Wednesday, June 25, 2014
Chandler v. Commissioner—Façade Easements Had No Value and Strict Liability Penalty Applied for 2006
In Chandler v. Commissioner, 142 T.C. No. 16 (2014), the Tax Court held that façade easements donated to the National Architectural Trust (NAT) with respect to two residences in Boston’s South End Historic District had no value even though they contained some restrictions in addition to those imposed by local historic preservation laws. The court also rejected the taxpayers’ argument that imposition of the new “strict liability” gross valuation misstatement penalty with regard to their 2006 tax return constituted a retroactive application of the new penalty rules enacted as part of the Pension Protection Act of 2006.
The Chandlers claimed charitable contribution deductions with regard to the façade easement donations for taxable years 2004, 2005, and 2006. The IRS disallowed the deductions on the ground that the easements had no value because they did not meaningfully restrict the properties more than local law. The IRS also imposed gross valuation misstatement penalties for each year.
The Tax Court examined the appraisal reports submitted by both parties’ valuation experts and found both wanting.
- The court found the report prepared by the taxpayers’ expert, Mr. Ehrmann, not credible on a number of grounds, including that it contained procedural errors, analyzed properties outside Boston’s unique market, and involved flawed comparable sales analyses. Although not mentioned by the court, Mr. Ehrmann was the subject of a 2013 Department of Justice lawsuit alleging abusive appraisal practices. As part of the agreement settling that suit, he is barred from preparing any kind of appraisal report or otherwise participating in the appraisal process for any property relating to federal taxes.
- The court also found the report prepared by the IRS’s expert to be unpersuasive because it did not isolate the effect of façade easements on the properties examined. The IRS’s expert looked at the sale of nine façade-easement-encumbered properties in Boston and found that the properties had appreciated in value despite of the easements’ restrictions. However, many of the properties had been significantly renovated and the IRS’s expert did not account for the effect of the renovations on value.
Having found both experts’ reports wanting, the Tax Court embarked on its own valuation analysis. It first noted that construction restrictions impair the value of commercial property more tangibly than they impair the value of residential property because commercial property derives its value from its ability to generate cash flows. The court explained that construction restrictions affect residential property values more subtly because personal rather than business reasons usually motivate construction on a home. The court then noted that the difficult task of quantifying the loss of freedom to make changes to the exterior of one’s home becomes even more difficult when local law already imposes restrictions because easements have value only to the extent their unique restrictions diminish the value of the properties they encumber.
The Chandlers identified three differences between local law and the facade easement restrictions.
- The easements restricted construction on the entire exterior of the homes and required the owners to make repairs, while local law restricted construction on only those portions of the properties visible from a public way and did not require repairs.
- NAT inspected each of its properties annually for compliance with applicable standards, while local authorities relied on the public to report violations.
- NAT can enforce easement terms even when doing so would impose substantial economic hardship on the property owner, while, under State law, an owner may obtain an exemption from local restrictions if compliance would cause a substantial economic hardship.
In assessing the impact the additional easement restrictions might have on value, the Tax Court looked to Kaufman v. Commissioner, T.C. Memo. 2014–52, which involved a similar façade easement donated to NAT with respect to a residence in the South End Historic District. The court noted that, in Kaufman, it determined that the easement had no value because buyers do not perceive any difference between the two sets of restrictions. The court saw no reason to break with this result in Chandler and, accordingly, it sustained the IRS’s complete disallowance of the deductions claimed.
Because the Tax Court determined the easements had no value, the Chandlers' misstatements of the value of their easements on their tax returns constituted “gross valuation misstatements,” potentially subjecting them to 40% penalties. The Pension Protection Act of 2006 eliminated the reasonable cause exception for gross valuation misstatements relating to charitable contribution property. This new “strict liability” penalty applies with respect to returns involving façade easement donations filed after July 25, 2006.
Chandler, which involved deductions claimed on the taxpayers’ 2004, 2005, and 2006 returns, raised the novel issue of whether the taxpayers could assert the reasonable cause defense for their valuation misstatement on their 2006 tax return because it was the result of a carryover of deductions from their 2004 return. The taxpayers argued that denying them the right to raise a reasonable cause defense with regard to their 2006 return would amount to retroactive application of the new penalty rules. The Tax Court disagreed, noting that (i) the penalty statute, as revised by the Pension Protection Act, by its plain language applies to all returns filed after a certain date and (ii) when the taxpayers filed their 2006 return they reaffirmed the easement’s grossly misstated value.
The Tax Court did, however, find that the Chandlers were not liable for penalties with regard to the valuation misstatements on their 2004 and 2005 returns because those misstatements were made with reasonable cause and in good faith. The IRS argued that Mr. Chandler should have known the easements were overvalued because he was well educated (he had a JD and an MBA). The Tax Court disagreed, noting that even experienced appraisers find valuing conservation easements difficult and the flaws in the appraisals would not have been evident to the Chandlers. The court also noted that, unlike in Kaufman, where it sustained the imposition of penalties, there was no evidence that the taxpayers in Chandler relied on the appraisals they obtained in bad faith. The court concluded that the Chandlers’ reliance on National Park Service guidance, appraisals obtained from appraisers recommended by NAT, and the advice of an experienced accountant represented a good-faith attempt to determine the easements’ values.
Nancy A. McLaughlin, Robert W. Swenson Professor of Law, University of Utah S.J. Quinney College of Law