The United States Tax Court recently decided yet another case[1] involving conservation easements and the corresponding charitable contribution deduction. Such cases have been prevalent lately, although recent cases have dealt more with syndicated conservation easements and the IRS’s failure to follow certain procedural rules.[2] In the subject case of this article, however, the Court, for a litany of reasons, upheld the disallowance of carryover charitable contribution deductions, for three taxable years, relating to the taxpayers’ interest in a contribution of conservation easement over rural property they conveyed to the county government.
Facts
In December of 2006, the Petitioners, a married couple, purchased approximately 85 acres in southeast Georgia for $1,350,000. This purchase was made through an LLC owned exclusively by the couple. On the same day of the purchase, the LLC divided the property into two separate parcels of roughly equivalent size. One year later, in December of 2007, the LLC granted and recorded a conservation easement over one of these parcels, referenced hereafter as the “encumbered parcel.” The LLC claimed a total charitable deduction of $5,100,000 on its return, claiming $748,702 in 2007 and carrying forward the remaining deduction to future tax years. The Court specifically ruled whether the Petitioners were entitled to deductions of $657,135, $763,835, and $743,862 in the 2010, 2011, and 2012 tax years, respectively, as well as whether Petitioners were liable for accuracy related penalties.[3]
The Deed
The deed conveying the easement on the encumbered parcel placed restrictions as to its use. These restrictions were not novel, including much of the same language seen in similar conservation easement deeds, including the prohibition of constructing buildings, mining, draining wetlands, displaying signs, and dumping trash. The LLC also reserved some rights enumerated in the deed, including the right to construct two paddocks, to harvest timber to construct the paddocks, to remove certain plants and trees to protect the natural state of the property, to plant indigenous trees and shrubs, and to maintain and replace existing road beds and paths.
Much of the remaining provisions of the deed were boilerplate, including provisions that the grantor agreed to “convey and donate” the easement, that the terms and conditions were “set forth herein,” and that the terms, condition, and promises were “herein contained.” One major omission from the deed, however, was a provision establishing that the deed constituted the entire agreement between the parties. As seen below, omission of such provision proved detrimental to the taxpayers, although in this case, their deduction would have been disallowed for other reasons as well.
The Baseline Documentation Report
The deed also contained two attached exhibits. Exhibit A included a half-page description of the property’s location and a map illustrating the outside boundaries of the encumbered parcel. Exhibit B contained the baseline documentation report (“BDR”), an essential element of conservation easements, as it establishes the condition of the property at the time the owner grants the easement and is designed to protect the conservation interests associated with the property which could be adversely affected by the exercise of reserved rights.[4] This particular BDR consisted of only three substantive pages, with the descriptions contained therein being extremely vague, such as “much of the property being grassy pasture” and describing improvements only as two words, “access roads.” This sorely lacking BDR also proved unsatisfactory to the Court, as discussed in more depth below.
The Valuation
Both the petitioners and the IRS provided experts to value the easement. Both experts determined that the highest and best use of the property before granting the conservation easement was as a residential subdivision and development, and both valued the easement by subtracting the value of the property after granting the easement from the value prior to the easement. Similarities between the two experts’ valuation end here. The Petitioners’ expert valued the property before the granting of the easement at $7,660,000 and after the granting of the easement at $4,030,000, resulting in the conservation easement being valued at $3,630,000. The IRS’s expert, on the other hand, valued the easement at only $470,000, valuing the property before the easement at $1,410,000 and after the easement at $940,000.
The Petitioners’ expert based his valuation on the sale of six lots from a nearby preserve which was zoned as a planned unit development, of which the property at issue was not included. The petitioners’ expert also conceded that unlike the lots sold from the nearby preserve, the property would lack marshland, a golf course, lake or river views, provide less privacy, and be farther from existing amenities. The IRS’s expert recognized that the property was not zoned for development and based his valuation using sales of comparable undeveloped land.
Notice of Deficiency and Trial
The IRS issued a notice of deficiency to petitioners in August of 2015, providing adjustment exclusively related to the disallowance of the carryforward deductions from the charitable contribution for the 2010, 2011, and 2012 tax years. The IRS also determined a 40% accuracy-related penalties resulting from gross valuation misstatements.[5]
Opinion
First, the Court looked as to if Petitioners had met the requirements provided in Section 170(f)(8), which states that for contributions of $250 or more, the taxpayer must substantiate the contribution by a contemporaneous written acknowledgement (CWA).[6] The acknowledgment must include the amount of cash and a description of any other property contributed, whether the donee organization provided any goods or services in consideration for the contributed property, and a description and estimated value of any such goods or services.[7]
If no explicit statement is provided, as happened in the present case, the deed taken as a whole must prove compliance with this Section.[8] Factors supporting compliance include the deed providing for no consideration other than preservation of the property and a provision stating that the deed is the entire agreement between the parties.[9] Silence in a deed satisfies the CWA only if the deed qualifies that the terms of the deed are the entire agreement.[10] The deed conveyed by the Petitioners, or rather, the Petitioners’ LLC, lacked such qualification. Petitioners argued that although the deed lacked a merger clause, it nonetheless constituted the entire agreement between the parties, and also that Liberty County, the donee whom the deed was conveyed, never provided any goods or services to Petitioners. The Court found neither argument persuasive, stating, “Proving the facts that should have been included in the CWA cannot replace the strict substantiation requirements of Section 170(f)(8).” For this reason and the others provided below, the Court upheld the disallowance to Petitioners.
The Court next determined whether the BDR sufficiently documented the condition of the property as required by the Regulations.[11] The Regulation provides examples of what may constitute adequate baseline documentation, such as survey maps from the United States Geological Survey, an up-to-date aerial photograph of the property, on-site photographs taken throughout the property, maps showing all existing improvements, identification of flora and fauna, land use history, and distinct natural areas. The Petitioners’ BDR referred to maps but did not attach such. With respect to the property’s flora and fauna, the BDR identified only a type of soil in one portion of the property, and the description of improvements to the property was limited to “Access Roads.”
The Court found the Petitioners failed to comply with the Regulation, which provides that the purpose of the BDR is to “protect the conservation interests associated with the property… which would be adversely affected by the exercise of the reserved rights.”[12] The Court found that the information provided in the BDR was insufficient to evaluate whether any changes would fall within the limits of the reserved rights. For example, the Court stated, “The property owners may maintain or replace existing roads, but without knowing the location of the access roads at the time of donation, it is difficult or impossible to prove whether a new road replaces an old one.” For this reason too, the disallowance was upheld.
The Court next found that Petitioners did not meet the substantiation requirements under the Deficit Reduction Act of 1984 (DEFRA),[13] which provides that anyone claiming a deduction under Section 170 for a contribution of property valued greater than $5,000 must attach an appraisal summary and include the cost basis of the contributed property. Here, the Petitioners reported a cost basis of $1,350,000, the cost at which the Petitioners bought the entire 85 acres, not the basis of the 41.201 acre encumbered parcel. Petitioners argued such overstatement was a scrivener’s error, but the Court did not find this argument persuasive, stating, “We cannot find that, in reporting roughly twice the accurate cost basis, [P]etitioners substantially complied with DEFRA.” This again was another basis for the Court upholding the disallowance.
Lastly, the Court determined whether Petitioners were liable for accuracy related penalties. A gross valuation misstatement includes any valuation misstatement where the value of the property claimed on the tax return is 200% or more of the correct value.[14] The Petitioners claimed a deduction of $5,100,000. Therefore, for penalties to apply, the Court would have to find the value of the easement at $2,550,000 or less. Here, too, the Court found against Petitioners, finding that the Petitioners’ expert’s valuation was “incredible as a practical matter,” as he valued the property at approximately six times the amount the LLC had purchased the property for just a year earlier. The Court agreed with the IRS’s expert’s valuation of the easement at $470,000, and thus found the Petitioners liable for accuracy related penalties.
Conclusion
The Petitioners in this case failed for a multitude of reasons which, unfortunately for them in hindsight, could have been prevented with better planning. The deficiencies with the contributed easement in this case include:
- Petitioners failed to meet the contemporaneous written acknowledgement requirement that could have been easily satisfied by the inclusion of a merger clause in the conservation easement deed.
- Petitioners’ Baseline Documentation Report was grossly insufficient to the point of being an afterthought.
- Petitioners reported their basis in a property that would inherently be subject to increased IRS scrutiny at twice its actual basis.
- The Petitioners’ expert’s valuation of the property was not only liberal but also lacked supporting documentation. For example, the expert’s valuation turned on the entire property being rezoned for development, but the expert never corresponded with the county to see if this was an actual possibility.
While I wholeheartedly support taking advantage of tax incentives, particularly those that will conserve property and wildlife for future generations, it needs to be done in careful compliance to avoid disastrous situations such as this.
[1] Brooks v. Commissioner, T.C. Memo. 2022-122.
[2] https://esapllc.com/goodbye-notice-2017-10/
[3] I.R.C § 6662(h).
[4] Treas. Reg. § 1.170A-14(g)(5).
[5] I.R.C § 6662(h).
[6] I.R.C. § 170(f)(8)(A).
[7] I.R.C. § 170(f)(8)(B).
[8] French v. Commissioner, T.C. Memo. 2016-53, at 11-12.
[9] Id.
[10] Big River Dev., L.P. v. Commissioner, T.C. Memo. 2017-166.
[11] Treas. Reg. § 1.170A-14(g)(5)(i).
[12] Id.
[13] Pub. L. No. 98-369, § 155(a), 98 Stat. 494.
[14] § 6662(h)(2)(A).
