Cautious Appraisals Required for Donations of Conservation Easements

Rory and Steven Rothman purchased their home in the Brooklyn Heights Historic District of Brooklyn, N.Y., in 1998.[i] The U.S. Department of the Interior National Park Service had certified this home as a historic structure, and in 2004, the Rothmans contributed a historic preservation façade easement on their home to the National Architectural Trust (NAT), an Internal Revenue Code Section 501(c)(3) charitable organization. This easement specifically covered only that portion of the façade visible from the street level opposite the house. The deed of easement that the Rothmans granted to NAT required that before the Rothmans make any alterations to that particular portion of their home’s façade, they must obtain NAT’s consent.

As part of this charitable contribution, the Rothmans retained Mitchell, Maxwell & Jackson, Inc. (MMJ), a New York real estate appraisal services firm, to appraise their home and the easement. To determine the value of the easement, MMJ attempted to use the approved before-and-after approach, which compares the value of the property before the easement to the value of the property after the easement. MMJ examined market data on sales of similar properties to determine that the value of the home before the easement was $2.6 million. However, MMJ had difficulty determining the value of the home after the easement, since sales of comparable eased properties were unavailable or nonexistent. To get around this problem, MMJ examined a few court cases and Internal Revenue Service materials and concluded that this easement would decrease the fair market value (FMV) of the Rothmans’ home by about 11.15 percent, or $290,000.

Based on this appraisal, the Rothmans claimed a noncash charitable contribution deduction of $247,010 on their 2004 federal income tax return and a carryover charitable contribution deduction of $42,990 on their 2005 federal income tax return. The taxpayers attached a copy of MMJ’s appraisal to their tax returns. The IRS denied these deductions, arguing that the taxpayers didn’t comply with the requirements of IRC Section 170 and the corresponding regulations. As a result of this disallowance of the deductions, the IRS assessed tax deficiencies on the Rothmans’ 2004 and 2005 federal income tax returns and imposed accuracy-related penalties.

“Qualified Appraisal” Requirement Under the IRC and Regulations

At trial, the parties both moved for partial summary judgment on the issue of whether MMJ’s appraisal was a “qualified appraisal” as required under IRC Section 170 and the corresponding regulations. IRC Section 170(f)(11) and Treasury Regulations Section 1.170A-13(c)(2) provide that a taxpayer may claim a noncash charitable contribution of property worth more than $5,000 only if he obtains a qualified appraisal of the property, attaches this appraisal to the tax return for the year in which the deduction is claimed and maintains sufficient records. To be a “qualified appraisal,” the appraisal must:

• be completed by a qualified appraiser no earlier than 60 days before the contribution date and no later than the extended due date of the federal income tax return on which the deduction is claimed;[ii]
• sufficiently describe the property, so that a person unfamiliar with the property can determine whether the appraised property and the contributed property are the same;
• describe the physical condition of the property;
• list the date of contribution;
• identify the terms of the agreement, if any, between the donor and donee with respect to the use, sale, or disposition of the property;
• provide information about the appraiser, such as his name and address;
• list the qualifications of the appraiser, including his education;
• include a statement that the appraisal was prepared for income tax purposes;
• note the date of appraisal;
• provide the appraised FMV of the property as of the date of contribution;
• describe the method of valuation used to determine the property’s FMV; and
• provide the basis for the valuation.[iii]

The taxpayers argued that these provisions aren’t mandatory and that all that’s required is substantial compliance. However, the Tax Court disagreed, based on precedent that established that the inclusion in the appraisal of the method of valuation and the basis of valuation are mandatory.[iv] Alternatively, the taxpayers argued that any noncompliance with IRC Section 170 and the regulations thereunder should be excused on the grounds of reasonable cause under IRC Section 170(f)(11)(A)(ii)(II). The Tax Court held that there were genuine issues of material fact as to whether reasonable cause excused the taxpayers’ noncompliance and therefore left this issue for trial.

The Faulty Appraisal

The Tax Court held that MMJ’s appraisal wasn’t a “qualified appraisal” under the IRC and regulations and issued partial summary judgment on this issue in favor of the IRS. After all, MMJ didn’t include its method and basis of valuation in its appraisal, and therefore the appraisal failed to meet the mandatory provisions of the regulations. In addition, the appraisal didn’t substantially comply with the other provisions of Treas. Regs. Section 1.170A-13(c)(3)(ii)(A)-(K), as it omitted most of the information provided in these regulations. Even though this additional information was directory, not mandatory, the court found that the cumulative failure to include this information in the appraisal was a serious problem.

In holding that the appraisal didn’t include MMJ’s method of valuation, the court considered whether MMJ’s methods were approved under Section 170. MMJ properly analyzed the value of the home before the easement by examining sales prices of similar homes in the area. However, the court held that MMJ didn’t use an approved method to determine the value of the home after the easement. First, the appraisal failed to analyze the effect that the restrictions contained in the easement had on the value of the property. In addition, the regulations and prior Tax Court decisions[v] didn’t recognize as an approved method of valuation the application of a fixed percentage to the before-value of the property.

The court also held that the appraisal didn’t include MMJ’s basis of valuation. The appraisal didn’t analyze the impact of the terms and conditions in the easement or the impact of any zoning regulations or other preservation laws. In addition, the appraisal noted various elements, such as maintenance and insurance costs, that might lead to a reduction in the value of a piece of property after an easement is placed on such property; however, the appraisal didn’t analyze the impact, if any, that these elements had on the value of Rothmans’ home after the easement. Therefore, the court held that the appraisal couldn’t be considered a “qualified appraisal” under Section 170 since it failed to include both MMJ’s method and basis of valuation.

In addition, the court held that the appraisal didn’t substantially comply with the other requirements of the regulations, as only a few of them were satisfied. While these requirements aren’t mandatory, the court was troubled by the taxpayers’ continued failure to comply. For instance, the appraisal was made earlier than 60 days before the contribution date, which in New York is the date the deed of easement is recorded. In addition, the appraisal provided a confused description of the easement, stating that the easement covered the “entire exterior of the subject property” rather than only that part of the façade that was visible from the street level opposite the home. The appraisal also didn’t include the contribution date, the terms of any finalized agreement among the taxpayers and NAT with respect to the disposition of the easement or the background information of the appraisers. Finally, the appraisal didn’t include a statement specifically saying that “the appraisal was made for federal income tax purposes.” Therefore, based on all these cumulative failures, the court granted partial summary judgment in favor of the commissioner, holding that the taxpayers didn’t obtain a qualified appraisal in connection with their charitable contribution of the easement.

Due Diligence Necessary

This case demonstrates that, with respect to a client’s planned charitable donation, wealth planners should exercise due diligence over the required property appraisals. The requirements set forth in the IRC and Treasury regulations aren’t unduly burdensome to follow, so take a look at them if your client is considering making a noncash charitable donation of more than $5,000. In addition, take charge of the appraisal and ensure that the expert appraisers have included all the necessary information. Otherwise, the IRS and the courts may disallow your client’s charitable deduction, which may lead to substantial tax deficiency assessments and perhaps also the imposition of penalties.

For more information on conservation easements, take a look at Conrad Teitell’s article, “Conservation Easements, General Patton and the IRS,” available at http://wealthmanagement.com/blog/conservation-easements-general-patton-and-irs.

End Notes