Saturday, April 5, 2014
In the fourth in a line of cases, Kaufman v. Commissioner, T.C. Memo. 2014-52 (Kaufman IV), the Tax Court sustained the IRS’s complete disallowance of charitable deductions claimed under IRC § 170(h) for a façade easement donation. The court also sustained the imposition of penalties on the basis of gross valuation misstatement, negligence, or substantial understatement of income tax. The property involved is a residential rowhouse in the South End historic district of Boston, Massachusetts.
In the first two Kaufman cases (Kaufman v. Commissioner, 134 T.C. No. 9 (2010) and Kaufman v. Commissioner, 136 T.C. No. 13 (2011)), the Tax Court held that the mortgage subordination agreement obtained in connection with the façade easement donation, which granted the Kaufman’s lender priority rights to insurance or condemnation proceeds in the event of the easement’s extinguishment, caused the donation to fail as a matter of law to comply with the “enforceable-in-perpetuity” requirements of the Treasury Regulations interpreting § 170(h).
In the third Kaufman case (Kaufman v. Shulman, 687 F.3d 21 (2012)), the First Circuit vacated the Tax Court’s holdings in part, but remanded on the issue of valuation. The First Circuit noted that the IRS had pointed to evidence that the value of the easement was close to zero, and “170(h) does not allow taxpayers to obtain six-figure deductions for gifts of lesser or no value.” The First Circuit also explained that the Kaufmans had expressed concern to the donee—the National Architectural Trust (NAT)—about the high appraised value of the façade easement because it implied a substantial reduction in the resale value of their home. “In an effort to reassure them, a [NAT] representative told the Kaufmans that experience showed that such easements did not reduce resale value.” “This,” said the First Circuit, “could easily be the IRS's opening argument in a valuation trial.”
And so it apparently was. In Kaufman IV, in sustaining the complete disallowance of the deductions claimed with regard to the easement donation as well as the imposition of penalties, the Tax Court placed particular emphasis on the fact that a NAT representative had sent an email to Mr. Kaufman explaining that façade easements do not reduce the value of the properties they encumber, and the Kaufmans nonetheless claimed charitable deductions based on an appraisal, obtained from an appraiser NAT had recommended, indicating that their easement reduced the value of the rowhouse by 12% (or by $220,800). In its opinion, the Tax Court reproduced portions of this “smoking gun” email, which explained, in part:
One of our directors, Steve McClain, owns fifteen or so historic properties and has taken advantage of this tax deduction himself. He would have never granted any easement if he thought there would be a risk or loss of value in his properties.
The Tax Court also noted an article written by a former President of NAT that stated, among other things:
By preserving a piece of historic architecture for future generations, the property owner can get a big tax deduction with little cost or risk.
The Tax Court further noted that, in requesting that the bank holding a mortgage on the rowhouse subordinate its interest to the easement, the Kaufmans’ represented to the bank that:
The easement restrictions are essentially the same restrictions as those imposed by current local ordinances that govern this property.
While assuming the appraisal the Kaufmans obtained was a “qualified appraisal,” the Tax Court gave no weight to its estimate of value because the court found the appraiser’s method (application of a standard diminution percentage to the value of the property before the easement's donation) to be unreliable and his analysis unpersuasive.
On the other hand, the Tax Court found the IRS’s valuation expert, who determined that the value of the easement was zero, to be more persuasive. The IRS’s expert opined, among other things, that the typical buyer would find the restrictions in the façade easement no more burdensome than local historic preservation restrictions and, even if the façade easement were more restrictive, it would not necessarily reduce the value of the property because homeowners in historic districts place premium value on the assurance that the neighborhood surrounding their homes will remain unchanged over time.
The Kaufmans were also unable to persuade the Tax Court that they made a good-faith investigation of the value of the easement, or acted with reasonable cause and in good faith, or had a reasonable basis for claiming the deductions, and should therefore be able to avoid penalties. This was in large part due to the fact that NAT had represented to Mr. Kaufman, a sophisticated MIT Emeritus Professor of Statistics, that the easement would not reduce the value of the rowhouse, and the Kaufmans nonetheless proceeded, without further investigation, to claim charitable deductions based on the appraiser’s estimated $220,800 reduction in the value of the property.
Nancy A. McLaughlin, Robert W. Swenson Professor of Law, University of Utah S.J. Quinney College of Law