Opinion ID: 2796442
Heading Depth: 2
Heading Rank: 1

Heading: The Easement Donation

Text: In 1999, Lorna Kaufman, a company president with a Ph.D. in psychology, bought a single-family residence for herself and her 1 Unless otherwise noted, all references to Title 26 of the United States Code (the Internal Revenue Code) and to IRS regulations refer to the versions applicable in 2003 and 2004, the tax years at issue. -3- husband Gordon at 19 Rutland Square in the South End of Boston for just over $1 million. Kaufman III, 687 F.3d at 22. The home is subject to certain zoning restrictions by virtue of its location in the South End historic preservation district. Around October 2003, she and Gordon, an emeritus professor of statistics at MIT, learned about a tax incentive program for historic preservation promoted by the Trust, which the Trust represented would allow the couple to qualify for a charitable deduction in the amount of 10-15% of the value of the South End residence. Id. at 23. As explained in Kaufman III, A provision of the Internal Revenue Code, 26 U.S.C. § 170(h) (2006), creates an incentive for taxpayers to donate real property interests to nonprofit organizations and government entities for conservation purposes. . . . [T]he statute allows taxpayers to claim a deduction for donating a real property interest -- including an easement -- exclusively for conservation purposes. These purposes include the preservation of historically important land areas or structures. The deduction for granting the easement is intended to reflect the value of what the taxpayer has donated which, in the absence of a market for such easements, can be measured by the difference between the fair market value of the entire contiguous parcel of property before and after the granting of the restriction. Id. (citations omitted). In December 2003, the Kaufmans entered into a Preservation Restriction Agreement (PRA) with the Trust, which granted to the Trust an easement in gross, in perpetuity, in, on, -4- and to the Property, Building, and the Facade and limited alterations to the property. Under the Trust's system, donors were also required to give a cash contribution to the Trust equal to 10% of the value of the donated easement. Kaufman III, 687 F.3d at 23. The Kaufmans did so. As the Trust requested, the Kaufmans also sent a form letter in late 20032 to their mortgage lender, Washington Mutual Bank, asking it to subordinate its interest in the property to the Trust's easement. Id. at 23-24. The letter stated that the easement convey[ed] the right of prior approval or [sic] any future changes [the owner] wish[ed] to make on the exterior of the property. Significantly, the letter also noted that [t]he easement restrictions are essentially the same restrictions as those imposed by current local ordinances that govern this property. Gordon later testified that he [d]idn't notice the sentence stating that the PRA restrictions were the same as the South End zoning restrictions already in place and that he made a mistake in signing the form. He stated that he thought the PRA restrictions were much tougher, but admitted that he did not compare the two sets of restrictions. Lorna testified similarly, stating that she probably didn't focus on the sentence in 2 The letter is undated, but the Kaufmans apparently sent it sometime between October 2003, when they began corresponding with the Trust about the easement donation, and December 2003, when the Kaufmans signed the final PRA. -5- question and that she believed that granting the easement would subject their home to stricter controls. In order to obtain a charitable deduction for the donation of the easement, the Kaufmans were required to obtain an appraisal of its fair market value. See 26 U.S.C. § 170(f)(11). The Trust offered the names of two appraisers it recommended, and the Kaufmans selected Timothy Hanlon. Kaufman III, 687 F.3d at 24. Hanlon was a certified professional appraiser who managed his own residential appraisal company. Id. However, the only appraisals of partial interests in real property that he had done were nine appraisals of the value of facade easements donated to the Trust. As the Tax Court explained, Hanlon had learned to appraise facade easements by speaking with representatives from the Trust, who had told him that the range of values for facade easements is between 11% for properties in highly regulated areas and ('towards') 15% in less regulated or unregulated areas. Trust representatives also suggested language for him to include in his appraisals, which Hanlon in fact incorporated almost verbatim into all of his reports, regardless of the property involved. Hanlon's January 2004 appraisal attempted to arrive at the value of the easement through the before and after method of valuation, which involved determining the difference between 'the fair market value of the property prior to donation of the easement and the fair market value of it after donation of the easement.' -6- He determined that the value of the property before the grant of the easement was $1,840,000. He acknowledged that there was much overlap between the burdens imposed by the PRA and the burdens imposed by the South End zoning restrictions, but concluded that the PRA restrictions were stricter. His explanation for why the PRA controls were purportedly stricter, however, was vague, nonspecific, and not entirely logical. A representative excerpt from his report reads as follows: The [PRA] easement is granted in perpetuity while the historic district ordinances and local zoning practices may change over time to reflect changes in political, economic and aesthetic needs and tastes in a community. The Historic District ordinances contain relief for economic hardship, which the [PRA] does not. The [PRA] may result in higher insurance and property maintenance costs than those on properties not so encumbered. Rehabilitation costs may be higher also as the property owner could be obligated to restore or replace deteriorated materials rather than replace them with cheaper substitute materials. . . . Marketability could be affected as a segment of the buying public may show resistance to being subjected to yet additional limitations and restrictions on their property rights. Despite his conclusion that the PRA imposed more robust restrictions on the use of the property than did the South End zoning restrictions, Hanlon also opined that the PRA did not change or inhibit the property's development to its highest and best use as a single-family dwelling. -7- Hanlon estimated that the burdens imposed by the PRA would reduce the property's fair market value by 12%, and so he calculated the value of the easement at $220,800. To reach this conclusion, Hanlon relied on a document prepared by IRS employee Mark Primoli stating that the proper valuation of a facade easement should range from approximately 10% to 15% of the value of the property.3 Hanlon then made a list of burdens that he believed would affect the value of a property encumbered by a facade easement and assigned a percentage to each such that the percentages added up to 15%. These calculations were based on his judgment, experience, and . . . 'common sense,' not on any data or statistical analysis. Kaufman IV, 107 T.C.M. (CCH) 1262, slip op. at 26. He then adjusted the percentages to reflect th[e] differences and similarities between the South End zoning restrictions and the restrictions imposed by the PRA. Hanlon acknowledged that his method was unique and that it was not a generally accepted appraisal practice or valuation method. 3 The Primoli article, entitled Facade Easement Contributions, was prepared sometime prior to November 2003 (the record does not disclose the precise date) as part of an IRS program focusing on specialized areas of tax law. Scheidelman v. Comm'r, 682 F.3d 189, 196 n.5 (2d Cir. 2012). In crafting the article, Primoli had relied upon a 1994 IRS 'Audit Technique Guide,' used to train tax examiners but not intended to set IRS policy. Id. In 2003 both the Audit Technique Guide and a revised version of Primoli's article omitted any reference to the ten to fifteen percent range for fear the numbers were being misconstrued. Id. This omission was not mentioned in Hanlon's January 2004 appraisal. -8- Gordon testified that he thought Hanlon's appraisal looked like a professionally [sic], respectable appraisal by a credentialed appraiser. He sent the appraisal to his longtime accountant, David Cohen. According to Gordon, Cohen replied that the appraisal looked professional and well done, [and] the results were reasonable. Cohen testified that he had seen many real estate appraisals and the Hanlon appraisal seemed very similar to the other ones [he] had seen. He also stated that he offered the Kaufmans no opinion on whether the magnitude of the easement valuation was reasonable. A week after receiving Hanlon's appraisal, Gordon e-mailed Mory Bahar, a representative of the Trust. Lorna and Cohen were copied on the e-mail. Gordon expressed concern as to whether the reduction in resale value of the property due to the easement [would be] so large as to overwhelm the tax savings that accrue from it. He then asked if Bahar had statistical documentation that bears on how much of a reduction in resale value takes place for residential properties. Gordon also noted Hanlon's statement that the restrictions imposed by the . . . Trust are much stricter than Boston Landmark's restrictions, and he asked Bahar to read that section of the appraisal and give me your comments about it. Bahar's reply to Gordon, copied to Lorna and Cohen, reads, in relevant part, as follows (emphases added): -9- In areas that are regulated by local historic preservation ordinances and bodies such as Boston historic neighborhoods (including yours) the property owners are not allowed to alter the facade of their historic buildings, whether there is an easement or not. . . . Therefore, properties with an easement are not at a market value disadvantage when compared to the other properties in the same neighborhood. But if the district is not being regulated and historic preservation is not being enforced then the presence of the easement . . . will be viewed negatively by those buyers who would want to change the facade or demolish the building. And here are some supporting data for that principle: [] We have tracked 26 resold properties to-date on which we held an easement, and none was resold at a loss or had any issues for resale that we are aware of. . . . [] Over 100 lenders have approved to subordinate their loans to our easements to-date in over 800 cases. . . . Why would these banks (including yours) approve these transactions if they saw a risk or adverse financial impact on their collateral?? . . . . [] One of our directors, Steve McClain, owns fifteen or so historic properties and has taken advantage of this tax deduction himself. He would never have granted any easement if he thought there would be a risk or loss of value in his properties. Gordon testified that he found Bahar's e-mail only mildly informative because, . . . as a mathematical statistician, he was skeptical of the statistical significance of Bahar's supporting data, and because Bahar was an agent of the Trust and so had an interest in convincing Gordon to donate the easement. However, he responded to Bahar, again copying Lorna and Cohen, and -10- stated that he appreciated the very detailed reply and that he would talk to Dave Cohen about final implementation. The Kaufmans decided to go forward with the easement donation despite the warning signals in the Bahar e-mail. They spread the $220,800 deduction over two tax years, 2003 and 2004, because they otherwise would have exceeded the statutory limits on deductions in a single year. Kaufman III, 687 F.3d at 24 (citing 26 U.S.C. § 170(b)(1)(E)). B. The IRS Investigation And First Round Of Litigation In March 2007, evidently as part of a wide-ranging investigation into perceived abuses of the easement program, the IRS opened an investigation into the Kaufmans' claimed charitable deductions. Id.4 In 2009, the IRS issued deficiencies of $39,081.25 plus $14,535.80 in accuracy-related penalties for 2003, and $36,340.00 plus $14,536.00 in accuracy-related penalties for 2004. The agency disallowed the deductions on two grounds relevant here: (1) they were invalid as a matter of law because the easement conveyance did not comply with relevant regulations, and (2) the 4 The IRS became concerned in the mid-2000s that individuals and organizations ha[d] been abusing the conservation statute to improperly shield income or assets from taxation. Kaufman III, 687 F.3d at 32 (internal quotation marks omitted) (quoting IRS news releases from 2005 and 2006). In fact, the agency placed historic preservation easements on its Dirty Dozen list of tax scams in 2005, 2006, and 2009, and has continued taking steps since then to crack down on abuse of the program. See generally L.J. Kreissl & K.B. Friske, IRS Takes A Hard Stance on Deductions for Conservation Easements, Prac. Tax Strategies, Feb. 2010. -11- Kaufmans had not established that the value of the easement was $220,800. Id. at 24-25. The Kaufmans petitioned for review by the Tax Court, which, on a motion for summary judgment, upheld the IRS's disallowance on ground (1). Kaufman I, 134 T.C. at 187. The court reaffirmed that finding after a trial on other issues in the case. Kaufman II, 136 T.C. at 313. In its post-trial opinion, the Tax Court did not reach the issue of valuation of the facade easement and so did not impose any accuracy-related penalties on the Kaufmans, reasoning that the court should not now be required to invest the time and effort necessary to resolve the difficult factual questions of intent and value presented by the IRS's claim that the Kaufmans had acted negligently or unreasonably in claiming the deduction. See id. at 324-26. The Kaufmans then appealed to this court, challenging the disallowance of the facade easement deduction. We found that the Tax Court erred in disallowing the deduction as a matter of law and vacated that aspect of the decision. Kaufman III, 687 F.3d at 30.5 5 The IRS had argued, and the Tax Court had agreed, that the conveyance of the easement did not comply with 26 C.F.R. § 1.170A-14(g)(6), the extinguishment provision. That provision requires that when a change in conditions gives rise to the extinguishment of a perpetual conservation restriction [by judicial proceeding], the donee organization, on a subsequent sale, exchange, or involuntary conversion of the subject property, must be entitled to a portion of the proceeds at least -12- We further explained that, since the Tax Court's decision not to impose penalties with respect to the [facade easement deduction] depended on the same rationale on which it based its grant of partial summary judgment, . . . the Tax Court's decision not to impose further penalties on the Kaufmans must be vacated as well. Id. (citations omitted). We remanded for the Tax Court to consider the grounds left unaddressed, including the proper value of the easement. Id. (internal quotation mark omitted). We also noted that, if the value was determined to be zero, then the Kaufmans would be liable for penalties under 26 U.S.C. § 6662 . . . unless they could show 'reasonable cause.' Id. C. The Tax Court's Decision On Remand
On remand, the Tax Court, in a thorough analysis, found that the easement's value was zero. The court accepted Hanlon as equal to that proportionate value of the perpetual conservation restriction, unless state law provides that the donor is entitled to the full proceeds from the conversion. Kaufman III, 687 F.3d at 26 (alteration in original) (quoting 26 C.F.R. § 1.170A-14(g)(6)(ii)). The Tax Court held that, because the Kaufmans' mortgage lender had retained a claim to all insurance proceeds . . . and all proceeds of condemnation superior to the claim of the Trust, the Trust was not guaranteed to receive its due proportion of the proceeds in the event of a condemnation of the Kaufmans' residence. Id. (alteration in original). We held that this was error because it was sufficient that the Trust retained a claim to its due proportion of the proceeds as against the owner-donor; the regulation did not require the Trust to have an absolute right to those proceeds as against the rest of the world. Id. at 27. -13- an expert appraiser of partial interests in property but evaluated his testimony with some skepticism given his closeness to [the Trust] and the singularity of his experience in valuing facade easements for clients and for a patron all interested in establishing high values for the easements. Kaufman IV, 107 T.C.M. (CCH) 1262, slip op. at 46-49. The court ultimately rejected Hanlon's methodology and assumptions as unsupported and unreliable. See id. at 51-54. Instead, the Tax Court found persuasive the testimony of the IRS's expert, John Bowman. See id. at 57. Bowman, who, like the Tax Court, rejected Hanlon's analysis, see id. at 14, 30-35, opined that the donation of the facade easement would not result in a diminution in property value for several reasons. First, he agreed with Hanlon that after the donation, there would be no change in the highest and best use of the property. Id. at 14, 36. Second, Bowman found, based on a component by component comparison of the South End zoning restrictions with the PRA restrictions, that the latter were 'basically duplicative' of, and 'not materially different' from the former. Id. at 36, 38; see also id. at 57-63. Finally, relying both on published literature and on his own study of data concerning sales and resales of residential properties in the Boston area, Bowman found no evidence that owners of restriction-encumbered properties have historically had difficulty marketing or financing them or that -14- restriction-encumbered properties actually sell for less than comparable properties without restrictions. Id. at 34-36, 39-43. Bowman accordingly concluded that the easement was worthless. Id. at 43-44. The Tax Court agreed and sustained the IRS's disallowance of the Kaufmans' charitable deduction for the easement donation. Id. at 63-64.
The court then turned to the issue of penalties. Before explaining the Tax Court's findings, we provide an overview of the relevant statutory provisions. Section 6662 of the Internal Revenue Code imposes a penalty equal to 20% of any underpayment of income tax due to, among other things, [n]egligence or disregard of rules or regulations, [a]ny substantial understatement of income tax, or [a]ny substantial valuation misstatement. 26 U.S.C. § 6662.6 In the case of a gross valuation misstatement, defined as a 400% or more overstatement of the value of any property claimed on a tax return, the penalty is increased to 40% of the underpayment. Id. § 6662(h). The value . . . claimed on a return of any property with a correct value . . . of zero is considered to be 400% or more of the correct amount, and the 6 A substantial understatement of income tax is defined as at least 10% of the actual amount of the tax or $5,000, whichever is greater. 26 U.S.C. § 6662(d)(1)(A). A substantial valuation misstatement occurs if the value of any property . . . claimed on any return of tax . . . is 200 percent or more of the amount determined to be the correct amount of such valuation. Id. § 6662(e)(1)(A). -15- applicable penalty is 40%. 26 C.F.R. § 1.6662-5(g). Only one accuracy-related penalty may be assessed with respect to a given underpayment, even if the underpayment is subject to a penalty on multiple grounds. See id. § 1.6662-2(c). There are exceptions to imposition of penalties. Section 6664(c) sets forth a reasonable cause exception for underpayments. It provides, in relevant part:
imposed . . . with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.
overstatements. In the case of any underpayment attributable to a substantial or gross valuation overstatement . . . with respect to charitable deduction property, paragraph (1) shall not apply unless-- (A) the claimed value of the property was based on a qualified appraisal made by a qualified appraiser, and (B) in addition to obtaining such appraisal, the taxpayer made a good faith investigation of the value of the contributed property. 26 U.S.C. § 6664(c). The regulations instruct that [t]he determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances, including, inter alia, the taxpayer's experience, knowledge, and education; whether the taxpayer relied on an appraisal, and if so, whether such reliance was reasonable and in good faith; and whether the taxpayer relied -16- on information in a W-2 or other tax form, provided that the taxpayer did not know or have reason to know the information was incorrect. 26 C.F.R. § 1.6664-4(b)(1). The Tax Court found the Kaufmans liable for a 40% penalty for a gross valuation misstatement because they claimed a deduction for the donation of a facade easement whose true value was zero. Kaufman IV, 107 T.C.M. (CCH) 1262, slip op. at 66-67. The court further determined that the reasonable cause exception was not applicable. That was because, although the first prong of the test was met, that is, the reported value of the easement was based on a qualified appraisal made by a qualified appraiser, the second prong was not, that is, the Kaufmans had not made a good faith investigation of the easement's value. Id. at 71-75. The court explained that there is no evidence that, other than consulting Mr. Bahar -- who in fact told them that the donation of the easement would not reduce the value of their home -- the Kaufmans made any independent investigation of the value of the facade easement, much less an investigation confirming that its value was the value they reported on the 2003 and 2004 returns, viz, $220,800. Id. at 75. In a separate analysis, the court also found, for essentially the same reason, that the Kaufmans had not acted with reasonable cause and in good faith. Id. at 76-81.7 7 The Tax Court held in the alternative that the Kaufmans were liable for a 20% penalty for substantial understatement of income tax and negligence. Kaufman IV, 107 T.C.M. (CCH) 1262, slip -17- This appeal followed. The Kaufmans challenge the Tax Court's finding that they are liable for accuracy-related penalties. They have not, however, appealed the court's finding that the actual value of the easement was zero.