Wednesday, August 13, 2014
In Schmidt v. Commissioner, T.C. Memo. 2014-159, the Tax Court determined that the value of a conservation easement for purposes of a federal charitable income tax deduction under IRC § 170(h) was $1,152,445, as opposed to the $1.6 million value claimed by the taxpayer. The court also found that the taxpayers were not liable for penalties.
Schmidt involved the donation of a conservation easement on a 40-acre parcel located in El Paso County, Colorado, to the county. Mr. Schmidt purchased the subject property in 2000 and, with the help of a consultant, prepared preliminary zoning change and plan applications for the development of the subject property and an adjacent property. In the summer of 2003, however, Mr. Schmidt began constructing a personal residence on the subject property, donated the easement to the county, and terminated an agreement he had to purchase the adjacent property. Before the donation of the easement, the subject property could have been developed as a 13-lot subdivision either separately or in conjunction with the development of the adjacent property. After the donation of the easement, only one homesite was permitted on the subject property.
The Schmidts valued the conservation easement at $1.6 million and claimed portions of the deduction on their 2003, 04, 05, and 06 returns. The IRS challenged the deductions and the Tax Court considered both the value of the easement and the impostion of penalties.
Valuation of Easement
The parties agreed that both the subdivision development method and the comparable sales (or “market”) method were appropriate methods by which to value a property before the donation of an easement. However, the parties disagreed as to which of those methods was more appropriate in this case. The Schmidts’ valuation expert contended that the market method was inappropriate because there were insufficient comparables and the comparables used by the IRS’s valuation expert were inappropriate because they lacked the development entitlements that Mr. Schmidt had secured for the subject property. The IRS countered that comparables used by its expert were appropriate because Mr. Schmidt had not actually obtained any development entitlements when he granted the conservation easement. The Tax Court sided with the Schmidts, noting, in part, that
“[e]ven though the pending applications were nontransferable, the record establishes that the applicants had been able to address all relevant issues that could have prevented or delayed the granting of development entitlements for the subject property and that the proposed development of the subject property was consistent with the … Comprehensive Plan. Moreover, … much of the work [the development consultant] had done was transferable even if the applications themselves were not.”
Once it determined that the subdivision development method was the appropriate method by which to value the subject property before the conveyance of the easement, the Tax Court conducted a detailed review of each expert’s application of that method to the property. Because the court did not find either expert’s report to be complete and convincing, however, it drew its own conclusions based on its examination of the evidence. The court ultimately determined that the easement had a value of $1,152,445, or 72% of the $1.6 million value that had been claimed by the Schmidts.
As part of its valuation analysis, the Tax Court confusingly noted that “what the before and after method is trying to measure is the price that a hypothetical purchaser of a conservation easement would have to pay a hypothetical seller for the easement” (emphasis in original). This statement is odd given the description of the before and after method in Treasury Regulation § 1.170A-14(h)(3)(i). The regulations explain that, if there is no substantial record of market-place sales of comparable easements to use as a meaningful or valid comparison (which generally will be the case because easements are not bought and sold in the open market), then the fair market value of a conservation easement is equal to the difference between the fair market value of the subject property before the grant of the easement and the fair market value of the subject property after the grant of the easement, with fair market value defined as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.” In other words, the before and after method is not trying to measure what a hypothetical purchaser would pay a hypothetical seller for the easement. Rather, it measures what a hypothetical purchaser would pay a hypothetical seller for the subject property immediately before and immediately after the donation of the easement, with the difference between those two amounts being the value of the easement.
In determining that the Schmidts were not liable for penalties, the Tax Court first explained that the amount the Schmidts had claimed on their 2003 return for the easement was less than 200% (and less than 150%) of the amount the court determined to be the correct amount. Accordingly, the Schmidts were not liable for a substantial valuation misstatement penalty for any of the years at issue.
The Schmidts also were not liable for a substantial understatement penalty because they had reasonable cause and acted in good faith with regard to any understatement. The court found that the Schmidts reasonably relied in good faith on the appraisal they obtained and the problems the court found with that appraisal did not call into question the reasonableness of their reliance. The IRS attempted to show unreasonableness and bad faith by, for example, pointing to the appraiser's handwritten notes, which contained estimates of value that were different than those found in his report. The court dismissed this, noting that such notes might have been a "preliminary, uninformed guess."
Nancy A. McLaughlin, Robert W. Swenson Professor of Law, University of Utah S.J. Quinney College of Law