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Wednesday, July 16, 2014
Facade Easement Deduction Allowed
Originally Published on forbes.com on July 5th,2011
In a recent case Dorothy Simmons was allowed deductions for contributions of facade easements.
I once asked one of my clients what it really meant to own real estate. He told me it was a “bundle of rights”. Among those rights is the the right to develop the property. When an appraiser determines what the fair market value of a property is, she first looks for properties that are just like it that have sold recently. Real estate is one of the least fungible assets in existence, though. Every piece is unique. It can also be illiquid and subject to price volatility. So sometimes there aren’t any comparable sales or at least not enough of them, which is why we have the “income approach”. The first step in the income approach is to determine the property’s “highest and best use”. If you love the earth, you might be distressed to learn that the “highest and best use” is the use that garners the most money for the owner of the property. Much as I appreciate those long stretches of road where there is aCVS ever quarter of a mile or so since I never know when I might have to quickly fill a prescription or desperately need a bottle of Mountain Dew, I also appreciate scenic vistas and quaint historic structures, with footprints ill suited to contemporary retailing. I am not alone in this, which is why there are conservation and facade easements.
Property owners are encouraged to give up some of their rights to develop the property. If the recipient of those rights is a charitable organization, the owner might be entitled to a tax deduction. It is also possible that his real estate taxes, which can be based on fair market value will be lower. Now if the property owner wanted the property to continue in its current form, regardless, the charitable deduction for the easement is close to a free lunch. Whether the free lunch is at McDonalds or Alain Ducasse at the Essex House depends on the appraised value. Not the appraised value of the property, which after all the property owner is going to keep. No, its the appraised value of the easement.
To get the value of the easement, using the income approach, you need to figure out what the value of the propety would be at its highest and best use. Then you need to subtract the costs you would have to incur to get it there. Then you subtract the value of the property in its preserved form. That’s something of a simplification, because you should also consider the risk that you would have to take to develop the property. Of course if there are numerous properties in the same area, some with and some without easements, you might be able to use a market approach. With all those hypothetical numbers flying around to value a deduction for something somebody might want to do anyway, it is not surprising that conservation and facade easements have generated significant attention from the IRS. Janet Novack recently wrote about a suit by the Department of Justice against the Trust for Architectural Easements, because of perceived abuses in this area.
I have a couple of recent posts on the topic one of them titled “Conservation Easements a New Field for Villainy” concerns an organization whose exempt status was revoked. It was set up to accept conservation easements. In a bit of brilliant one stop shopping, you could get consulting services about your easement from the founder. If you subsequently decided that maybe you would like to do just a little more development and the easement had become inconvenient, he would also consult with you on how to adjust it.
In “How to Screw Up an Easement Deduction”I discussed four cases that went bad for the taxpayer. One of the points that was made was that if there are already numerous restrictions on the property, then an easement will not detract further from its value. It would be a little like me renouncing my super powers to give a facade easement on a property subject to severe zoning restrictions or other limitations on development.
The L’Enfant Trust is a 501(c)(3), non-profit organization founded in 1978 to promote a public aesthetic in land use planning. The Trust creates and maintains programs to promote the beauty of Washington’s urban environment. The Trust was a pioneer in the use of a unique and powerful preservation tool – the Conservation Easement. The easement is an enforceable promise, voluntarily made by a property owner and binding on all subsequent owners, that no change in the exterior appearance of a protected building will be made unless consented to by The L’Enfant Trust.
The IRS had two objections to Ms. Simmons easement deduction. The first had to do with the language in the agreement:
The Commissioner argues Simmons is not entitled to deductions for charitable contributions because the easements she granted L’Enfant satisfy neither the statute nor the regulation quoted above. More specifically, the Commissioner points to the clause in the deeds stating “nothing herein contained shall be construed to limit the Grantee’s right to give its consent (e.g., to changes in a Façade) or to abandon some or all of its rights hereunder.” This clause, he maintains, is inconsistent with conservation in perpetuity because it leaves L’Enfant free to consent to an ahistorical change in the façade and to abandon altogether its right to enforce the restrictions set out in the deeds. The Commissioner also asserts the deeds will not prevent uses of the properties “inconsistent with” their conservation because neither easement includes a clause providing for the perpetuation of the easements in the event L’Enfant ceases to exist or simply abandons its right to enforce the easements.
The Court, however accepted the explanation that L’Enfant had for the need for such language:
As the amici curiae — the National Trust for Historic Preservation, L’Enfant, and the Foundation for the Preservation of Historic Georgetown — further explain, this type of clause is needed to allow a charitable organization that holds a conservation easement to accommodate such change as may become necessary “to make a building livable or usable for future generations” while still ensuring the change is consistent with the conservation purpose of the easement.
Moreover, the Commissioner has not shown the possibility L’Enfant will actually abandon its rights is more than negligible. L’Enfant has been holding and monitoring easements in the District of Columbia since 1978, yet the Commissioner points to not a single instance of its having abandoned its right to enforce. Simmons’s deeds in particular make express L’Enfant’s intention to ensure her properties “remain essentially unchanged.”
I think the key to the taxpayer’s credibility, here, is that the taxpayer donating the easement to a strong organization. According to its most recent Form 990 L’enfant had over $4,000,000 in marketable securities on its balance sheet and had over 1,000 conservation easements, which it spent over $200,000 monitoring. The firm that prepared the 990 for the organization,Squire Lemkin, appears reasonably substantial.
The other problem the IRS had was with the appraisal. They said it did not meet the requirements of the regulations.
The Commissioner argues the Tax Court erred in holding Simmons’s appraisals were “qualified.” First, he contends Donnelly failed to explain the “method of valuation” he used and to include a substantive basis for the valuation, as required by paragraphs (J) and (K), set out above. In doing the appraisals, Donnelly had relied upon an article prepared by Mark Primoli, an IRS employee, which stated, “Internal Revenue Service Engineers have concluded that the proper valuation of a façade easement should range from approximately 10% to 15% of the value of the property.” Internal Revenue Service,Façade Easement Contributions (2000). The Commissioner suggests Donnelly arbitrarily picked a percentage between 10 and 15 rather than stating any identifiable method to determine the “after-easement” value.
If that is what the appraiser had done, the deduction would have been doomed, but the Court gave him credit for having done more:
We hold the Tax Court did not clearly err in concluding the appraisals sufficiently identified the method and basis for the valuations. To determine the fair market value of the property before being encumbered, Donnelly consulted sales of similar properties and identified some of these sales in the appraisals. In ascertaining the fair market value after encumbrance, Donnelly explained he spoke with and considered “the mindset of competent buyers and sellers” and took account of the “considerations they have actually had, or are likely to have, in the buying or selling of a property encumbered by a façade easement.” For example, each appraisal noted the property would lose some value because the easement imposed more onerous requirements than does D.C. law. It also listed several factors that would lower the value of the encumbered property, such as potential legal exposure if the donor were to breach the easement and L’Enfant’s right of prior approval for any change to the facade.
As it turned out, even though the Tax Court had accepted the appraisal as sufficient to allow some deduction, they had not agreed with it and carved back Mrs. Simmons deduction substantially:
The appraiser, James Donnelly, determined that prior to the easement the fair market value of the Logan Circle property was $1,250,000 and that of the Vermont Avenue property was $845,000. Donnelly estimated donation of the easement would diminish the value of the former by $162,500 (13 percent), and that of the latter by $93,000 (11 percent).
The Tax Court allowed $56,250 and $42,250.
So Ms. Simmons probably did not get much of a free lunch out of this whole thing. At the maximum rate she would have saved about $34,000. If they were using the same rate schedule then as now she had to pay L’Enfant about $10,000 (maybe call it $7,000 after tax). Interestingly L’Enfant charges based on the fair market value of the property, not the easement. In order, I imagine, to discourage last minute Louies, as my mother used to say, the fee varies from 42 to 60 basis points depending on when in the year you make the donation. That leaves about $27,000 in tax savings before you start in with the appraiser and the lawyers.
The IRS tenacity in this case is a little disturbing. They didn’t challenge the valuation that the Tax Court had allowed. They were still trying to blow up the whole deal, which to me clearly was basically legitimate. It reminds me of what happened to Rev. Thomas F. Chambers. He clearly set up a legitimate church, but he managed to stumble on just about every stupid thing that phony churches do. The Tax Court was only able to partially save him from himself.