Sunday, May 11, 2014

Palmer Ranch v. Commissioner—$19.9 million Conservation Easement Deduction Allowed Based on “Reasonably Probable” Rezoning

Palmer Ranch eagle nest copyIn Palmer Ranch Holdings, Ltd. v. Commissioner, T.C. Memo 2014-79, the Tax Court allowed a $19.9 million deduction for a partnership’s donation of a conservation easement, which represented a 95% diminution in the value of the property. The court found the partnership’s appraisal, which assumed the subject property could have been rezoned before the easement donation to allow higher density development, to be more persuasive.

The subject property is an 82.19-acre parcel located in Sarasota County, Florida, that includes upland developable acreage as well as wetlands, a wildlife corridor, and a bald eagle nest. The partnership donated the easement to the county in December of 2006 for the purpose of preserving the property for public use, conservation, and open space.

The IRS conceded that the easement constituted a qualified conservation contribution for purposes of IRC § 170(h), so the only issue before the Tax Court was the fair market value of the easement. The court explained that the fair market value of a conservation easement is generally equal to the difference between the fair market value of the subject property before the granting of the easement (the “before-value”) and the fair market value of the subject property after the granting of the easement (the “after-value”) and, in determining the property’s before-value, there must be taken into account not only the property's then-current use, but also its highest and best use. Quoting Olson v. United States, 292 U.S. 246, 255 (1934), the court noted that a property's highest and best use is “the highest and most profitable use for which it is adaptable and needed or likely to be needed in the reasonably near future.” The court explained that “[i]f different from the current use, a proposed highest and best use requires ‘closeness in time’ and ‘reasonable probability.’”


The IRS’s appraiser estimated the before-value of the Palmer Ranch property to be $7.7 million. This estimate was based on the property’s actual zoning classification on the date of the donation.

The partnership’s appraiser, on the other hand, estimated the property’s before-value to be $25.2 million. This estimate was based, in part, on the assumption that the property could be successfully rezoned. Although the property’s zoning classification in 2006 was for “residential estates,” which limited current development to 41 units (1 unit per 2 acres), a land planning and engineering firm hired by the partnership concluded that the property could have been rezoned to permit a 360-unit multifamily development, provided the denser development was concentrated (or clustered) on the developable portions of property and left the environmentally sensitive areas largely as open space.

At trial, the IRS argued that successful rezoning of the property at the time of the donation was not reasonably probable given four factors: (i) a failed rezoning history with respect to the property, (ii) environmental concerns, (iii) limited access to outside roads, and (iv) neighborhood opposition. The court examined each of those factors in turn and found for the partnership. The court determined that (i) nothing in the rezoning history foreclosed the possibility of a successful rezoning, (ii) the proposed rezoning would have protected the eagle nest and wetland areas, and given due consideration to the wildlife corridor, within which there were significant developable areas, and (iii) required road access for development on the subject property could have been provided through adjacent land owned by the partnership and through extension of a "stubbed out" residential street in an adjacent development. The court noted that the stubbed out road demonstrated a general expectation that future residents of the subject parcel would use the road to access their homes. The court also gave little credence to the IRS’s arguments that neighborhood opposition would have precluded the hypothetical development, despite the IRS’s pointing to the neighbors’ “fervor and organization” against proposed development of the subject property in 2004. The court refused to assume that neighbors would object to the rezoning or that the board of county commissioners would find merit to their objections.

The court ultimately determined that the before-value of the property was $21,005,278—it adjusted the partnership’s appraised value downward slightly to account for the softening of the real estate market in the area 2006.

The Olson Formula

It is not clear from the Tax Court’s opinion whether the partnership’s appraiser or the court took into account the costs, time, and risks associated with obtaining the rezoning approval in estimating the property’s before-value. Consideration of those factors would appear to be required under the Olson formula, which, stated in full, provides: “The highest and most profitable use for which the property is adaptable and needed or likely to be needed in the reasonably near future is to be considered, not necessarily as the measure of value, but to the full extent that the prospect of demand for such use affects the market value while the property is privately held” (emphasis added).

The court noted that the process to rezone and develop land would have involved the following steps:

  • a preapplication meeting with County staff,
  • a neighborhood workshop with adjacent property owners, 
  • submitting of applications to the County, which would be subject to staff review,
  • public hearings by a lay body (the planning commission), and
  • a public hearing by the board of county commissioners, wherein the commissioners would take final action.

In addition, even if the commissioners issued a final determination, the determination would still be subject to the circuit court's review. And for the subject property to receive rezoning approval, the applications would have to be consistent with the region’s master development order, the comprehensive plan, zoning regulations, and land development regulations.

Although obtaining approval of the rezoning may have been reasonably probable, a hypothetical willing buyer would have factored into the price he or she would be willing to pay the costs, time, and risks associated with the process outlined above. Whether this was taken into account in estimating the before-value of the hypothetically rezoned property is not clear.


The conservation easement limits use of the subject property to a nature park; recreational improvements, such as campgrounds, swimming pools, and athletic fields; and agricultural uses. The property is now used as a public park, a community garden, a conservation area, and preserved open space.

Given the use restrictions in the easement, the court determined that potential purchasers of the property would be limited to either a nonprofit organization or the State of Florida. The court also noted that this already shallow pool of purchasers is further reduced because any purchaser would also have to be willing to carry out any of the permitted uses subject to the easement's restrictions.

While both parties’ appraisers agreed that the conservation easement severely limits the marketability of the subject property and, thus, significantly reduced the property’s value, the IRS’s appraiser estimated a 90% diminution in value, while the partnership’s appraiser estimated a 95% diminution in value. After explaining that “reasonable minds may disagree when it comes to providing estimates such as these” and valuation is necessarily an approximation, the court ultimately adopted the partnership’s estimate. Accordingly, the court determined that the conservation easement had a value of $19,955,014 (i.e., a $21,005,278 before-value less a $1,050,264 after-value).

No Penalty

The Tax Court held that the partnership was not liable for an accuracy-related penalty because it acted with reasonable cause and in good faith (i.e., it relied in good faith on the advice of a qualified tax adviser) with regard to its claimed deduction for the easement donation.

Nancy A. McLaughlin, Robert W. Swenson Professor of Law, University of Utah S.J. Quinney College of Law

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Typically if in performing the highest and best use analysis, it can be documented that there is a high probability of the zoning being changed, and that the zoning recognizes the highest and best use for the property, then the cost of obtaining the zoning AND a risk factor would be an adjustment to the opinion of of market value since the zoning has not been changed yet. It is not just a matter of the costs but also including a deduction for the risk. There is always some amount of risk. Or alternatively what happens many times is that a purchaser has an option contract on the property contingent to obtaining the new zoning. The buyer usually pays the owner a forfeitable amount of money to obtain the option period.

The point of the H&BU analysis is to recognize the market—how does the market perceived the situation. Does the market think there is a high probability of obtaining the new zoning district?

For many properties (at least in the Dallas, TX area), cities have a “holding zoning district which is usually “agriculture”. The city keep it in ag until a party is ready to initiate a development. At which time a zoning change is initiated. In such a situation buyers do NOT pay ag prices for the land because they are purchasing the land for development purposes and realize that the highest and best use is something else. Owners are not so naive as to think their property is worth only ag value.

Buyers also find out what zoning might be approved by the city (depending on the land plan for the city and staff recommendations). Of course a major protest by people in the community can force the city council to vote down approval even in the face of P&Z staff and zoning board approval. This is not unusual. Therefore, it sounds like the court took a balanced view of the situation and apparently perceived that the odds of the zoning change were much higher than not. Nevertheless, these types of situations are not black/white.

Posted by: Joe Milkes, MBA MAI CCIM, Milkes Realty Valuation | May 12, 2014 6:27:32 PM

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