Hughes v. CommissionerHughes v. Commissioner
The Tax Court holds an individual taxpayer liable for a deficiency resulting from overstating the value of a conservation easement
May 27, 2009
David A. Handler, partner, and Patricia H. Ring, associate, Kirkland & Ellis, LLP, Chicago
Two valuations experts did battle before the Tax Court in Hughes v. Commissioner. The court criticized both experts’ assessments of real estate. But in the end, the taxpayer lost.
In Hughes, T.C. Memo 2009-94 (May 6, 2009), Nick Hughes bought one parcel of land on Oct. 6, 1999, for $1.535 million (Parcel 1) and a second parcel of land on Sept. 18, 2000, for $671,350 (Parcel 2). On Dec. 28, 2000, Hughes granted a qualified conservation easement over both parcels of land to a qualified conservation organization and claimed a $3.1 million charitable contribution deduction as a result.
The Internal Revenue Service disallowed $1,107,625 of the charitable contribution deduction and Hughes filed a petition with the Tax Court.
At trial, each party offered an appraisal report and testimony of an expert witness to establish the fair market value (FMV) of the conservation easements and accordingly, the value of Hughes’ charitable contribution. Both experts employed the “before-and-after” approach that values a conservation easement as equal to the difference between the FMV of the property, taking into account its highest and best use, before it’s encumbered by the easement, and the FMV of the property after it is encumbered.
The Tax Court agreed with the IRS’ expert that the value of Parcel 1 before the grant of the easement was $1.710 million.
Both experts had used the sales comparison approach to value Parcel 1, relying heavily on the purchase price of $1.535 million paid by Hughes for the property 15 months before the easement was granted.
Both experts also had reflected a positive adjustment to the value of the property over the price paid by Hughes as a result of generally increasing property values in the area between the time Hughes purchased the property and the time he granted the easement.
But the Tax Court did not agree with the additional positive adjustments made by Hughes’ expert, who concluded that the value of Parcel 1 before the grant of the easement was $3,509,650.
Notably, the Tax Court disagreed with Hughes’s expert that the highest and best use of the property was residential development, as opposed to agricultural and recreational use.
Because Hughes held Parcel 2 for less than one year before the easement was granted, Parcel 2 did not qualify as long-term capital gain property. Accordingly, Internal Revenue Code Section 170(e)(1)(A) applies to limit Hughes’ charitable contribution deduction for the contribution of the Parcel 2 easement to Hughes’ cost basis in Parcel 2, which was $671,350.
Thus, the court pointed out that the amount of Hughes’ charitable deduction with respect to Parcel 2 is the same regardless of whether Parcel 2 appreciated between the date Hughes purchased it and the date on which he granted the easement.
Finally, the Tax Court disagreed with both experts regarding the value of the parcels after Hughes granted the easement.
Hughes’ expert concluded that the value of both parcels diminished by 70 percent after the easement was granted because the highest and best use of the parcels before the easement was residential development but the parcels were limited to agricultural and recreational use after the easement.
Because the Tax Court found that the highest and best uses of the parcels both before and after the easement were agricultural and recreational, the Tax Court concluded that the development restrictions imposed by the easement had much less effect on the parcels’ use and did not warrant the 70 percent diminution in value.
But the Tax Court also criticized the IRS’ expert (who found a 0- to 10 percent diminution in value) for disregarding the value of the state income tax credits for conservation easements in his valuation. By granting the easements, Hughes had precluded any subsequent purchaser from granting an easement and receiving the benefit of such tax credits.
Moreover, the IRS expert neglected the possibility that future circumstances would make residential development on the parcels feasible and the easement would prevent Hughes from taking advantage of potentially lucrative development opportunities. Thus, the Tax Court concluded that Hughes’ 70 percent diminution was too high and the IRS’ 0- to 10 percent diminution was too low.
But because of its holding on the FMV of the parcels before the easement was granted, the Tax Court concluded that no diminution in that range would result in a greater charitable contribution deduction than the deduction the IRS already allowed.
Accordingly, the Tax Court sustained the deficiency determined by the IRS.
