Qualified conservation easements provide a deduction under Section 170(h) of the Internal Revenue Code to a taxpayer who permanently encumbers her property in favor of an appropriate organization for conservation purposes. I.R.C. § 170(h). There are some complex rules at work in this area, and it has generated a fair amount of litigation. A key factor in conservation easements is valuation; the amount of the deduction is driven by the impact on market value that a conservation easement has. Consequently, the Code requires an appraisal to support the deduction. I.R.C. § 170(f)(11).
Last week the First Circuit took up the case of a Boston couple who had an appraisal to support the value of their conservation easement deduction but wound up losing not only the deduction but paying a forty percent penalty for a gross valuation misstatement. Kaufman v. Comm’r, 2015 U.S. App. LEXIS 6830 (1st Cir. 2015).
Lorna and Gordon Kaufman owned a home in a historic preservation district that was subject to certain zoning restrictions. Kaufman, 2015 U.S. App. LEXIS 6830, slip op. at *3. In 2003, they entered into a conservation easement with the National Architectural Trust. The easement was supported by an appraisal conducted by an appraiser that the trust suggested. One problem was apparent from the appraisal report: the conservation easement imposed restrictions that overlapped with the existing zoning restrictions, although the appraiser concluded that the easement restrictions were stricter. Id., slip op. at *7. Ultimately, the appraiser determined that the easement restrictions decreased the market value of the property by $220,800. Id., slip op. at *8.
The Kaufman’s easement was challenged by the IRS, which disallowed their deduction and assessed a forty percent penalty under Section 6662(h) of the Code for a gross valuation misstatement. The case then ping-ponged between the Tax Court and the First Circuit. The latest chapter of the story was focused upon the penalty: the taxpayers accepted the Tax Court’s conclusion that the easement had no value, but they contested the penalty, arguing that they had acted in good faith.
Treating the Tax Court’s determination that the Kaufmans did not act in good faith as a fact-finding subject to review for clear error, the First Circuit had little difficulty affirming. The record was not a great one for the taxpayers; after they received the appraisal, Mr. Kaufman emailed a representative of the trust, asking whether the impact of the easement on the market value of the home would “overwhelm the tax savings.” Id., slip op. at *11. The response he received indicated that the Trust’s experience with properties that were already subject to zoning restrictions was that there was no impact on resale from the easement restrictions. Id., slip op. at *11-*12. The First Circuit found that this exchange was a red flag that should have alerted the Kaufmans that the appraisal was suspect. Id., slip op. at *24.
It also didn’t help that the Kaufmans had sent a letter to their mortgage lender requesting it to subordinate its mortgage lien to the easement; that letter had noted that the easement restrictions were “essentially the same” as the zoning requirements that already governed the property. Id., slip op. at *5-*6. While the Kaufmans professed that they didn’t focus on that language, the First Circuit noted that the Tax Court was free to reject that self-serving testimony. Id., slip op. at *25.
While the letter to the lender hurt, it strikes me that Mr. Kaufman’s email exchange with the trust’s representative was fatal: his inquiry went to the heart of the valuation issue, as he sought reassurance that the easement restrictions would not harm resale value. I wonder how the case would have turned out if he hadn’t made that inquiry.
Jim Malone is a tax attorney in Philadelphia; he focuses his practice on federal, state and local tax controversies. This post is intended to provide background on a relevant issue; it is not intended as legal advice. © 2015, Malone LLC.