Court Opinion

ID: 4635937
Source: CourtListenerOpinion
Date Created: 2020-11-24 21:50:04.549578+00
Date Added: 2024-06-11T07:58:27.579597
License: Public Domain

T.C. Memo. 2020-153

                         UNITED STATES TAX COURT

    ANTHONY M. KISSLING AND SUZANNE R. KISSLING, Petitioners v.
        COMMISSIONER OF INTERNAL REVENUE, Respondent

      Docket No. 19857-10.                          Filed November 12, 2020.

      Robert J. Lane, Jr., Stephen W. Kelkenberg, James M. Bandoblu, Jr.,

and William S. Turkovich, for petitioners.

      Marc L. Caine, Gennady Zilberman, and Peggy Gartenbaum, for

respondent.

              MEMORANDUM FINDINGS OF FACT AND OPINION

      HOLMES, Judge: In 2004 the Kissling Interests, LLC contributed facade

easements on three commercial buildings to the National Architectural Trust. The

buildings were in a historic preservation district that under local law already
                                        -2-

[*2] restricted what building owners could do with their property. This case thus

poses a question of interest to donors of the subset of conservation easements that

protect facades on old buildings: How does one gauge the marginal effect of the

easement in light of local law?

      Anthony Kissling, a member of Kissling Interests, took his distributive

share of the associated charitable-contribution deduction that he and his wife

claimed in part for 2004, with the remainder carried over to 2005 and 2006. The

Commissioner disallowed the Kisslings’ deductions in full based on his belief that

the easements had no effect on the value of the properties. He also now asserts

gross-valuation-misstatement penalties under section 6662(h).1 The Kisslings

disagree, and argue that the easements reduced the properties’ values by small but

discernible amounts.

                               FINDINGS OF FACT

      The buildings that led to this case are all in Buffalo, New York. Buffalo

was America’s eighth largest city in 1900--a position held by San Diego today--

during the last great immigration boom. Its population kept growing for the first

half of the twentieth century and peaked at nearly 600,000 in the 1950 census.

      1
        All section references are to the Internal Revenue Code in effect for the
years in issue, and all Rule references are to the Tax Court Rules of Practice and
Procedure, unless we say otherwise.
                                          -3-

[*3] Then, with the opening of the St. Lawrence Seaway, the collapse of grain

milling and steelmaking, and the cratering of much of its blue-collar industry, it

shrank to only 260,000 people today. When Buffalo was growing into a great city,

it attracted the attention of great architects and great designers--its largest park

was designed by Frederick Olmsted, its first skyscraper by Louis Sullivan, and

what was for a time the largest office building in the world by D.H. Burnham &

Co. Such achievements are the happy legacy of a prosperous economy.

      Cities that keep booming complain about the problems of growth and find it

hard to protect the best parks and buildings of their past from the pressure to

redirect land to a new higher and best use. Cities that are shrinking envy them--

maintaining the infrastructure for a larger population that has vanished can lead a

local government to hard choices of neglect or the imposition of tax and regulatory

burdens their smaller populations cannot easily bear. And the economic outlook

for Buffalo in the early 2000s showed how grim these choices could be. In 2003

then-Governor George Pataki placed the City under the control of the Buffalo

Fiscal Stability Authority to put it on a path to fiscal recovery and responsibility.

See Buffalo Fiscal Stability Authority Act, N.Y. Pub. Auth. Law secs. 3850-3873

(McKinney 2006); Buffalo Teachers Fed’n v. Tobe, 464 F.3d 362, 366 (2d Cir.
                                        -4-

[*4] 2006). That meant budgetary restraints,2 and the City’s preservation agencies

weren’t immune.

I.    Buffalo’s Building Code Enforcement and Historic Preservation

      Building-code enforcement and historic preservation in Buffalo is a

multitiered system. The first tier is the Buffalo Preservation Board established

under chapter 337 of the Charter and Code of the City of Buffalo (City Code).

City Code section 337-3 creates a Preservation Board of eleven members--though

two seats have remained empty for many years--nine of which are appointed by

the City’s Common Council and the Mayor, and two of which are representatives

of the Buffalo and Erie County Historical Society and the Landmark Society of

Niagara Frontier. The Preservation Board is charged with, among other things,

      2
        The Act forced the City of Buffalo to submit financial plans to the Buffalo
Fiscal Authority for approval for at least four years after it became law. See N.Y.
Pub. Auth. Law secs. 3856 and 3857 (McKinney 2006); Buffalo Teachers Fed’n,
464 F.3d at 366. The Act also imposed several financial limitations on the City:
Aggregate operating expenses couldn’t exceed operating revenue, see N.Y. Pub.
Auth. Law sec. 3857(1); major operating funds had to be balanced, id. sec.
3857(2); and if estimated expenses or revenue changed, the mayor had to submit
an updated budget, see id. sec. 3857(2)(f).
                                          -5-

[*5] approving all certificates of appropriateness,3 no effect,4 and exception5 “for

the erection, alteration, restoration, renovation, relocation, demolition or site

improvement of any landmark * * * or of any building, structure or site within a[]

historic district when the exterior of such property would be affected.” City Code

sec. 337-5(F). In making such determinations the Preservation Board is guided by

both the standards in City Code section 337 and the Secretary of the Interior’s

Standards for Rehabilitation and Guidelines for Rehabilitating Historic Buildings.

City Code sec. 337-20.

      The Preservation Board, however, does not have any independent

enforcement powers--that’s where Buffalo’s Department of Permits and Inspection

Services (DPI) comes in, at least sometimes. According to the current

Commissioner, James Comerford, the DPI “oversee[s] all the building code

      3
       A certificate of appropriateness is a “certificate issued by the Preservation
Board * * * approving plans for alteration, construction, relocation, removal or
demolition of * * * a structure within a[] historic district.” City Code sec. 337-2.
      4
        A certificate of no effect is a “certificate issued by the Preservation Board
* * * indicating that proposed plans hav[e] no effect on the exterior of * * * a
structure within a[] historic district and that a certificate of appropriateness is not
required.” City Code sec. 337-2.
      5
        A certification of exception is a “certificate issued by the Preservation
Board * * * approving plans for alteration, construction, removal or demolition of
* * * a structure in a[] historic district where these plans do not meet the standards
for a certificate of appropriateness.” City Code sec. 337-2.
                                        -6-

[*6] enforcement in the City of Buffalo,” which includes the standards enacted by

the Preservation Board. The DPI issues licenses, performs demolitions, inspects

properties for required permits, and reacts to complaints from the public about

properties that do not comply with the building code. It also issues certificates of

occupancy on all multiple-dwelling-unit buildings every three years, which are

supposed to include a complete interior and exterior inspection for compliance

with state and local codes. When it finds a building in violation, the DPI may

withhold permits and licenses or issue letters of violation.

      Even with these legal powers, the DPI still depends in large part on

voluntary compliance. If a building owner disregards a letter of violation, the DPI

may “write up” a lawsuit against the owner to be filed in Buffalo Housing Court.

Whether to proceed with the case, however, is left up to the discretion of yet

another part of Buffalo’s government, the Corporation Counsel. If the

Corporation Counsel brings the case and wins, the Housing Court may fine or

even imprison the violator. City Code sec. 337-32.

      During Buffalo’s fiscal crisis in the early 2000s, this enforcement machinery

became strained. Louis Petrucci gave us valuable and credible insight into the

City’s preservation efforts at that time. Petrucci has worked for the City of

Buffalo almost continuously since 1989. During 2004 and 2005 he was the
                                         -7-

[*7] Director of Housing, and in 2006 and 2007 he was a building inspector with

the DPI. He credibly explained that the Buffalo Fiscal Stability Authority put

severe budget restraints on the DPI between 2004 and 2006. He also explained

that the real-estate market in Buffalo was so depressed in the early 2000s that

people were buying properties in historic districts simply to speculate on the

market, which meant they would “sit on them forever and ever, hoping that things

would change, [and] that there’d be some grand economic development.” But

when that didn’t occur, a great number of properties fell into disrepair as their

owners let them go unmaintained.

      The Preservation Board saw this problem and put together a list of

“distressed” historic buildings deemed to be “at risk,” which it gave to the DPI to

help focus its inspections. The problem with this method was that the DPI “didn’t

really have a standard of what ‘at risk’ was.” When the DPI discovered a

violation, it did try to start actions against the owners in housing court. But when

it did so, the DPI “received mixed results.” Petrucci described the DPI’s “fair

amount of frustration” with the housing court because it “didn’t always get what

[it] wanted”--namely, having the court “force [property owners] to fix up the

buildings.” As he explained, “oftentimes the opposing counsel would make [a]

convincing argument” for why a building should be demolished, and a housing
                                        -8-

[*8] court judge might agree and order the buildings to “come down[,] and they

came down.” This was all part of the larger problem known as “demolition-by-

neglect,”6 which Petrucci acknowledged was prevalent in the early 2000s due in

no small part to the fact that under the budget restraints imposed by the Buffalo

Fiscal Stability Authority “[t]here was a budget for demolition, [but] not for

emergency repairs on the properties or structures.”

      Budget restraints also affected the City’s ability to conduct inspections. In

2004 Petrucci estimated that the City had only 53 to 55 building inspectors, who

were each charged with performing 2,000 to 3,000 inspections per year.

Inspectors would understandably give priority to inspections of new construction

that aimed to protect public safety, and inspections aimed at preserving the

exterior condition of historic buildings became “primarily complaint driven.”

Petrucci credibly testified as well that the inspectors who were left weren’t

“specifically trained in [Buffalo’s] preservation standards” and weren’t at all

“trained under the Secretary of Interior standards.” The City also failed to make

and keep good records of the baseline conditions of historic properties, which

      6
       Tim Tielman, a member of the Preservation Board, defined “demolition-
by-neglect” as the process by which “structures deteriorate to the point where the
argument is made that they ought to be demolished simply because [the] cost [is]
too much to rehabilitate it or it’s a danger to the public.”
                                        -9-

[*9] made it even more difficult for inspectors who tried to detect changes in

protected buildings from year to year.7 The result was a system of crisis

management.

      These difficult times began to ease after the tax years here. In 2012 the

Fiscal Stability Authority moved into an advisory role, see Annual Report of the

Buffalo Fiscal Stability Authority: Fiscal Year Ended June 30, 2012, at 2 (Sept.

24, 2012); Buffalo Fiscal Stability Authority, Meeting Minutes (May 29, 2012),

and some of the budget pressures that had affected preservation eased as well.

Already in 2007, Comerford, who had moved to the private sector, returned to

government as deputy commissioner of the DPI and then commissioner in 2010.8

By 2015 the DPI had expanded its workforce to 70 inspectors, each of whom

performed “only” around 1,000 inspections per year. The DPI was also able to

assign each historic district a dedicated inspector who “concentrates on * * * all

      7
         The City did appear to have maintained something called “blue sheets,”
which it files when it designates a property as historic. We have one in the record.
It is a one-page document, with a single grainy 4-1/2- by 3-inch photograph, with
a line on which someone can classify the property’s condition as either excellent,
good, fair, or deteriorated. There is no evidence that the City updates these
records after their creation.
      8
        Comerford admitted that he was completely unfamiliar with the DPI’s
inspection activities before his return. To the extent the Commissioner uses his
testimony as evidence of the City’s enforcement efforts at the time of the
easements’ donations in 2004, we give his testimony no weight.
                                         - 10 -

[*10] exterior property maintenance violations” and “is cognizant of the

preservation issues,” particularly as they relate to “historic buildings and facades.”

      The DPI has also started to more systematically assess historic properties’

conditions and to improve reporting of noncompliant structures. Around 2006,

Buffalo created the “311 system,” which allows the public to report potential

building-code violations. By 2015 the DPI was receiving over 20,000 complaints

through this system alone. In 2010 Comerford commissioned one of his top

inspectors to survey “all the preservation worthy buildings in the city” and “wr[i]te

up anything that wasn’t up to code” after a number of historic buildings collapsed

due to neglect. That survey was finished around 2012, and was the first such list

compiled by the City--although the City still did not have a “base of all the historic

buildings.” The City also created the “Hansen system,” which “inspectors use on

a daily basis [to] track their daily inspections, to track permits, [and] to track

licenses.” Until a permit or license is approved, or until a noncompliant property

becomes compliant, the Hansen system places a red line over the property,

providing inspectors a quick way to check on the status of properties. We do note,

however, that the system provides limited information about historic facades--it

has no information about the condition, materials used, or distinctive features of

the facades of buildings within historic districts.
                                        - 11 -

[*11] These changes led Comerford to conclude that the DPI’s enforcement of the

building code and preservation standards is better now than when he joined the

department in 2007. Buffalo’s housing market has also recovered, which has

aided the DPI’s enforcement efforts, though even with these changes demolition-

by-neglect remains a substantial problem.

II.   Kissling Interests’ Buffalo Real Estate Purchases

      Anthony Kissling is a real-estate developer from New York City. As with

all developers, Kissling searches for investments that can make him a profitable

return. But New York City’s real-estate market was very strong in the late ‘90s,

and Kissling set his sights on Buffalo in the hope of “find[ing] some pretty good

bargains.” In 1999 Kissling Interests--of which Kissling during all relevant times

held a 90% share of profit, loss, and capital--invested in its first Buffalo property.

Kissling recounted his sobering views on the Buffalo real-estate market at that

time, which formed the basis of his investment strategy:

      Buffalo was quite a dead city. There was nothing going on. The
      prices didn’t go higher or lower. There were a lot more apartments
      than people. Every building had a lot of vacancies. No buildings
      were in good physical shape. The kitchens were old, floors were old.
      The doors didn’t fit. So I began to look for good locations with the
      idea that I’d fix these building up and rent them out. Even if I didn’t
      get more in rent, at least [I’d] have a fully rented building that went
      [sic] for the whole market to improve.
                                         - 12 -

[*12] Soon after its first purchase Kissling Interests bought the three properties

that are the focus of this case. Each is in the Allentown Historic District. They are

      !      165 North Street (the Mansion);

      !      175 North Street (the Ambassador); and

      !      131 Allen Street.

      Kissling Interests bought 131 Allen Street in October 1999. The property is

a three-story apartment building, eclectic in style, built in the early 20th century.

It has a brick facade with contrasting stone features. The front facade is eleven

bays wide and is arranged symmetrically, with the main entrance centered and set

slightly forward in an enclosed porch. The porch has a staggered roofline,

emphasized by a thick stone trim band, and quoins.9 The entry door is wood-

paneled with small glass inserts and is flanked by single-pane sidelights. A thick

stone band wraps the base of the facade, and like the porch, the building has

quoins and a staggered roofline, which is raised at the corners and in the center,

where a circular stone shield draws the eye.

      9
        “Quoins” are corners of a building that are typically made of stone, or
another material meant to imitate stone, dressed or arranged so as to form a
decorative contrast with the adjoining walls. Quoin, American Heritage
Dictionary (5th ed. 2020). Some quoins are quite elaborate and add to a building’s
beauty.
                                        - 13 -

[*13] This was something of a distress sale. Kissling Interests bought the

property from the mortgagee. M&T Bank had been unwilling to foreclose on the

property even though the previous owner had disappeared and the tenants weren’t

paying rent, so Kissling Interests bought the mortgage at a discount, finished the

foreclosure, and got the building vacant. It then began substantial renovations--it

“put in new windows, redid the roof, redid the hallways, put in new kitchens and

did some work in the bathrooms to all 17 apartments”--which it completed by late

November 2000. The renovations enabled Kissling Interests to rent almost all of

the apartments in the building.

      Kissling Interests next bought the North Street properties in February 2000.

165 North10 is a three-story apartment building, built in the early 20th century as a

single-family home. It is in the Italian Renaissance style with a main entrance that

is reached by a wide, circular stoop set in the center of the ground floor within a

wide entry portico. The portico has a flat circular roof and grooved terra-cotta

columns atop chiseled square bases. The windows across the facade are

elaborately detailed and topped by heavy pediments that are straight on the ground

      10
         While both parties stipulated that this building “occupies the tract of land
generally known as 165 North Street,” the property also has the address 173 North
Street, which sometimes showed up in the record.
                                         - 14 -

[*14] floor and arched on the second floor. The building has a rusticated

limestone base with quoins at the corners and an ornate cornice.

       175 North Street is a grand eight-story apartment building built in the 1920s

with Renaissance Revival features. During the last Roaring ‘20s, it was a first-

class rental building, and apartments there are again in high demand. The first two

floors of the building, as well as the basement level, are rusticated limestone,

while the upper floors are brick with contrasting stone detailing. The main

entrance is in the center of the ground floor. The window directly above the

entrance is topped by a broken arched pediment, which rests above a continuous

segmented band-course and divides the second and third floors. The windows

across the facade are organized symmetrically and are all of the double-hung,

multipane variety with sashes and simple straight sills.

       Kissling Interests bought these properties from a limited partnership in a

private sale that required the unanimous agreement of about 15 partners. The

buildings have more than 125 units combined, were in fairly good shape, and were

almost fully rented at moderate rents at the time of purchase.

III.   Donation of Conservation Easements

       In December 2003 the United States Department of the Interior certified that

all three buildings are historic. Each certification states that the property
                                         - 15 -

[*15] contributes to the significance of the Allentown Historic District and is a

“certified historic structure” eligible for a charitable contribution for conservation

purposes in accordance with the Tax Treatment Extension Act of 1980. See sec.

1.170A-14(d)(1)(iv), Income Tax Regs.

      Once Kissling Interests had these certificates in hand, it contributed

conservation easements on all the properties’ facades to the National Architectural

Trust. Kissling Interests and the Trust executed two deeds of easement--one on

the North Street properties, and one on 131 Allen--which were recorded on

December 13, 2004.11 Each property was subject to a mortgage when the

easements were granted, and each lender joined in the execution of the deeds of

easement through lender-subordination agreements.12

      The easements broadly define the term “facade” to include “all exterior

surfaces of the improvements on the [p]roperty, including all walls, roofs, and

chimneys” and state that “[i]t is the intent of the parties that the [f]acade visible

      11
        The terms of the deeds of easement are nearly identical. As a result, when
we refer to a specific term, we refer to both easements.
      12
         The lender-subordination agreements may have given the lenders priority
over the Trust for all insurance proceeds and proceeds of condemnation. This
might have made the easement vulnerable to attack under Palmolive Bldg. Inv’rs,
LLC v. Commissioner, 149 T.C. 380, 394-95 (2017). But the parties stipulated
this issue away, and we won’t look into it further.
                                        - 16 -

[*16] from the street-level on the opposite side of [the property] remains

essentially unchanged and in full public view.” The easements also restrict what

Kissling Interests can do to the properties without the Trust’s consent. These

restrictions include “any alteration, construction or remodeling of existing

improvements * * * , or the placement * * * of signs or markers, that would

materially alter or change the appearance of the [f]acade.” They also restrict

“exterior extensions of existing improvements * * * [and] the erection of new

improvements, including an architecturally consistent [f]acade, to replace existing

improvements which have been wholly or partially destroyed (e.g., by fire).”

Painting or cleaning the facade also requires the Trust’s consent, unless the

properties had been damaged as a result of a casualty loss, destruction, or

deterioration, in which case Kissling Interests may perform any necessary

“maintenance, reconstruction, repair and refinishing * * * so long as it is

conducted in a manner which will maintain or recreate the essential appearance of

the [f]acade.” Kissling Interests also promised at all times to “maintain in good

order the roof, the [f]acade, the foundations and the overall structural integrity of

the building” while “comply[ing] with the requirements of all applicable federal,

state and local governmental laws and regulations * * * [with] attention * * *
                                        - 17 -

[*17] directed to the Secretary of the Interior’s Standards for Rehabilitating

Historic Buildings.”

      The easements provided various rights to the Trust, including the right “to

enter upon and inspect the [f]acade, and any improvement thereon, but not

including the inside of the [b]uilding.” If Kissling Interests violated the terms of

the easements and failed to cure after being given notice, the Trust had the right

to: (i) “institute legal proceedings to enjoin such violation * * * to require the

restoration of the [p]roperty * * * to its prior condition” and seek reimbursement

for legal costs and attorneys fees; (ii) “enter upon the [p]roperty and improvements

thereon in order to correct such violation and * * * to hold [Kissling Interests]

responsible for the cost thereof”; and (iii) place a lien on the property. And

finally, if the easements are ever extinguished, whether through condemnation,

judicial decree or otherwise, the Trust is entitled to receive a portion of proceeds

from any sale, exchange, or conversion of the properties.13

      13
         The extinguishment clause grants the Trust “a portion of the proceeds
* * * equal to the same proportion that the value of the initial easement donation
bore to the entire value of the property * * * as estimated by a state licensed
appraiser.” (Emphasis added.) Though the Commissioner stipulated away any
potential issue related to the extinguishment clause, this doesn’t run afoul of our
recent decision in Oakbrook Land Holdings, LLC v. Commissioner, T.C. Memo.
2020-54.
                                         - 18 -

[*18] IV.    Kissling Interests’ Post-easement Relations With the Trust

      Once it donated the easements, Kissling Interests had to endure the Trust’s

annual property inspections. These inspections are thorough and include a

complete interior and exterior inspection. An inspector from the Trust takes field

notes, identifies any required maintenance, and checks for any alterations that

were made to the properties. If he finds any, he checks for a record of whether the

Trust had approved them. The Trust also keeps baseline information from the time

of the donation in the form of detailed photographs that it retakes each year to

show any changes. Following its review of the field notes and the photographs,

the Trust sends a letter to Kissling Interests to present its findings. If the Trust

discovers a violation, it asks Kissling Interests to propose how to fix it.

      We specifically find that the Trust took its responsibilities for these

properties seriously. Kissling admitted that he made several changes to the

properties without the Trust’s consent. These were not that extraordinary--at 131

Allen he removed flowers in the front of the building, changed the awnings from

green to black, and installed a vacancy sign to attract tenants. On each occasion,

the Trust noted the changes, contacted Kissling Interests to demand an

explanation, and then remedied the matter. There is no evidence of any such
                                         - 19 -

[*19] correspondence or contact from the DPI or the Preservation Board about any

such issues for any of the Properties.

      The Trust also issued demands. The Trust wanted wires removed from the

exterior of 175 North Street and required Kissling Interests to repaint the cornice.

These were not expensive repairs, and Kissling could point to no increases in

management, insurance, professional, or repair and maintenance costs caused by

the easement during the first couple years the easement was in place.

V.    Reporting the Contribution and Audit

      Kissling Interests reported a noncash charitable contribution of $855,900

attributable to the grant of the easements to the Trust on its 2004 Form 1065, U.S.

Return of Partnership Income. It also issued a Schedule K-1, Partner’s Share of

Income, Deductions, Credits, etc., to Kissling for the 2004 tax year, which

reported his distributable share of the contribution as $770,310 (90% × $855,900).

The Kisslings were limited, however, in the amount of their charitable

contribution deduction in 2004 by section 170(b) and had to carry forward some of

the deduction to their 2005 and 2006 tax years.

      The Commissioner audited all three years and completely disallowed the

Kisslings’ deductions for the contribution of the easements to the Trust. The
                                         - 20 -

[*20] Kisslings filed a petition, and we tried the case in Buffalo.14 The trial was

mostly a battle of experts, although the Commissioner amended his answer to

assert gross valuation-misstatement penalties under section 6662(h) for tax years

2005 and 2006.

                                      OPINION

I.    Qualified Conservation Contributions

      Section 170 allows a taxpayer to deduct the value of any charitable

contribution he makes. There is an exception for contributions of real property, if

the gift “consists of less than the * * * entire interest in such property.” Sec.

170(f)(3)(A). There is an exception to this exception that allows a deduction for a

partial interest in real property if the donation is a “qualified conservation

contribution.” Sec. 170(f)(3)(B)(iii). A “qualified conservation contribution” is

“a contribution (A) of a qualified real property interest, (B) to a qualified

organization, (C) exclusively for conservation purposes.” Sec. 170(h)(1). Under

section 170(h)(2)(C), a qualified real-property interest must be “a restriction

(granted in perpetuity) on the use which may be made of the real property.” And

section 170(h)(5)(A) tells us that “[a] contribution shall not be treated as

      14
        The Kisslings were residents of Florida when they filed their petition.
This case is therefore presumptively appealable to the Eleventh Circuit. See
sec. 7482(b)(1)(A).
                                        - 21 -

[*21] exclusively for conservation purposes unless the conservation purpose is

protected in perpetuity.”

      In Pine Mountain Pres., LLLP v. Commissioner, 151 T.C. 247, 280-82

(2018), aff’d in part, rev’d in part, and vacated, __ F.3d __, 2020 WL 6193897

(11th Cir. Oct. 22, 2020), we held that the retained power of all contracting parties

to change contractual terms does not by itself destroy an easement’s required

perpetuity. We also held there that a donor’s retained right to add improvements

“appurtenant to residential development” does violate the perpetuity requirement

as a matter of law when the precise location of those improvements is not set forth

in the deed of easement. Id. at 275-79.

      Once we decided in Pine Mountain that the power of parties to amend a

deed of easement did not ipso facto render all donations of such easements

nondeductible, this case became one of the apparently rare instances in which the

only dispute is about the proper value of an easement. That’s because the parties

stipulated that the deeds of easement in this case satisfy each of section

170(h)(1)’s requirements.

      And so we turn to the regulations. They tell us that the value of a

conservation easement is the “fair market value of the perpetual conservation

restriction at the time of the contribution.” Sec. 1.170A-14(h)(3)(i), Income Tax
                                        - 22 -

[*22] Regs. (emphasis added). But in the case of contributions of real property

interests, there are two potentially relevant dates for determining when the

contribution was made: the grant date and the recordation date. The regulations

don’t expressly tell us which date to use, but they do tell us that ordinarily “a

contribution is made at the time delivery is effected.” Sec. 1.170A-1(b), Income

Tax Regs. Whether delivery is effected is a question of state law. United States v.

Nat’l Bank of Commerce, 472 U.S. 713, 722 (1985) (state law determines real-

property rights, federal law determines consequences). Because the Properties are

in New York, we look to its law to determine when Kissling Interests made its

donations.

      We’ve previously concluded that “[u]nder New York law, an instrument

purporting to create, convey, modify, or terminate a conservation easement is not

effective unless recorded.” Zarlengo v. Commissioner, T.C. Memo. 2014-161,

at *21 (citing N.Y. Envtl. Conserv. Law sec. 49-0305(4) (McKinney 2008 &

Supp. 2014)). The easements in this case were recorded on December 13, 2004.

That sets the date on which we determine the easements’ fair market value.

      The regulations tell us how. They tell us that where “there is a substantial

record of sales of easements comparable to the donated easement * * *, the fair

market value of the donated easement is based on the sales prices of such
                                         - 23 -

[*23] comparable easements.” Sec. 1.170A-14(h)(3)(i), Income Tax Regs. In the

absence of such sales, “the fair market value of a perpetual conservation restriction

is equal to the difference between the fair market value of the property it

encumbers before the granting of the restriction and the fair market value of the

encumbered property after the granting of the restriction.” Id. This approach is

known as the “before and after” approach and we have often used it. See, e.g.,

Hilborn v. Commissioner, 85 T.C. 677, 689 (1985); Zarlengo, T.C. Memo.

2014-161, at *41-*42; Gorra v. Commissioner, T.C. Memo. 2013-254, at *49;

Simmons v. Commissioner, T.C. Memo. 2009-208, slip op. at 18-19, aff’d, 646

F.3d 6 (D.C. Cir. 2011). Under this approach, the “before” and “after” values are

to reflect the property’s highest and best use, which we’ve described as “[t]he

reasonably probable and legal use of vacant land or an improved property that is

physically possible, appropriately supported, and financially feasible and that

results in the highest value.” Whitehouse Hotel Ltd. P’ship v. Commissioner, 139

T.C. 304, 331 (2012) (quoting Appraisal Institute, The Appraisal of Real Estate

277-78 (13th ed. 2008)), aff’d in part, vacated in part, and remanded on other

grounds, 755 F.3d 236 (5th Cir. 2014).

      There are three widely accepted methods to value property under the

“before and after” approach: (1) sales comparison, (2) income capitalization, and
                                        - 24 -

[*24] (3) replacement cost. The premise of the sales-comparison approach is that

market value is directly related to the prices being paid for competing properties.

This requires not only that the comparable properties chosen be themselves similar

to the subject property, but also that the sales occurred at arm’s length and within a

reasonable time of the valuation date. See Chandler v. Commissioner, 142 T.C.

279, 285 (2014) (citing Wolfsen Land & Cattle Co. v. Commissioner, 72 T.C. 1,

19 (1979)). The income-capitalization method measures the subject property’s fair

market value by the present value of the future income stream that its owners can

expect to realize. Whitehouse Hotel Ltd. P’ship, 139 T.C. at 321-322. The focus

of this method is on forecasting market income and discounting it by an

appropriate capitalization rate, which (at a high level of generality) captures the

risk inherent in the investment. Id. at 322. Finally, the replacement-cost method

“derives the value of a property by estimating the reproduction or replacement cost

of the improvements, deducting therefrom the estimated depreciation, and then

adding the market value of the land.” Talkington v. Commissioner, T.C. Memo.

1998-412, slip op. at 22. This method is particularly suspect when used to value

older historic structures. See Whitehouse Hotel Ltd. P’ship, 139 T.C. at 316.

      We have also already recognized the special problem of owners who donate

facade easements on buildings in historic-preservation districts. The regulations
                                         - 25 -

[*25] tell us that we “must take into account * * * any effect from zoning,

conservation, or historic preservation laws that already restrict the property’s

potential highest and best use.” Sec. 1.170A-14(h)(3)(ii), Income Tax Regs. This

tells us to determine what protection, if any, an easement adds beyond local law.

      This isn’t a new problem either. See, e.g., Chandler, 142 T.C. at 280;

Whitehouse Hotel Ltd. P’ship, 139 T.C. at 307-08; Kaufman v. Commissioner,

T.C. Memo. 2014-52, at *2, aff’d, 784 F.3d 56 (1st Cir. 2015); Zarlengo, T.C.

Memo. 2014-161; Scheidelman v. Commissioner, T.C. Memo. 2013-18, aff’d, 755

F.3d 148 (2d Cir. 2014); Gorra, T.C. Memo. 2013-254; Simmons, T.C. Memo.

2009-208. These cases show just how factbound this review is. After all,

“‘[v]aluation is . . . necessarily an approximation[,]’ and ‘[i]t is not necessary that

the value arrived at by the trial court be a figure as to which there is specific

testimony, if it is within the range of figures that may properly be deduced from

the evidence.’” Scheidelman, 755 F.3d at 151 (quoting Silverman v.

Commissioner, 538 F.2d 927, 933 (2d Cir. 1976), aff’g T.C. Memo. 1974-285).

      With that we turn to the experts in this case.

II.   The Experts

      Both parties submitted expert reports on the value of the easements. The

Kisslings’ experts were Jan Barenholtz, Darrel Lloyd, and Kevin Mahoney; the
                                         - 26 -

[*26] Commissioner’s expert was Gregory Klauk. We briefly introduce them and

their approaches.

      A.     Jan Barenholtz

      Barenholtz works at MMJ Commercial, Inc., and Kissling first retained him

at the Trust’s recommendation to appraise the Properties before the easements’

contribution. Barenholtz is a member of the Appraisal Institute, a highly regarded

organization of appraisers, and is also certified by New York State as a general

appraiser. Before he appraised the Properties here, Barenholtz had appraised more

than a half dozen other facade-easement contributions, all in connection with the

Trust where it was the probable donee.

      Barenholtz appraised the Properties for the first time in 2004. He sent

Kissling Interests letters in August 2004 that stated his opinion of the market value

of the Properties before and after granting the easement as of June 29, 2004. He

concluded that the highest and best use of the Properties, both before and after

granting the easements, was their continued use as residential apartment buildings.

To calculate the Properties’ “before” or pre-easement values, Barenholtz

considered but rejected the sales-comparison and replacement-cost methods and

instead used the income-capitalization method. He used the Properties’ historical

revenue and expense information to estimate each property’s net operating income
                                       - 27 -

[*27] (NOI), which he divided by a risk-adjusted capitalization rate to arrive at a

final value. After calculating the easements’ before values, he then reduced them

by 11% (for 131 Allen) and 12% (for the North Street properties) to arrive at their

after values. He claimed in his report that those percentages were based upon

“guidelines issued by the Internal Revenue Service as well as Tax Court

decisions” which “suggest[ed] that the granting of historic conservation easements

cause a diminution of value ranging between 10% and 15%.” His analysis

produced the following results:

                                          131 Allen         North Street Properties
 Property value: pre-easement             $690,000                $6,500,000
 Property value: post-easement             614,100                  5,720,000
 Value of Easement                          75,900                    780,000

      Barenholtz later updated his appraisals for the Properties in letters dated

September 2004. These updated appraisals valued the Properties before and after

the granting of the easements as of September 7, 2004. In them Barenholtz

concluded that the value of the Properties and the easements “were unchanged

from the values estimates as of June 29, 2004.”

      Barenholtz returned to the task a third time after the Commissioner

examined Kissling Interests’ 2004 return. During that audit the Commissioner
                                        - 28 -

[*28] offered Kissling Interests an opportunity to present any additional appraisal

information. Back came Barenholtz with addenda to his 2004 appraisals, which he

sent to Kissling Interests in March 2007. In these he walked back his use of a flat

percentage-off approach at calculating posteasement values. For the first time he

considered the enforcement powers of the Preservation Board as compared to the

powers conferred on the Trust and concluded that the easements were more

restrictive and imposed more obligations than the Preservation Board. This led

him to increase his estimate of several post-easement expenses, and increase the

Properties’ post-easement capitalization rates to reflect what he identified as

increased risk. These adjustments, however, led to post-easement values that were

nearly identical to the ones he’d calculated in 2004.

      B.     Darryl Lloyd

      At trial the Kisslings had a second expert, Darrel Lloyd of IREM Solutions,

Inc. Lloyd is a certified general real-estate appraiser in both New York and

Pennsylvania and has more than 30 years’ experience, much of which has been in

appraising properties within Buffalo’s various historic districts. He has even

appraised the Guaranty Building--the only other building in Buffalo with a facade

easement in place.
                                           - 29 -

[*29] Lloyd also valued the Properties using only the income-capitalization

approach but valued them as of October 25, 2004--the date the Trust executed the

easements. He calculated the Properties’ NOI using market-adjusted revenue and

expense information, and he also concluded that the Properties’ highest and best

uses, both before and after the easement, were as multifamily residential apartment

complexes. Based on his analysis, Lloyd concluded that the easements reduced

the fair market value of the Properties.

      Like every other appraiser who testified in this case, Lloyd rejected the

replacement-cost approach as unnecessarily speculative. And like Barenholtz he

also rejected the sales-comparison method because of what he called a lack of

“sales of similar type properties encumbered with a facade easement” and his

belief that any such attempt to use this method would require “substantial

adjustments of 40 [to] 50 percent.” Lloyd felt that adjustments of that magnitude

were “unreliable” and potentially “misleading.”

      C.     Kevin Mahoney

      The Kisslings’ third and final expert was Kevin Mahoney. Mahoney is the

senior vice president and partner of Baer & Associates, LLC, a construction-

consulting firm that specializes in cost estimation, condition assessments, claims

analysis, and related services. Mahoney has over 30 years’ experience in
                                        - 30 -

[*30] construction, much of it in the Buffalo market. We recognized him as an

expert in assessing building conditions and estimating the costs of historical

restoration.

      The focus of Mahoney’s expert report was “on the comparison and

differences between the City of Buffalo Preservation Board’s enforcement of

maintenance and preservation requirements on buildings within historic

preservation districts with the requirements” of the facade easements granted to

the Trust. Part of his review was to look at the deterioration of the Properties’

facades and to estimate the cost of repairing them to the standards for historic

buildings that the Secretary of the Interior had established. Mahoney concluded:

      The financial commitment for maintaining the historical facades of
      the [Properties], based simply on the requirements and history of
      enforcement of city code by the City of Buffalo and the Buffalo
      Preservation Board, would be zero; based on the requirements of the
      conservation easements financial requirements are assured and costs
      will be significant.

      To the extent Mahoney directly compared the terms of the easements to

Buffalo’s enforcement of its preservation code to reach his final conclusion, we do

not give his opinion any weight. That’s because when he was retained by the

Kisslings, he testified that he “had only a general concept of * * * facade

easement[s]” and did not have any direct experience determining whether
                                        - 31 -

[*31] particular renovations met Buffalo’s preservation code. He was therefore

not qualified to give an expert opinion regarding whether the easements were more

or less burdensome than Buffalo’s enforcement of its preservation code.

      We do, however, credit the portions of his report that identified specific

deterioration that occurred to the Properties’ facades before Kissling Interests

granted the easements to the Trust--in other words, while the Properties were

solely under the City’s watch--and his opinion on what it would cost to restore the

Properties. Mahoney identified several elements of each building’s facades that

were either replaced with nonhistorical materials, repaired using nonhistorical

standards, or in need of significant rehabilitation in the near future. For example,

at 165 North Street, Mahoney identified areas of brick replaced with nonmatching

material, terra cotta window sills replaced with modern stone sills, and terra cotta

columns in need of “substantial rehabilitation or reproduction in the near future.”

At 175 North Street, he identified some windows replaced by nonhistorical vinyl

windows with metal trim. And at 131 Allen Street, he identified windows that

“appear[ed] to be of non-historic quality replacements.”

      D.     Gregory Klauk

      The Commissioner’s expert was Gregory Klauk of KLW Appraisal Group,

Inc. (f.k.a. Klauk, Lloyd & Wilhelm Inc.). Klauk is also a certified general real-
                                        - 32 -

[*32] estate appraiser in New York with over 30 years’ experience primarily in the

Buffalo market. Klauk and Lloyd were partners at Klauk, Lloyd & Wilhelm, Inc.

between 1995 and 2012.

       Klauk also valued the Properties using the income-capitalization method,

and he also found that the Properties’ highest-and-best uses, both before and after

the easement, were as multifamily apartment buildings. Klauk, however, valued

the Properties as of December 13, 2004--the date the easements were recorded--

and he concluded that the easements did not reduce the fair market value of the

Properties at all.

       Klauk was also the only expert to use the sales-comparison method. He

found four properties he said were comparable to 131 Allen and five that he said

were comparable to the North Street properties. Based upon his analysis, Klauk

concluded that the values of 131 Allen and the North Street properties were

$382,500 and $4,646,000.

       We have some serious concerns about these comparable sales: None of the

properties that he used was subject to a facade easement at the time of its sale,

which means he couldn’t perform a paired-sales analysis.15 See Kaufman, T.C.

       15
        A paired-sales analysis compares the fair market value of a comparable
property with and without an easement. This analysis divides the fair market
                                                                     (continued...)
                                        - 33 -

[*33] Memo. 2014-52, at *37 (Commissioner’s expert “did no sales comparison

analysis to determine the postcontribution value of the property because * * * he

could find no properties both burdened by a preservation restriction and sold

contemporaneously with the contribution of the facade easement”). Klauk instead

used the selected comparable properties to calculate pre-easement values and then

begged the question of an easement’s effect by concluding that the after values

would remain unchanged because “there is no credible support for a Facade

Easement adversely effecting the market value of a property like the subject when

the property is already encumbered with Historic Preservation Restrictions.” This

logical flaw alone would undermine Klauk’s sales-comparison analysis.

      Even if it didn’t, at least two of the properties Klauk used in his analysis

weren’t even located within a historic district. Yet nowhere in his report does

Klauk make a location adjustment to account for what he claims are the burdens

and costs of owning a property in a historic district because of the City’s

enforcement of the preservation code. Klauk acknowledged at trial, for example,

      15
        (...continued)
value of the property after it’s encumbered by its fair market value before it’s
encumbered. The resulting fraction is then subtracted from one, producing the
percentage diminution in value attributable to the easement. See Gorra, T.C.
Memo. 2013-254, at *57-*58 (citing Strasburg v. Commissioner, T.C. Memo.
2000-94, slip op. at 12 n.8). This of course requires the use of comparable
properties that are encumbered by an easement.
                                         - 34 -

[*34] that 420 Jersey Street--one of the comparable properties that he used to

value 131 Allen--was located outside a historic district. He made what he called

“a location adjustment” but did not make an adjustment “specific to the

preservation issue.” His report confirms this. Klauk states there that the location

adjustment to 420 Jersey is attributable to the fact that it “is in a less desirable

location based on occupancy and rent levels” compared to 131 Allen but makes no

mention of adjusting the value based on its location outside a historic district.

This also undermines his analysis.

      These were not the only problems. Klauk admitted at trial that he had been

unaware that Kissling Interests substantially renovated 131 Allen before it donated

the easement--which resulted in Klauk’s undervaluing 131 Allen when he

compared it to what he said were comparable properties. And a bigger problem in

Klauk’s appraisal was that so many of his comparables were so dissimilar that he

had to make large or numerous adjustments. Three of the five properties that he

used as comparable to the North Street properties required total net adjustments of

43.9% to 56.6%. And even though Klauk made net adjustments of only around

10% to 13% to the comparables in his 131 Allen appraisal, he had to make a

number of significant adjustments to get there. As we’ve previously stated,

“[w]hen an appraiser makes numerous adjustments to a subject property’s
                                       - 35 -

[*35] comparables, the subject property’s valuation becomes less reliable.”

Chandler, 142 T.C. at 287 (affording little weight to two of the appraiser’s

comparables where sale price adjustments “ranged from 11.2% to 20.3% and

included significant adjustments based on [the appraiser’s] subjective evaluation

of the properties’ ‘condition’”).

       We therefore give no weight to Klauk’s sales-comparison analyses.

III.   Income-Capitalization Method

       Although he used the preferred income-capitalization method, we still have

problems with Barenholtz’s analysis. We find his testimony neither credible nor

“the product of reliable principles and methods.” See Fed. R. Evid. 702(c). There

are several reasons for this. The first is his use of blanket diminution amounts for

the values of the Properties. Even Barenholtz himself questions this method. He

at first appraised the post-easement Properties simply by knocking off a

percentage of their pre-easement values. He picked these percentages based on

“guidelines issued by the Internal Revenue Service as well as Tax Court decisions

which have established * * * that the granting of historic conservation easements

cause a diminution of value ranging between 10% to 15%.” Nowhere in his report

does he specify what IRS guidance or Tax Court opinions he consulted, and when

asked at trial he was no more specific. The Kisslings argue that Barenholtz was
                                       - 36 -

[*36] referring to an article previously posted on the National Park Service

website by Mark Primoli--an IRS employee--entitled “Facade Easement

Contributions” (Primoli article). The Primoli article includes the following

sentence: “Internal Revenue Service Engineers have concluded that the proper

valuation of a facade easement should range from approximately 10% to 15% of

the value of the property.” And as to the Tax Court decisions, we suspect he was

referring to a string of historic-facade easement cases, mostly out of Louisiana, in

the mid-to-late ‘80s and early ‘90s. See, e.g., Hilborn, 85 T.C. at 699 (finding a

10% diminution in value); Dorsey v. Commissioner, T.C. Memo. 1990-242, 59

T.C.M. (CCH) 592, 602 (1990) (10% diminution); Nicoladis v. Commissioner,

T.C. Memo. 1988-163, 55 T.C.M. (CCH) 624, 629 (1988) (10% diminution);

Griffin v. Commissioner, T.C. Memo. 1989-130, 56 T.C.M. (CCH) 1560, 1564

(1989) (20% diminution), aff’d, 911 F.2d 1124 (5th Cir. 1990).

      We’ve found such rule-of-thumb valuations unpersuasive. In Kaufman, the

taxpayer’s expert similarly assumed “that the percentage reduction in value of the

property on account of the contribution of the facade easement to [the Trust] fell

somewhere between 10% and 15%” based upon the Primoli article and Tax Court

guidance. Kaufman, T.C. Memo. 2014-52, at *24-*25. We refused to accept this

method. Id. at *50-*52; see also Scheidelman, T.C. Memo. 2013-18, at *14. And
                                         - 37 -

[*37] even Barenholtz testified that, as of the time of the trial, this valuation

technique was not appropriate.

      The unreliability of deriving post-easement values by assuming that they are

a percentage of pre-easement values is why Barenholtz prepared his 2007

addendum to “amplify issues relating to the diminution of value of the [Properties]

* * * following the donation of a facade conservation easement.” In this

addendum he again calculated the Properties’ post-easement values but used

various expenses and capitalization rates to adjust for what he, at that point,

identified as increased costs and risks associated with owning the encumbered

Properties. But despite what appears to be an interesting factual analysis,

Barenholtz remarkably--and not very credibly--arrived at the same post-easement

values he calculated in 2004. We find the probability that this is a coincidence is

close to zero, especially when acknowledging how susceptible valuations using

the income-capitalization approach are to minor changes in their inputs. When

Barenholtz was asked at trial what the chances of two appraisers reaching the

same valuation for a property are, he responded that it would be “unusual

* * * [b]ecause different appraisers have different ways of going about doing

appraisals.” In the same way, we find the chances of one appraiser reaching the

same valuation using two distinct appraisal methods to be “unusual”. We also
                                       - 38 -

[*38] have concerns with the inputs that he used. For example, Barenholtz was

the only appraiser to apply a lower “before” capitalization rate for 131 Allen

(8.25%) than for the North Street properties (8.5%). He was also the only

appraiser to use historical, as compared to market, rent and expense data in his

model. When questioned about these choices, Barenholtz testified that he used the

lower capitalization rate for 131 Allen because he believed that the North Street

properties represented a greater risk to an investor in 2004 and that he used

historical rents because he “wouldn’t expect there to be a big difference” between

them and market rents. However, he provided no further explanation for why he

believed 131 Allen was less risky than the North Street properties; and while he

may not have expected a large difference between historical and market data, his

report fails to explain the reason for that expectation. We accord Barenholtz’s

report no weight.

      A.     “Before” Valuation

      That leaves us with Lloyd’s and Klauk’s valuations. The way we analyze

these appraisals is to describe them in detail and examine each point of

disagreement. We then plug our findings on each contested detail back into the

appraisal. The reader will be unsurprised to learn that we end up somewhere

between the extremes of both valuations.
                                              - 39 -

[*39] Let us begin with the summaries. First, 131 Allen:

                                              Lloyd                    Klauk

                            %      Before        %      After    %     Before/After

 Rental revenue                    $97,620             $97,620           $101,400

 Laundry revenue                     2,652              2652                   1,326

 Potential gross revenue           100,272             100,272            102,726

 Vacancy & collection
  loss                     5%       (5,014)            (5,014)   5%        (5,136)

 Effective gross income             95,258             95,258              97,590

 Operating expenses

 Real estate taxes                   6,908              6,908                  6,576

 Insurance                           1,764              1,764                  3,400

 Utilities                          12,750             12,750              17,170

 Garbage removal                     ---                 ---                    595

 Repairs/maintenance                 5,100              5,610              10,200

 Payroll                             3,400              3,400                   ---

 Cleaning & supplies                 1,275              1,275                   ---

 Snow & ground care                  ---                 ---                    300

 Management fees           5%        4,763      6%      5,716    6%            5,855

 Advertising                         1,700              1,700                    ---

 Professional services     1%         953       2%      1,905                  1,000

 Miscellaneous                        500               500                      ---

 Reserves for
  replacements                       4,250              4,250                  3,400

 Total expenses                     43,363             45,778              48,496

 Net operating income               51,896             49,481              49,093

 Capitalization rate       8.5%                9.25%             11%

 Value                            $610,540             534,927            446,303

           And next, the North Street properties:
                                             - 40 -

[*40]
                                             Lloyd                          Klauk

                           %      Before             %     After      %     Before/After

Rental revenue                   $982,260                $982,260             $967,260

Laundry revenue                    20,436                 20,436                    9,984

Beauty shop revenue                 7,860                  7,860                    6,500

Potential gross revenue          1,010,556               1,010,556             983,744

Vacancy & collection
 loss                     5%      (50,135)                (50,135)   5%        (49,187)

Effective gross income            960,421                 960,421              934,557

Operating expenses

Real estate taxes                  79,012                 79,012                75,229

Insurance                          18,940                 18,940                35,200

Utilities                         151,800                 151,800              179,200

Garbage removal                     ---                     ---                     ---

Repairs/maintenance                27,060                 32,472                51,200

Payroll                            26,400                 26,400                57,600

Cleaning & supplies                13,200                 13,200                27,520

Contracted services                 ---                     ---                 15,360

Management fees           5%       48,021        6%         9,604    6%         56,073

Advertising                         7,920                 57,625                    ---

Professional services     1%        9,604        2%        19,208    1%             9,346

Miscellaneous                       3,500                  3,500                10,880

Reserves for
 replacements                      26,400                  29,700               28,800

Total expenses                    411,857                 439,778              546,408

Net operating income              548,564                 520,643              388,149

Capitalization rate       8.5%                  9.25%                8.5%

Value                            6,453,693               5,628,575            4,566,457
                                       - 41 -

[*41] The most significant difference between Lloyd’s and Klauk’s valuations is

that Klauk concluded that the easements had no effect. But they also disagree

about the value of the Properties before the easements. And that’s where we’ll

start. We note that we need not accept the values computed by either side’s expert

witness in toto, and instead “may reach our own determination of value on the

basis of our analysis of the evidence in the record.” Zarlengo, T.C. Memo. 2014-

161, at *46 (citing Silverman, 538 F.2d at 933).

            1.     Rental Revenue

      To calculate revenue, both Lloyd and Klauk compared the Properties’

historical rental rates with comparable market rates. Many of the comparable

apartment rentals used in Lloyd’s and Klauk’s analyses were identical. Although

we find both valuations entirely reasonable, we adopt Klauk’s values because he

explicitly detailed each adjustment made to each comparable property’s rent, while

Lloyd did not.

            2.     Laundry Revenue

      To calculate laundry revenue, both experts assumed each unit would use the

laundry appliances in the Properties’ basements once per week. Lloyd, however,

assumed a per-load price of $3, while Klauk assumed a per-load price of $1.50.
                                       - 42 -

[*42] We have nothing in the record to help us decide this minor point, and will go

with Klauk’s, because Kissling had the burden of proof.

             3.    Beauty Shop Revenue

      This revenue flow sprang from an apartment at 175 North Street that was

used as a beauty shop. Klauk refers to this revenue stream simply as

“miscellaneous revenue,” historically within the range of $6,000 to $7,000 per

year. Lloyd identifies this revenue stream as beauty-shop rental revenue and used

the actual monthly rent charged, which he also determined to be within market

parameters. Lloyd was credible in his report and testimony on this point, and we

find his value persuasive.

             4.    Vacancy and Collection Loss

      Both experts agreed on a total vacancy and collection loss factor of 5% for

the Properties. To calculate the loss for 131 Allen, Lloyd and Klauk multiplied

5% by potential gross revenue. Klauk employed the same approach for the North

Street properties. Lloyd, however, without explanation applied 5% not to

potential gross revenue for the North Street properties but to potential gross

revenue less beauty shop revenue. We find no reason why the beauty shop cannot

also experience a vacancy loss. Therefore, to calculate the loss for the properties

we apply 5% to potential gross revenue.
                                        - 43 -

[*43]         5.    Real Estate Tax

        Both experts calculated this expense by examining the Properties’ historical

tax expense. Lloyd calculated this expense by taking the Properties’ 2004 true tax

expense and increasing it by 2% to account for potential inflation in the overall tax

rate. Klauk, on the other hand, used the Properties’ actual assessed values and tax

rates for January 2005 through December 2005. As of the effective date of the

valuations in 2004, the Properties’ actual tax for the 2005 tax year would have

been unknown. Therefore, we adopt Lloyd’s estimation based on the Properties’

2004 tax as adjusted.

              6.    Insurance

        To calculate insurance expense, Klauk estimated the expense per unit, while

Lloyd estimated the expense per square foot. Klauk’s insurance expense for 131

Allen amounts to around 3.5% of his calculated effective gross income, while

Lloyd’s amounts to approximately 1.9% of his. The comparables in Klauk’s own

report show insurance expenses ranging from 0.6% to 2.9% of effective gross

income. Because his values fall outside this range without explanation, and

Lloyd’s fall within it, we adopt Lloyd’s estimates of this expense for the

Properties.
                                        - 44 -

[*44]         7.    Utilities

        Both experts calculated utility expenses on the assumption that the landlord

was responsible for each unit’s heat, water, and common-area electric. For the

Properties, Klauk adopted a higher value than Lloyd. For 131 Allen, we find that

part of this discrepancy results from Klauk’s ignorance of the significant

renovations made to the property before the donation of the easement. See supra

p. 34. Lloyd expressly considered the recent renovations in his report, and we

adopt his value for 131 Allen. We also adopt Lloyd’s value for the North Street

properties because his report provides more detailed information than Klauk’s, and

his value is reasonable considering the range of historical and market data

provided.

              8.    Garbage Removal, Snow and Ground Care,
                    and Contracted Services

        We’ve combined our discussion of these three expenses because of the

different way Klauk included them in his reports. For 131 Allen, Klauk listed

garbage removal separate from snow and ground care. For the North Street

properties he included them--along with elevator servicing--under a category that

he called “contracted services.” Lloyd included no such expenses. We go with

Klauk on this one and find his estimates reasonable (and in the case of snow
                                        - 45 -

[*45] removal, we believe their necessity in Buffalo a subject fit for judicial

notice) and based on historical and market data. We adopt them.

             9.      Repairs and Maintenance

      To calculate this expense, Lloyd looked only at the cost of repairs and

maintenance, while Klauk included janitorial and supply costs16 for 131 Allen and

the cost of supplies and decorations for the North Street properties (Lloyd

considered these costs separate expense categories). Klauk’s numbers did not

reflect the substantial pre-easement renovations made to 131 Allen, while Lloyd’s

did. Lloyd’s approach was more detailed and reasonable, and we adopt his

estimates of them.

             10.     Payroll

      Both experts agree that this expense should be recognized. Klauk did not

estimate it for 131 Allen, so we adopt Lloyd’s value for that building. As for the

North Street properties, Klauk appears to have increased this expense by a certain

amount of unspecified “tax and benefit expense.” It’s unclear why this expense

would be unique to the North Street properties and what “tax and benefit expense”

includes. We therefore adopt Lloyd’s values for these properties too.

      16
        This amount also appears to include $300 per year for snow removal and
grounds care, which we’ve already allowed.
                                        - 46 -

[*46]         11.   Cleaning and Supplies

        For 131 Allen, Klauk included cleaning and supplies in his repairs and

maintenance expense and did not have a separate category for them in his report.

Since Lloyd’s value is within both the historical and market ranges for such an

expense, we adopt his value.

        We adopt Klauk’s value, however, for the North Street properties. We do

this because Lloyd’s value is unreasonably (and inexplicably) below the lower

bound of the properties’ historical expense ranges, while Klauk’s market-adjusted

value is squarely inside.

              12.   Management Fees

        The experts agree that this expense is appropriately calculated using a

percentage of effective gross income but dispute what that percentage should be.

Klauk says 6%, while Lloyd says 5%. The difference seems attributable to

Klauk’s inclusion of advertising and office-supply expenses as part of

management fees. Lloyd broke those expenses out. While both approaches

appear reasonable, we adopt Lloyd’s because of its more granular approach. As a

result, we adopt Lloyd’s management-fee percentage for the Properties.
                                        - 47 -

[*47]         13.   Advertising

        Lloyd projected advertising as a separate expense. He says the expense for

131 Allen historically ranged from $1,695 (or $100 per unit) to $2,131 (or $125

per unit), while the market’s advertising expense typically ranged between $40 to

$100 per unit. Based on this, he adopted an advertising expense of $100 per unit,

or $1,700 annually. For the North Street properties, the expense historically

ranged from $2,612 (or $20 per unit) to $8,500 (or $64 per unit). This, combined

with advertising expenses in similar buildings that ranged from $40 to $100, led

Lloyd to adopt an advertising expense of $60 per unit, or $7,920 annually. Since

Klauk didn’t separate advertising from management, we will continue to adopt the

more granular approach. We will use Lloyd’s advertising expense for the

properties.

              14.   Professional Services

        Both experts appear to agree that the professional services expense should

equal 1% of effective gross income. We find this reasonable and adopt it.

              15.   Miscellaneous

        Lloyd includes this expense for each of the Properties, while Klauk includes

it only for the North Street properties. Although Lloyd consistently applied the

expense to the Properties, he provided no justification for his estimates. Klauk’s
                                          - 48 -

[*48] estimate, on the other hand, is supported by historical and market data. We

adopt Klauk’s value for the North Street properties.

             16.    Reserve for Replacements

      Both experts agree that it is reasonable to include this expense as an amount

a property owner would set aside to repair major structural items, such as the roof,

appliances, and hot-water tanks. While both experts’ values appear reasonable,

Klauk performed a highly detailed breakdown of the reserve required for each

item that may require replacement. It’s persuasive, and we adopt it.

             17.    Capitalization Rate

      To calculate the Properties’ capitalization rates, both experts analyzed

national rate indicators and rates derived from the local market. Each also applied

the mortgage-equity band-of-investment technique, “which produces a weighted

average cost of capital based on the cost of debt and equity financing for the

subject property.” LeFrak v. Commissioner, T.C. Memo. 1993-526, 66 T.C.M.

(CCH) 1297, 1302 (1993). As a result of their analyses, both Klauk and Lloyd

agree that the appropriate capitalization rate for the North Street properties is

8.5%, which we find reasonable.

      They are not so agreeable about the proper capitalization rate for 131 Allen.
                                        - 49 -

[*49] Klauk’s analysis began with a review of national apartment-market

capitalization rates found in the PwC Korpacz Real Estate Investor Survey (4th

Quarter 2004). Because Klauk felt that “the subject is clearly not an institutional

grade property,” he was particularly interested in the survey’s findings on the

capitalization rates of noninstitutional properties, which “indicate[d that] a cap

rate for non institutional apartment projects should range from 5.25%-10.5% with

an average of 8.06%.”

      Klauk then proceeded to calculate the capitalization rate under the

mortgage-equity technique. He assumed that 75% of the value of the building

would be financed with debt and that the prevailing rate for a 10-year mortgage,

amortized over 20 years, was 6%. This interest rate was based on the rates of

federal Treasuries and corporate bonds of varying risk. Klauk also assumed that

25% of the value of the building would be financed with equity at a rate of 16%.

He based this on his interviews with investors in Western New York who

indicated that they would expect a return of 8% to 14%, while three additional,

undisclosed local investors said they would expect yields between 8% and 20%.

Klauk determined that the building would not increase in value over a 10-year

holding period. He then weighted his value by a number of factors to arrive at a

capitalization rate of 9.2%.
                                         - 50 -

[*50] Finally, Klauk analyzed the capitalization rates of the properties he used in

his sales-comparison method, which ranged from 10.2% to 15.6%. He reasoned

that the capitalization rates from the local market reflected the conditions of 131

Allen and concluded that the appropriate capitalization rate was 11%, though at

trial he testified that the rate should likely be 10% after learning of the significant

renovations Kissling Interests made at 131 Allen before it donated the easement.

      Lloyd’s analysis is quite similar to Klauk’s. He started by reviewing the

Realty Rates Investor Survey (4th Quarter 2014), which showed an average

national capitalization rate for apartments in 2004 of 9%. He then looked at local

property sales, mostly from 2001, which showed capitalization rates between

9.54% and 13.26%--although he noted that since these sale dates, both interest and

capitalization rates had on average dropped.

      Lloyd then calculated a capitalization rate using the mortgage-equity

technique. Many of his assumptions were the same as Klauk’s. For example,

Lloyd assumed a loan-to-value ratio of 75%, with a 6% interest rate on a 10-year

mortgage, amortized over 20 years. He also projected no appreciation in the value

of the buildings over a 10-year holding period. However, he altered one important

assumption about the equity yield rate, listing it at 13% compared to Klauk’s 16%.
                                         - 51 -

[*51] As a result of this change, Lloyd calculated a capitalization rate using the

mortgage-equity technique of 8.25%, in contrast to Klauk’s 9.20% rate.

       Weighing the national and local market rates, but relying principally on the

mortgage-equity technique, Lloyd finally chose a capitalization rate of 8.5% (in

contrast to Klauk’s final rate of 10%), which he believed was justified based on

the “lower interest rate environment at the time of valuation and the subject’s

recent renovations.”

       This single number explains a great deal of the difference in Klauk’s and

Lloyd’s analyses of 131 Allen’s before value,17 and we need to pay special

attention to it.

       A review of the record leads us to conclude that Lloyd’s analysis is more

reasonable than Klauk’s. Much of the Commissioner’s attack on Lloyd’s appraisal

springs from Lloyd’s use of 8.5% for the Properties. According to the

Commissioner, “there is no way the [Properties] can have the exact same

capitalization rates” because the North Street properties are clearly superior to 131

Allen. He bases this belief on the fact that the two “properties at issue are

significantly different in size, quality, condition, the two properties are millions of

       17
        For example, if Lloyd adopted Klauk’s capitalization rate of 10% it would
change his income approach value by $91,580. And if Klauk adopted Lloyd’s
8.5% rate it would change his income approach value by $86,635.
                                         - 52 -

[*52] dollars apart in value, and the income potential is vastly different.”

Therefore, he argues, 131 Allen must have a higher capitalization rate than the

North Street properties because it presents more risk and less return, and would

attract interest from different investors.

      Lloyd, however, credibly explained how he arrived at his conclusions.

Unlike Klauk, Lloyd “believe[d] there [was] very little risk” associated with 131

Allen in 2004 because of the recent renovations, high occupancy levels, and solid

rental income. This was in contrast to the much larger North Street properties,

which he felt presented a substantial risk to investors. According to Lloyd, there

was “a lot of risk * * * associated with larger properties in the Buffalo market” in

2004 because investors “ha[d] to keep [them] well occupied and

* * * maintain[ed].” Stated differently, although the sizes, values, and income

characteristics of the Properties differ in an absolute sense, the relative risk

associated with each is the same. We find this conclusion reasonable.

      We also have a number of concerns with how Klauk estimated his

capitalization rates. In his report Klauk selected, without any meaningful

discussion, a capitalization rate nearly 3% higher than what he found to be the

national average capitalization rate for noninstitutional apartment buildings. He

also seemingly disregarded the 9.2% capitalization rate he calculated under the
                                        - 53 -

[*53] mortgage-equity technique in favor of relying on the rates of the properties

he had chosen to include in his sales-comparison method--properties that we’ve

already found were not comparable. See supra pp. 32-35. Klauk also did not take

into account the substantial renovations made at 131 Allen, which would inflate

his capitalization rate under the mortgage-equity technique. And Klauk’s

reduction of that rate from 11% to 10% at trial, to account for the reduced risk

resulting from those renovations, was done on the fly and without meaningful

investigation. In all, we are left with the distinct sense that Klauk’s determination

of 131 Allen’s “before” capitalization rate was less a result of reasoned analysis

and more a result of his belief that it simply must be higher than the rate for the

North Street properties. We reject Klauk’s capitalization-rate analysis and adopt

Lloyd’s.

      B.     “After” Valuation

      Having analyzed the “before” valuation, we now turn to the parties’ most

strenuous disagreement--whether the easements actually reduced the Properties’

values. After all, if the easements had no appreciable effect on the Properties’

“before” values, it’s irrelevant for tax purposes what those values were. The core

of this dispute is whether the easements were redundant of the City’s preservation

laws, or whether they themselves reduced the Properties’ values.
                                        - 54 -

[*54] The Commissioner argues that the easements have no value because their

restrictions duplicate those already imposed by Buffalo’s Preservation Code. He

asserts that the Trust does not have monitoring or enforcement powers greater than

the City’s and that the Trust does not enforce the terms of the easements. He has

on his side a number of recent cases in which we held that donations to the Trust

of facade easements with similar restrictions on buildings in other historic districts

did not reduce property values. See, e.g., Chandler, 142 T.C. 279; Kaufman, T.C.

Memo. 2014-52; Scheidelman, T.C. Memo. 2013-18; Dunlap, T.C. Memo.

2012-126.

      The Kisslings respond that the easements that their company granted do

impose greater obligations--and thus costs--on the property owner than do those

imposed by the Preservation Code. They distinguish the cases cited by the

Commissioner as easements granted on personal residences, not commercial

properties. And by far their most significant argument focuses on Buffalo’s

alleged lack of enforcement of its Preservation Code at the effective date of

valuation in 2004.
                                        - 55 -

[*55]          1.   Restrictions Imposed: Easements Versus Preservation Code

        The Kisslings identify what they claim are numerous requirements imposed

by the easements that are not imposed by Buffalo’s Preservation Code. We can

summarize those alleged differences in a table:

            Issue                Terms of Easement             City of Buffalo
 Partial destruction (e.g.,   Must rebuild to match       No requirement to
  by fire)                                                rebuild; can demolish
 Maintenance
   Inspection frequency       Annual                      None to monitor
                                                          maintenance; 3-year
                                                          cycle to renew certificate
                                                          of occupancy; focus is on
                                                          life, safety, and fire code
   Standard                   Good order protecting       Good repair to prevent
                              historical and structural   deterioration
                              integrity
   Dangerous conditions       Must repair to existing     Can order demolition
                              condition
   Authority to require       Trust has power to direct   Requires order from the
    maintenance               work be done, and to        Housing Court
                              enter and perform work
                              in the event of a
                              violation of easement
                              terms
   Penalties                  Hold owner financially     Fines and imprisonment
                              accountable for costs and not enforced for
                              attorney fees, and place a preservation
                              lien
                                        - 56 -

 [*56]
   Inspection reports         Owner put on notice of      No preservation
                              current or pending          inspection reports
                              preservation
                              requirements
 Demolition                   Not permitted               Allowable on the basis
                                                          of “undue hardship”
                                                          resulting from lack of
                                                          reasonable return,
                                                          unsuitability for
                                                          reasonable use, or
                                                          prevention of purpose
 Appeals                      Not available               Preservation Board
                                                          decisions can be
                                                          appealed to Common
                                                          Council
 Durability of restrictions   Perpetual regardless of     Subject to repeal or
                              property owner              amendment
 Definition of facade         All exterior surfaces       Only the front of the
                              including all walls, roofs, building, not the roof or
                              and chimneys                sides

      The Commissioner attacks many of these alleged differences as either

untrue or of no consequence to valuation. He has the better of the argument here.

In Kaufman, T.C. Memo. 2014-52, we reviewed a Trust easement on a property in

Boston’s South End Historic District. The easement terms were very similar to

those in this case, see id. at *5-*6, and the taxpayers made many of the same

arguments for why those terms were more burdensome than the restrictions
                                        - 57 -

[*57] imposed by the historic district, see id. at *56-*62. We ultimately

determined that “the restrictive components of the preservation agreement [were]

basically duplicative of, and not materially different from” the historic district’s

preservation standards. Id. at *63; see also Chandler, 142 T.C. at 290 (“We

recognize technical differences between the easements and local law, but we agree

with respondent’s conclusion that the restrictions were practically the same”).

Given the similarity between the easement restrictions and historic preservation

standards in this case and those in Kaufman and Chandler, we are not persuaded

that the legal distinctions identified by the Kisslings would by themselves have a

material effect on the Properties’ values.

             2.     Income-Producing Versus Non-Income-Producing Properties

      The Kisslings nonetheless distinguish the Commissioner’s cases because

they all involved non-income-producing properties--in contrast with the properties

in this case--and they quote our acknowledgment in Chandler that easement

restrictions impair the value of “commercial property more tangibly than they

impair the value of residential property.” Chandler, 142 T.C. at 289.

      There is some strength to this argument. The easements at issue in Kaufman

and Chandler were all placed on single-family homes. The easement at issue in

Scheidelman was placed on a private three-family townhouse. And the easement
                                      - 58 -

[*58] at issue in Dunlap was placed on an owner-occupied condominium. In cases

that feature commercial properties, we’ve upheld valuations similar to the

Kisslings’. See, e.g., Whitehouse Hotel Ltd. P’ship, 139 T.C. 304; Dorsey, T.C.

Memo. 1990-242; Griffin, T.C. Memo. 1989-130; Losch v. Commissioner, T.C.

Memo. 1988-230.

      The problem with this argument, however, is not deciding whether the

Properties are income producing--they clearly are--but why income-producing

properties are, as a general matter, more affected by conservation-easement

restrictions than noncommercial properties. In Chandler, 142 T.C. at 289, we

summarized the reason as follows:

      Commercial property derives its value from its ability to generate
      cashflows. For commercial property, development generally
      correlates with increased future cashflows. More retail space, more
      space for tenants, and more room for customers generally increase
      profitability. Restrictions on the development of commercial property
      reduce potential for increased future cashflows and thus diminish
      value.

This is in contrast to single-family homes, whose buyers--though they don’t object

to capital gain when they sell--typically don’t do cashflow analyses when they

buy. See id. In some scenarios this must be true. If, for example, Kissling

Interests could otherwise have doubled the size of 131 Allen from 17 to 34 units
                                        - 59 -

[*59] absent the easement, the easement would have most definitely lowered the

property’s value by banning this possibly more profitable use.

      But as the Commissioner correctly points out, before Kissling Interests

granted these easements, the Properties were legally nonconforming under

Buffalo’s current zoning and there was no way to expand their sizes. Both experts

agreed that the easements had no effect on the Properties’ highest and best uses.

Lloyd, however, suggested that there may have been creative ways to expand the

Properties. According to him, Kissling Interests could have requested a zoning

variance from the City, or it could have converted the North Street properties to

senior assisted-living facilities, which would reduce the parking-space

requirements by two-thirds and thereby open a portion of the property for

additional development.

      We again think that the Commissioner has the better of the argument.

Whether the City would grant Kissling Interests a variance on the Properties is

very speculative. And whether the conversion of the North Street properties to

senior-living facilities would actually increase profitability--even if one assumes

some additional development--is also speculative and lacks any support in the

record.
                                        - 60 -

[*60] We find it more reasonable that the Properties are currently operating at

their highest and best use without the potential for significant additional

development. That the Properties produce income does not mean that the

easements reduced their values.

             3.     Buffalo’s Enforcement of Its Preservation Code

      The Kisslings’ final argument is about Buffalo’s enforcement of its

Preservation Code at the time of valuation in 2004.18 They claim that although

Buffalo had preservation standards, its economic problems made its monitoring

and enforcement of those standards ineffectual. They argue that the easements to

the Trust created a system of enforcement where none in fact had existed. The

Commissioner strenuously disagrees. According to him, preservation standards in

Buffalo are aggressively enforced, and it is the Trust that fails to enforce the terms

of its easements.

      We view this as a factual issue, and it is one that the Kisslings have the

better of on the particular facts of this case. We need to focus on the situation

when the donated easements were created back in 2004. At that time, Buffalo

      18
        We have in the past considered a city’s enforcement of its preservation
codes in highly regulated markets. See e.g., Chandler, 142 T.C. at 290; Kaufman,
T.C. Memo. 2014-52, at *56-*60; Dunlap, T.C. Memo. 2012-126, 2012 WL
1524660, at *19-*20.
                                       - 61 -

[*61] lacked the resources to record even a baseline condition of historic

properties. Without a record of what a building looked like when it became

protected by the Preservation Code, the City could not judge its deterioration year

by year. According to DPI Commissioner Comerford’s entirely credible

testimony, Buffalo still lacks such records. Almost all the witnesses agreed that

demolition-by-neglect is a bigger problem in Buffalo than demolition for new

development. And the number of inspectors who might have helped to prevent

this was slashed by the budget constraints imposed by the Buffalo Fiscal Stability

Authority. Demolition-by-neglect ran rampant at the time as speculators who had

no intention of maintaining properties bought them with hope for rising property

values sometime in the indefinite future. And even when the Preservation Board

and the DPI brought a lawsuit in Buffalo Housing Court to require enforcement of

the Preservation Code, that court would often allow demolition. All of this gives

us the distinct sense that Buffalo’s enforcement of its Preservation Code was not

proactive, but reactive; or as Comerford put it, “crisis management.”

      But we need not rely on testimony and anecdotes alone, as the City’s lack of

enforcement was borne out by the history of the Properties in this case. According

to Mahoney’s report, numerous elements of the Properties’ facades had either

substantially deteriorated or been replaced with historically inconsistent materials
                                        - 62 -

[*62] before the easements, when the Properties were subject only to the City’s

Preservation Code. These alterations, which appear to have gone completely

unnoticed by either the DPI or the Preservation Board, support a finding that in

2004 Buffalo had understandably focused its inspectors on health and safety

hazards and not on preserving its architectural legacy from better times.

      There is also the testimony and past appraisals of the experts in this case.

Lloyd credibly testified that in his more than 25 years of experience appraising

properties in Buffalo, the fact that a property is located within one of the City’s

historic districts has no impact on an appraiser’s valuation--a sentiment reiterated

in each of his appraisal reports. Klauk seemed to (possibly inadvertently) agree.

He stated in his appraisal reports that, “if this property were located in an area

* * * outside an identified historic district, the easement could conceivably be

cause for concern for a loss in value,” but as previously discussed, see supra pp.

33-34, when Klauk used the sales-comparison method he made no adjustments

even if comparable properties were outside a historic district.

      Klauk’s opinion that the easements duplicate local law and therefore do not

reduce the Properties’ values is also at odds with other appraisals he performed

near the time of the easements’ effective dates. In 2003 Klauk appraised two

avigation easements around the Buffalo airport--one for the Niagara Frontier
                                            - 63 -

[*63] Transportation Authority and the other for Budget Rent-A-Car.19 As in this

case, the purpose of Klauk’s appraisals was to provide a “damage estimate,” or

reduction in value, resulting from the easements. Despite finding in both

appraisals that “[t]he impact of the avigation easement [was] not appreciably

different than what already existed by virtue of the underlying zoning governing

the area in and around the airport,” Klauk nonetheless concluded that the

easements reduced the value of one property by 10% and the other by 5%. We

realize that avigation and facade easements impose different restrictions, but this

kind of inconsistent reasoning does affect our perception of his credibility on this

point.

         We would be less comfortable with this conclusion if the Trust also seemed

to be a paper tiger. But when Kissling Interests made alterations without first

getting the Trust’s consent, the Trust noticed the alterations and demanded a

response. The record has no evidence that the City even noticed any alterations in

the Properties’ facades. We therefore do find that the Trust’s enforcement of the

         19
              An avigation easement restricts the height of structures on the property.
                                        - 64 -

[*64] easements was much more proactive than the City’s enforcement of its

Preservation Code.20

      The City’s enforcement of its Preservation Code at the time of the

easements’ donation was largely ineffective. This means that the easements

themselves imposed material restrictions that lowered the Properties’ values. We

now have to measure that effect.

      Repairs and Maintenance. Lloyd increased this expense by 10% for 131

Allen and 20% for the North Street properties. Lloyd testified that the adjustments

were different because 131 Allen “didn’t have as much ornate detail or items that

would require replacement, reproduction[,] and/or maintenance” as did the North

Street properties. This is also reflected in Lloyd’s appraisal reports. In his North

Street Properties report, Lloyd specifically mentions that “there are ornate cast

stone and building materials which require specialized skills and knowledge.”

      20
         Even if we were to find that the Trust failed to enforce the easements’
terms, we question whether that would have any impact on the Properties’ valua-
tions. Because an easement is valued based on the information that could be
reasonably known as of its effective date, it seems improper to factor in post-
easement relations between donors and donees, unless they were foreseeable as of
that date. For the same reason, we do not credit Kissling’s testimony that manage-
ment, insurance, professional, and repair and maintenance expenses did not in-
crease after the easements. Not only is his testimony undercut by the record--for
example, Kissling Interests did perform restoration work at the request of the
Trust, see supra pp. 18-19--but we find it reasonably foreseeable to expect, as of
the effective date, that such expenses would increase after the easements.
                                        - 65 -

[*65] There is no such mention in his 131 Allen report. We find Lloyd’s increases

completely reasonable and adopt them.

      Management Fees. For each property, Lloyd estimated an increase in

management fees from 5% of effective gross income pre-easement to 6% post-

easement. He wrote that this was “[d]ue to additional requirements for compliance

with the provisions of the easement, including the management of additional

maintenance projects and costs.” We find these increases reasonable, since the

record contains numerous examples of correspondence between the Trust and

Kissling Interests discussing concerns noted by Trust inspectors during the annual

inspections. Responding to the Trust’s preservation concerns represented a

foreseeable new job duty not previously required of management. We adopt

Lloyd’s increases.

      Professional Services. Lloyd expected this expense to double from 1% to

2% of each property’s effective gross income after the easement “[a]s a result of

higher costs for engineering, architectural and legal services related to the

easement.” We have no explanation for why this expense would increase so much

post-easement, and we find it more likely than not that the increased costs for

engineering and architectural services were already included in our estimates of

increases in repairs and maintenance expense. We do find it reasonable that the
                                        - 66 -

[*66] easements could impose additional legal costs on the donor as a result of the

legal rights granted to the Trust in the event Kissling Interests violates the

easements. Therefore, we find that an increase of 0.5% of effective gross income

is appropriate.

      Reserves for Replacement. Lloyd increased this expense only for the North

Street properties “[d]ue to the ornate designs on the improvements” and because

“there can be higher anticipated expenses associated with reproduction cost versus

replacement costs.” Although 131 Allen may be less ornate than the North Street

properties, it’s unclear to us why Lloyd would not still have increased it but by a

smaller amount, as he did with the repairs and maintenance expenses. Without

further explanation from Lloyd, we don’t see any distinction between this increase

and his increase for repairs and maintenance. We therefore do not find this

increase reasonable.

      Capitalization Rate. Lloyd increased each property’s post-easement

capitalization rate by 0.75%. His reports attribute these increases to the following

factors:

      increased operating costs, higher risk due to less liquidity (limited
      market participants willing to purchase a property with a facade
      easement), limitation of utility to the site (no expansion or additional
      construction on site), potential repayment of easement value, risk of
                                        - 67 -

[*67] liens placed by easement holder and required lender subordination
      which would limit the pool of potential lenders.

      We find most of these assumptions reasonable, and we also find that these

factors, when viewed from the perspective of 2004, are attributable to the

imposition of the easements and not local law. We find it especially persuasive

that the easement’s reconstruction obligation meant that the probability of

demolition-by-neglect--a real possibility in the Buffalo of that time--was greatly

reduced. The existence of these factors is supported in part by various interviews

Klauk performed with local developers and bank officers as part of his reports. Of

the four developers Klauk interviewed, three were unfamiliar with facade

easements, one of whom “saw no real benefit to such a program in the Buffalo

area” and another who “felt it would be a program best avoided, if it involved

outside intervention.” Bank officers from Wells Fargo, M&T Bank, and

Northwest Savings Bank also said that the donation of a facade easement might

result in variations in both the loan-to-value ratio and the loan term, with one even

suggesting that he might require a personal guaranty from a prospective buyer.

Because both the loan-to-value ratio and the loan term are inputs in the mortgage-

equity technique, we find it more likely than not that the easements would change
                                          - 68 -

[*68] the resulting capitalization rates. We also adopt Lloyd’s estimates of those

increases.

IV.     Conclusion

        This table summarizes our findings as to the Properties’ values before and

after the easement:

                              131 Allen                       165 & 175 North
                   %     Before      %      After     %     Before      %       After
 Rental revenue         $101,400          $101,400         $967,260             967,260
 Laundry
  revenue                 1,326              1,326            9,984               9,984
 Beauty shop
  revenue                   ---               ---             7,860               7,860
 Gross revenue          102,726            102,726          985,104             985,104
 Vacancy &
  collection
  loss             5%    (5,136)            (5,136)   5%    (49,255)            (49,255)
 Effective gross
  income                 97,590             97,590          935,849             935,849
 Operating
  expenses:
 Real estate
  tax                     6,908              6,908           79,012              79,012
 Insurance                1,764              1,764           18,940              18,940
 Utilities               12,750             12,750          151,800             151,800
 Garbage
  removal                   595                595             ---                 ---
 Repairs/
  maintenance             5,100              5,610           27,060              32,472
 Payroll                  3,400              3,400           26,400              26,400
                                           - 69 -

 [*69]
 Cleaning &
  supplies                 1,275              1,275             27,520              27,520

 Contracted
  services                  ---                                 15,360              15,360
 Snow &
  ground care                300                300                ---
 Management
  fees             5%      4,880     6%       5,855     5%      46,792      6%      56,151
 Advertising               1,700              1,700              7,920               7,920
 Professional
  services         1%        976    1.5%      1,464     1%       9,358    1.5%      14,038
 Miscellaneous              ---                ---              10,880              10,880
 Reserves for
  replacements             3,400              3,400             28,800              28,880
 Total expenses           43,048             45,021            449,842             469,293
 Net operating
  income                  54,542             52,569            486,007             466,556
 Capitalization
  rate            8.5%             9.25%               8.5%               9.25%
 Value                   641,670            568,314           5,717,729           5,043,849

 Decrease in
  value                                     (73,356)                              (673,880)

         Based on our findings, we’ve determined that the correct total value of the

easements--and resulting deduction--to Kissling Interests is $747,236 (= $73,356

+ $673,880). Since Kissling held a 90% share of Kissling Interests profit, loss,

and capital, the Kisslings’ correct deduction is $672,512--$97,798 less than they

claimed in the aggregate on their 2004, 2005, and 2006 returns (= $770,310 !

$672,512). Because the value of the easements claimed on the Kisslings’ returns
                                      - 70 -

[*70] is only 15% more than the value that we’ve determined to be the correct

amount, the penalties under section 6662(h) do not apply.

                                               Decision will be entered under

                                     Rule 155.