Wednesday, August 13, 2014
Zarlengo v. Commissioner—Conservation Easement Overvalued and Not Protected In Perpetuity Until Recorded
Zarlengo v. Commissioner, T.C. Memo. 2014-161, involved a façade easement that Dr. Zarlengo and his ex-wife donated to the National Architectural Trust (NAT) effective in 2005. The Zarlengos had purchased the subject property—a four-story townhouse built in 1890 located on the Upper West Side of Manhattan—in 1975 and completely renovated the property using materials designed to preserve its historic character. The Zarlengos’ neighbors followed suit, and the New York City Landmarks Preservation Commission “took notice” and designated the neighborhood an historic district in 1985.
In the early 2000’s, the Zarlengos learned about the possibility of donating a façade easement to NAT from neighbors. Before meeting with NAT representatives, however, Dr. Zarlengo contacted his CPA to see if such a deduction would be legitimate. It was only after hearing back from the CPA that the deduction was, indeed, legitimate that Dr. Zarlengo and his ex-wife pursued the donation.
In 2004, the Zarlengos submitted an application to NAT regarding a proposed easement donation, NAT obtained the necessary approvals for the donation, the Zarengos obtained an appraisal from an appraiser recommended by NAT estimating that the easement had a value of $660,000 (11% of the townhouse’s estimated $6 million value before the donation), the Zarlengos and a NAT representative signed the easement deed, and NAT mailed the Zarlengos a letter thanking them for their donation. For reasons not explained in the Tax Court’s opinion, however, the easement deed was not recorded until January 26, 2005.
Meanwhile, the Zarlengos had listed the townhouse for sale through Mr. Pretsfelder, a real estate broker, at an asking price of $5.5 million. Mr. Pretsfelder believed that the asking price was too high and the townhouse eventually sold in 2007 for $4,650,500.
Dr. Zarlengo and his new wife filed a joint return for 2004 reporting a deduction of $330,000 for half the estimated value of the easement. Due to gross income limitations they claimed only a portion of the deduction on their 2004 return and carried the excess forward to subsequent returns. The only year at issue for Dr. Zarlengo and his new wife in Zarlengo was 2004, however, because the IRS apparently did not challenge the carryover deductions they claimed on later returns.
Dr. Zarlengo’s ex-wife also reported a deduction of $330,000 on her 2004 return, and she too was able to use only a part of that deduction in 2004 and carried the excess forward to subsequent returns. The only years at issue for her in Zarlengo were 2005-07 because the IRS apparently did not challenge the deduction she claimed on her 2004 return.
The Tax Court addressed numerous issues in assessing whether and the extent to which Dr. Zarlengo and his ex-wife were eligible for deductions with regard to the facade easement donation.
The IRS argued that the taxpayers were not entitled to deductions because the façade easement was neither (i) a “qualified real property interest” as defined in IRC § 170(h)(2)(C) (i.e., “a restriction (granted in perpetuity) on the use which may be made of the real property”) nor (ii) donated exclusively for conservation purposes as required under IRC § 170(h)(5) (i.e., the conservation purpose of the easement was not “protected in perpetuity”).
In analyzing these issues, the Tax Court first reiterated the well settled rule that, “[i]n a Federal tax controversy, State law controls the determination of a taxpayer’s interest in property while the tax consequences are determined under Federal law.” Accordingly, New York law governed when the taxpayers’ donation of the façade easement was regarded as complete, but Federal tax law determined the tax consequences. Because New York law provides that conservation easements in the state are not effective unless they are recorded, the façade easement was not effective until January 26, 2005—the date on which it was recorded.
The Tax Court then explained that, even assuming the easement had been legally enforceable by NAT against the taxpayers in 2004 because both parties signed the deed that year, the easement still would not have satisfied the perpetuity requirements in 2004 “because neither the use restriction nor the conservation purpose of the conservation easement was protected in perpetuity until January 26, 2005.” The court explained that, if a buyer had purchased the townhouse and recorded the purchase deed before January 26, 2005, the buyer would have taken the townhouse free and clear of the conservation easement. Moreover, the possibility that this could have occurred was not so remote as to be negligible.
Accordingly, the Tax Court determined that Dr. Zarlengo and his new wife were not entitled to a deduction for the donation of the facade easement on their 2004 return, which was the only year at issue for them in Zarlengo.
The result with regard to Dr. Zarlengo’s ex-wife was a bit different. The years at issue for her in Zarlengo were 2005-07 and those returns involved carryovers of the deduction she originally reported on her 2004 return. The Tax Court first held that, because the ex-wife would not have been entitled to the 2004 deduction for failure to satisfy the perpetuity requirements, it followed that she was not entitled to the carryover deductions for 2005-07. However, the IRS had acknowledged that the easement could be considered “made in perpetuity” in 2005 under IRC §§ 170(h)(2)(C) and (5)(A) because the easement was recorded in that year, and the Tax Court determined that “both the use restriction and the conservation purpose of the conservation easement were protected in perpetuity as of January 26, 2005.” The court also found that the ex-wife had satisfied the other requirements of § 170(h) (including the conservation purposes test) and the substantiation requirements. Accordingly, her tax liability for 2005, 06, and 07 could be redetermined assuming the donation had been made in 2005.
Conservation Purposes Test
The IRS argued the façade easement did not have a “conservation purpose” within the meaning of IRC § 170(h) because it did not preserve the townhouse in any way that local law did not. The Tax Court disagreed, noting that NAT, unlike New York City’s Landmarks Preservation Commission (LPC), actively monitors the properties encumbered by the easements it holds and NAT’s historic preservation standards were similar, but not identical to those applied by the LPC. The court determined that the facade easement provides the townhouse with an additional layer of protection over and above that provided by the LPC and, thus, the easement satisfied the historic preservation conservation purposes test.
The IRS argued that the taxpayers failed to satisfy a number of the qualified appraisal requirements in Treasury Regulation § 1.170A-13(c)(3). The Tax Court first explained that such requirements are directory rather than mandatory and, thus, require only substantial compliance. Quoting Bond v. Commissioner, 100 T.C. 32 (1993), the court explained that “the reporting requirements do not relate to the substance or essence of whether or not a charitable contribution was actually made.” Accordingly, rather than requiring strict compliance with the reporting requirements, the court said it considers whether the taxpayers “provided sufficient information to permit [the IRS] to evaluate their reported contributions, as intended by Congress.”
The Tax Court then proceeded to march through the various qualified appraisal requirements that the IRS argued the taxpayers failed to satisfy, finding that the taxpayers complied or substantially complied with all of the disputed requirements (e.g., the description of the appraised property requirement, the date of contribution requirement, and the requirement that each appraiser contributing to the appraisal satisfy all requirements, including signing the appraisal and appraisal summary).
Of particular note (and some confusion) is the Tax Court’s holding with regard to the timing of the appraisal report. Treasury Regulation § 1.170A-13(c)(3)(i) provides that a qualified appraisal is one prepared by a qualified appraiser “not earlier than 60 days prior to the date of the contribution.” In Zarlengo, the appraisal was dated August 24, 2004, and had an “effective date” of July 26, 2004 (i.e., the date on which the conservation easement was valued). However, the date of the contribution was January 26, 2005—the date on which the easement deed was recorded. Accordingly, the appraisal was prepared more than 60 days before the contribution date and, thus, was untimely. The court first explained that the timeliness requirement “does not relate to the essence of section 170,” and a taxpayer may substantially comply with the substantiation requirements notwithstanding a “premature appraisal.” Later in the opinion, though, the court confusingly stated that the ex-wife did not comply or substantially comply with the timeliness requirement in that the appraisal report was premature but, “as previously discussed, this requirement does not relate to the essence of section 170." Although its reasoning is unclear, the court ultimately concluded that the ex-wife satisfied the requirements to substantiate the conservation easement.
Valuation of Façade Easement
Each parties’ valuation expert employed the sales comparison approach to determine the value of the townhouse before the easement’s donation. The court criticized their analyses, noting that each expert “made adjustments designed to support his side’s litigating positions. Experts lose their usefulness and credibility when they merely become advocates for the position argued by a party.” The court found that the taxpayers’ expert computed unreasonably high “before” values, while the IRS’s expert computed an unreasonably low “before” value, and the true value of the townhouse lay somewhere in between. Based on the testimony of Mr. Pretsfelder, which the court found to be credible, the court determined that the “before value” of the townhouse was $4.5 million.
With regard to the value of the townhouse after the donation of the easement, the Tax Court found the taxpayers’ expert’s “paired sales analysis” to be conceptually sound but marred by flaws in its execution. The court also rejected the IRS’s expert’s summary conclusion that the easement had no value because it did not place any additional burdens on the property owner. The court noted, in part, that Mr. Pretsfelder had credibly testified that if two properties are identical in all respects, except for the fact that one of the properties is burdened by a conservation easement, the property without the easement will have a greater value. The court also noted that it did not find it particularly significant that the purchasers of the townhouse had not reduced their offer after they became aware of the facade easement. The court explained that returning to the negotiating table could very well have jeopardized the parties’ carefully negotiated agreement, and it was “certainly plausible that the buyers did not want to risk the prospects of striking a new agreement.”
Based on its own analysis of the evidence, the Tax Court concluded that the easement reduced the $4.5 million value of the townhouse by 3.5%, or by $157,500. Accordingly, the ex-wife was entitled to a deduction in 2005 of $78,750 for her contribution of a half interest in the easement.
Before the enactment of the Pension Protection Act of 2006 (PPA), a substantial valuation misstatement (subject to a 20% penalty) existed if the value of property reported on a tax return was 200% or more of the amount determined to be the correct value. A gross valuation misstatement (subject to a 40% penalty) existed if the value reported was 400% or more of the amount determined to be the correct value. Taxpayers could avoid these penalties if they made a valuation misstatement in good faith and with reasonable cause.
The PPA lowered the threshold from 200% to 150% for a substantial valuation misstatement and from 400% to 200% for a gross valuation misstatement. The PPA also eliminated the reasonable cause exception for gross valuation misstatements of charitable deduction property, making that penalty a strict liability penalty. The PPA changes apply to returns involving façade easement donations filed after July 25, 2006.
The Tax Court found that Dr. Zarlengo was not liable for penalties for 2004, and his ex-wife was not liable for penalties for 2005 because they relied on the advice of a tax professional, which can establish reasonable cause and good faith. The court explained that the taxpayers were not financially sophisticated and neither had a background in tax, finance, or accounting. Moreover, when the ex-wife brought the idea of donating the facade easement to Dr. Zarlengo’s attention, he consulted with his CPA and the CPA, who had approximately 20 years of experience, concluded that the deduction was legitimate. The court found that the CPA was a competent accountant with sufficient expertise to justify the taxpayer’s reliance. The court also found that the taxpayers honestly believed that the easement was a completed gift in 2004 and, thus, they acted in good faith.
The result was different with regard to the ex-wife’s 2006 and 2007 returns because they were filed after July 25, 2006, when the reasonable cause and good faith exception was no longer available with respect to gross valuation misstatements. The Tax Court first noted that, in Chandler v. Commissioner, 142 T.C. No. 16 (2014), it held that the “plain language” of the PPA made the strict liability penalty applicable to all returns filed after July 25, 2006, regardless of whether they involve deductions carried over from donations made in earlier years. The court also noted that it did not consider whether the pre- or post-PPA percentage thresholds applied to the Chandlers' 2006 return because the Chandlers failed to prove the conservation easement they donated had any value and, thus, they made a gross valuation misstatement on their 2006 return regardless of which threshold applied. In Zarlengo, the Tax Court similarly did not need to decide whether the pre- or post PPA percentage thresholds applied to the ex-wife’s 2006 and 2007 returns because she also made a gross valuation misstatement regardless. The value she claimed on her 2004 return for her half interest in the easement and then "reaffirmed" in filing her 2006 and 2007 returns (i.e., $330,000) was greater than either 200% or 400% of the court’s determination of the correct value of her half interest in the easement (i.e., $78,750). Accordingly, the ex-wife was subject to the gross valuation misstatement strict liability penalty for 2006 and 2007 assuming the applicable dollar limitations for impostion of the penalty were satisfied.
Nancy A. McLaughlin, Robert W. Swenson Professor of Law, University of Utah S.J. Quinney College of Law