Savvy property owners are always looking for ways to reduce their income taxes. Now, thanks to a ruling by the U.S. Court of Appeals for the First Circuit, owners may be able to claim a deduction for donating conservation easements on their properties even if those easements are subject to a mortgage.
The donation and deduction
In Kaufman v. Commissioner, the taxpayer bought a $1.05 million row house in an area of Boston subject to local restrictions aimed at historic preservation. She and her husband renovated the home, including restoring the original details of its façade.
Internal Revenue Code (IRC) Section 170(h) provides an incentive for taxpayers to donate real property interests to nonprofit organizations and government entities for “conservation purposes.” Taxpayers can claim a deduction for donating such an interest — including an easement — “exclusively for conservation purposes,” if certain requirements are met.
The couple in Kaufman granted the National Architectural Trust (now known as the Trust for Architectural Easements) a historic preservation façade easement. Because the house was mortgaged, they had to obtain a subordination of the bank’s right to the easement to satisfy the IRC requirement that a contributed easement be enforceable in perpetuity. The bank agreed but reserved the right to first priority on insurance proceeds and proceeds related to condemnation of the property.
The couple subsequently claimed a charitable contribution of $220,800 for the easement donation. The IRS disallowed the deduction, and the couple sought review by the U.S. Tax Court.
Tax Court sides with the IRS
The Tax Court disallowed any deduction for the easement. It relied on a regulation known as the “extinguishment provision.” For an easement donation to be deductible, it must provide that, if the easement were ever extinguished by a court, the donee organization would be “entitled” to a portion of the postextinguishment proceeds. (Those proceeds might come from a subsequent sale, exchange or involuntary conversion of the subject property.)
The Tax Court found that the bank’s right of first priority on insurance and condemnation proceeds undercut the charity’s right to postextinguishment proceeds.
First Circuit disagrees
On appeal, the First Circuit rejected the Tax Court’s interpretation of “entitled” as meaning “having an absolute right.” It found that a grant of an easement that’s absolute against only the owner-donor (like the couple in Kaufman) is also an entitlement that satisfies the extinguishment provision.
The appellate court also pointed out that the couple had no power to make the bank give up its priority — or to defeat tax liens the city might use to claim insurance proceeds. In fact, because tax liens are superior to most claims, the Tax Court’s interpretation would doom most easement donations.
The bigger picture
The First Circuit sent the case back to the Tax Court to determine the proper value of the easement. The IRS had argued that the value was zero because, among other things, even before the easement, the local historic preservation rules subjected the property to severe restrictions on alterations. The appellate court observed that, in light of these preexisting restrictions, the Tax Court could find that the easement was worth little or nothing.
But it also suggested that the IRS’s “aggressive legal positions” regarding valuation and other issues in the case represented an attempt to settle larger questions related to the abuse of conservation easements and preempt the litigation of individual claims. The court advised the IRS to simply adopt new regulations to prohibit abusive practices.
For more information contact Brian Lawrence at [email protected].