value of the property. I.R.C. § 6664(c)(3).
The Whitehouse Hotel Ltd. Partnership (“Whitehouse”) was formed in 1995 to purchase the Maison Blanche building in New Orleans, redevelop it and open it as a Ritz Carlton hotel. In developing the hotel, Whitehouse had intended to combine the Maison Blanche and the adjoining Kress building. In December 1997, Whitehouse transferred a conservation easement to the Preservation Alliance of New Orleans, a Louisiana nonprofit focused on historic preservation. The easement required Whitehouse to maintain the appearance of the Maison Blanche’s terracotta façade in perpetuity. Whitehouse claimed a $7.445 million charitable contribution deduction on its 1997 tax return based on the easement. In 2003, the IRS reduced the deduction to $1.15 million and assessed a gross valuation misstatement penalty for 40% of the underpayment of tax for that year. Whitehouse contested in Tax Court both the IRS revaluation of the easement and its imposition of the gross valuation misstatement penalty. Whitehouse Hotel Ltd. P’ship v. Comm’r, 131 T.C. 112 (2008).
The Tax Court, after hearing extensive and widely differing testimony from two appraisers, ultimately concluded that the easement value was $1,792,301, resulting in a $5,652,699 overstatement, which meant that Whitehouse had overstated the deduction by 415%. The Court imposed a gross valuation misstatement penalty, finding that Whitehouse did not qualify for the reasonable cause defense.
Whitehouse appealed to the Fifth Circuit Court of Appeals. The Appellate Court remanded the case back to the Tax Court to reconsider the easement’s valuation under specific guidelines as well as the reasonable cause defense to the gross valuation misstatement penalty. On remand, the Tax Court valued the easement at $1,857,716, resulting in a 401% overstatement. The Tax Court again concluded that the reasonable cause defense did not apply to the overstatement penalty because Whitehouse did not investigate the valuation of the easement in good faith. Whitehouse again appealed the Tax Court decision to the Fifth Circuit, which resulted in this decision.
The Fifth Circuit upheld the Tax Court’s valuation of the easement. In particular, the Fifth Circuit held that the Tax Court properly valued the easement according to the encumbered property’s highest and best use. The Tax Court specifically held that the property’s valuation remained the same regardless of whether the Maison Blanche was to be used as a luxury or non-luxury hotel. Additionally, the Appellate Circuit held that the Tax Court appropriately considered the effect of the easement on the fair market value of the Maison Blanche and Kress buildings under the assumption that the easement prevented building an additional 60 rooms atop the Kress building. Finally, the Fifth Circuit held that the Tax Court did not err in only considering local comparable sales in determining the easement’s value because the income and cost of reproduction approaches were not relevant.
However, the Fifth Circuit reversed the Tax Court’s imposition of the gross valuation misstatement penalty. The Tax Court had concluded that although Whitehouse relied on the advice of attorneys and accountants in valuing the easement, it failed to make a good faith investigation of the value of the easement. The Fifth Circuit disagreed with the Tax Court and stated that reasonable reliance on the appraisal of qualified tax professionals sufficed for the reasonable cause exception in this circumstance. The Fifth Circuit noted the difficulty of valuing a gratuitous transfer of property as opposed to property involved in a negotiated transaction, where market forces shed light on a reasonable valuation. The difficulty of valuing the transfer was evidenced by the different easement valuations made by the IRS, the IRS’ expert, and the Tax Court. In addition to considering the difficulty of valuing the easement, the Fifth Circuit looked to Whitehouse’s obtaining not one but two qualified appraisals in finding that Whitehouse met the reasonable cause defense.
This case indicates the standards necessary in valuing an easement. While the 40-percent penalty did not apply here, donors and their advisors are on notice to take care in applying the section 170(h) rules and in the selection of an appraiser. While the donation of easements will remain an important part of charity, there is little doubt that the IRS will continue to closely review the area.
Steven Miller is National Director of Tax at alliantgroup.
Dean Zerbe is National Managing Director at alliantgroup.