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Tax Court Rejects Charitable Deduction for Easement That Didn't Sufficiently Restrict Use. (Parker Tax Publishing June 5, 2014)

Because the taxpayers failed to prove their donated easements had any value, they were not entitled to charitable contribution deductions for the donations and were liable for a 40 percent gross valuation misstatement penalty for one of the three years at issue because the rules in effect when they filed their 2006 return did not provide a reasonable cause exception. Chandler v. Comm'r, 142 T.C. No. 16 (5/14/14).

Congress created the Federal Historic Preservation Tax Incentives Program to encourage the preservation of historic structures. The National Park Service (NPS) publicizes the program and assists the IRS in administering it. Logan Chandler learned of the program, and he and his wife decided to grant faeasements to the National Architectural Trust (NAT) on two Boston homes they owned. Under the terms of each easement, the property owner must obtain NAT's approval before beginning any construction that will alter the exterior of the buildings. NAT periodically sends representatives to inspect easement properties for unauthorized changes, for which NAT can order remediation.

The South End Landmark District Commission (SELDC), one of nine Boston municipal government historic district commissions, has jurisdiction over the Chandler's properties to regulate construction. The SELDC's powers closely approximate NAT's powers under the easement agreements, with some exceptions. First, the easement agreements grant NAT authority to regulate construction and order repairs on any exterior surface of the home, but SELDC has no power to regulate construction that is not visible from a public way and may not require property owners to make repairs. Second, NAT has staff members who perform annual site visits, while the SELDC relies on the public to alert it to potential violations. Finally, NAT has absolute authority to enforce the terms of its easements, even when doing so would produce substantial economic hardship for the property owner. Under Massachusetts law, a property owner who faces significant financial hardship may receive an exemption from the SELDC's enforcement.

The Chandlers followed guidance from the NPS and consulted their easement holding organization to find an appraiser to value their easements. The valuations came in at $191,400 and $371,250. The Chandlers consulted with their accountant concerning the appraisals before claiming deductions on their returns. Because of relevant limitations, the Chandlers claimed charitable deduction in 2004, 2005, and 2006. A portion of each of the 2005 and 2006 deductions resulted from a carryforward of the 2004 deduction.

The IRS disallowed the deductions because it determined the easements were valueless since they did not meaningfully restrict the Chandlers' properties more than local law. The IRS also imposed gross valuation misstatement penalties of 40 percent on the underpayments resulting from the alleged easement overvaluations.

At trial, both the Chandlers and the IRS submitted expert reports concerning the values of the Chandlers' easements. The Chandler's expert was Michael Ehrmann and the IRS's expert was John Bowman.

The Tax Court held that the Chandlers failed to prove their easements had any value and consequently were not entitled to the related charitable contribution deductions. The Tax Court found Ehrmann's appraisal report unpersuasive. The court noted that he analyzed sales of seven properties encumbered with easements similar to the Chandler's and compared those sales with sales of comparable unencumbered properties to determine whether the easements diminished property values. Of the seven encumbered properties he chose, four were in Boston and three were in New York City. The court rejected the analyses of the values of easements in other markets, saying it told them little about the easement values in Boston's unique market. With respect to comparable Boston properties, the court concluded that only one analysis was not flawed. The two others were flawed because the "comparable" properties were not really comparable, specifically because one of the "unencumbered" properties was not actually unencumbered by an easement. According to the court, the errors in Ehrmann's appraisal report undermined his credibility, and the court rejected his conclusion that the Chandler's easements diminished their property values by 16 percent.

The court went on to state that Ehrmann's failure to persuasively value the easements did not necessarily mean they had no value. The court looked at several cases cited by the Chandlers in which it had upheld valuations similar to theirs. However, the court noted, each of those cases involved commercial property, and restrictions on construction impair the value of commercial property more tangibly than they impair the value of residential property.

Additionally, the court said that even if the Chandlers had not granted the easements, local law would have prevented them from freely altering their homes. Thus, the court said, the easements had value only to the extent their unique restrictions diminished the Chandlers' property values. In determining whether the value of the Chandler's properties were diminished because of the additional restrictions imposed by NAT, the court noted that it had recently performed this analysis under identical circumstances in Kaufman v. Comm'r, T.C. Memo. 2014-52. In that case, the court determined that the differences in restrictions did not affect property values because buyers do not perceive any difference between the competing sets of restrictions. Thus, the court concluded that the donated easements had no value and no charitable deduction was allowed.

With respect to the 40 percent gross valuation misstatement penalty assessed by the IRS, the court noted that the Pension Protection Act (PPA) of 2006 amended the rules to eliminate the reasonable cause exception for gross valuation misstatements of charitable contribution property. The change applies to returns filed after July 25, 2006. The court concluded that the Chandlers had reasonable cause to avoid the penalty for their 2004 and 2005 tax returns. However, the facts raised a novel issue for the court concerning the Chandlers' right to raise a reasonable cause defense for their 2006 underpayment. The Chandlers noted that a portion of the underpayment resulted from the carryover of charitable contribution deductions they first claimed on their 2004 return, which they filed before the effective date of the change in rules. Accordingly, they argued, denying their right to raise a reasonable cause defense would amount to retroactively applying the PPA. The court disagreed and upheld the 40 percent penalty with respect to the Chandlers' 2006 tax return.

For a discussion of the rules for deducting easement contributions, see Parker Tax ¶84,155. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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