Accuracy-Related Penalty for Worthless Facade Easement
The First Circuit Court of Appeals, in Kaufman,1 affirmed a decision of the Tax Court imposing a 40% accuracy-related penalty on taxpayers who claimed a charitable deduction for a facade easement. While the taxpayers obtained a qualified appraisal from a qualified appraiser, the court found that the true value of the easement, and therefore the charitable contribution, was zero. In affirming the imposition of the penalty, the court found that the taxpayers had not made a good faith investigation of the easement's value and were required to do some basic inquiry into the reasonableness of the appraisal once they became aware of evidence that contradicted that value set forth in the appraisal.
In 1999, the Kaufmans bought a home in Boston that was subject to certain zoning restrictions since it was located in a historic preservation district. In 2003, the Kaufmans granted a conservation easement in perpetuity on the property to the National Architectural Trust that limited the extent to which the property could be altered.
As part of the transaction of granting the easement, the Kaufmans sent a letter to their mortgage lender asking the bank to subordinate its mortgage on the property to the Trust's easement. The letter stated that "the easement restrictions are essentially the same restrictions as those imposed by current local ordinances that govern this property." At trial, the Kaufmans testified that they did not notice that sentence of the letter and that they thought that the restrictions contained in the easement were "much tougher" than the restrictions contained in the local zoning ordinances, but they did not actually compare the two restrictions.
In order to obtain a charitable deduction for the donation of the easement, the Kaufmans were required to obtain an appraisal of the fair market value of the easement. The appraiser used the before-and-after method of valuation of the easement which involved determining the difference between the fair market value of the property prior to the donation of the easement and the fair market value of the property after the donation of the easement. The appraiser determined that the easement reduced the fair market value of the property by 12% and, therefore, calculated that the value of the easement was approximately $220,000. The Kaufmans provided their accountant with a copy of the appraisal. The accountant testified at trial that he offered the Kaufmans no opinion regarding whether the value of the easement was reasonable.
After receiving the appraisal, the Kaufmans sent an email message to a representative of the Trust since they were concerned whether "the reduction in resale value of the property due to the easement would be so large as to overwhelm the tax savings that accrue from it." The representative of the Trust replied and in part stated:
In areas that are regulated by local historic preservation ordinances and bodies such as Boston historic neighborhoods (including yours) the property owners are not allowed to alter the facade of their historic buildings, whether there is an easement or not.... Therefore, properties with an easement are not at a market value disadvantage when compared to the other properties in the same neighborhood. But if the district is not being regulated and historic preservation is not being enforced then the presence of the easement will be viewed negatively by those buyers who would want to change the facade or demolish the building.
In March 2007, the IRS opened an investigation of the Kaufman's claimed charitable deduction. At the conclusion of the investigation, the IRS issued a deficiency and accuracy-related penalties. The Kaufmans petitioned for review by the Tax Court and the court found that the contribution failed to comply with the requirement of Reg. 1.170A-14(g) that the easement be enforceable in perpetuity since the pre-existing mortgage on the property would entitle the bank, rather than the Trust, to condemnation proceeds upon the happening of certain events. Since the Tax Court did not have to decide the issue regarding the valuation of the easement, the court did not impose any accuracy-related penalty on the Kaufmans.
The Kaufmans appealed the decision of the Tax Court to the First Circuit Court of Appeals. The First Circuit disagreed with the Tax Court's interpretation of Reg. 1.170A-14(g) and therefore vacated the opinion of the Tax Court, and remanded the case back to the Tax Court.
On remand, the Tax Court found that the value of the easement was zero because local zoning ordinances contained stringent enough restrictions that the easement did not result in any diminution in value of the property. In addition, the Tax Court held that the Kaufmans were liable for a 40% accuracy-related penalty for making a gross valuation misstatement.
Furthermore, the Tax Court held that the Kaufmans did not qualify for the reasonable cause exception since they had not made a good faith investigation of the easement's value. The Tax Court stated that "there is no evidence that, other than consulting the representative of the Trust, who in fact told them that the donation of the easement would not reduce the value of their home, the Kaufmans made any independent investigation of the value of the facade easement, much less an investigation confirming that its value was the value they reported on their return. The Kaufmans appealed the decision of the Tax Court regarding the accuracy-related penalties, but they did not appeal the Tax Court's decision that the actual value of the easement was zero.
The Appeals Court began its analysis by setting forth the law regarding accuracy-related penalties. Section 6662 imposes a penalty equal to 20% of any underpayment of income tax due to either negligence or disregard of rules or regulations, any substantial understatement of income tax, or any substantial valuation misstatement. Section 6662(h) provides that in the case of a "gross valuation misstatement," defined as a 400% or more overstatement of the value of any property claimed on a tax return, the penalty is increased to 40% of the underpayment. Reg. 1.6662-5(g) provides that "the value claimed on a return of any property with a correct value of zero is considered to be 400% or more of the correct amount," and the applicable penalty is 40%.
There are exceptions to the imposition of penalties. Section 6664(c) sets forth a "reasonable cause exception" for underpayments. It provides, in relevant part:
- In general. No penalty shall be imposed with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.
- Special rule for certain valuation overstatements. In the case of any underpayment attributable to a substantial or gross valuation overstatement with respect to charitable deduction property, paragraph (1) shall not apply unless-
(A) the claimed value of the property was based on a qualified appraisal made by a qualified appraiser, and
(B) in addition to obtaining such appraisal, the taxpayer made a good faith investigation of the value of the contributed property.
Reg. 1.6664-4(b)(1) provides that the determination of whether a taxpayer acted with reasonable cause and in good faith is made case by case, taking into account all pertinent facts and circumstances, including, among other things:
- The taxpayer's experience, knowledge, and education.
- Whether the taxpayer relied on an appraisal, and if so, whether such reliance was reasonable and in good faith.
- Whether the taxpayer relied on information in a W-2 or other tax form, provided that the taxpayer did not know or have reason to know the information was incorrect.
Next the court set forth the law regarding the standard of review to be applied in reviewing the decision of a lower court. The standard of review that applies in reviewing decisions of lower courts is that factual findings by the lower court are accepted except where clear error is found and legal rulings are reviewed do novo. The court stated that the determination of whether a taxpayer is liable for an accuracy-related penalty is a factual determination made by the lower court and therefore would be reversed only if such a decision was found to be clear error.
After a careful review of the record, the court concluded that the evidence presented at trial clearly supported the findings of the Tax Court that the Kaufmans failed to make a good faith investigation into the value of the easement. The court noted that after the Kaufmans received the appraisal, they became concerned that the easement might hurt the market value of the house and contacted a representative of the Trust. That representative assured them that the easement would not affect the value of the house. The court believed that this communication from the representative of the Trust should have raised red flags with the Kaufmans regarding whether the value of the easement was zero.
In addition, the court pointed to the letter signed by the Kaufmans and sent to their mortgage lender that stated that the restrictions contained in the easement were the same as those already in place on the house by reason of local zoning ordinances. Neither the Tax Court nor the appeals court expected the Kaufmans to be able to critically review the appraisal. However, both courts found that the Kaufmans should have recognized obvious warning signs indicating that the appraisal's validity was subject to serious questions, and that they should have undertaken further analysis in response.
The court rejected the Kaufmans' assertion that they must have acted in good faith because they relied on their accountant who reviewed the appraisal and expressed no reservation about the Kaufmans taking a deduction for the easement. At trial, however, the accountant testified that he offered the Kaufmans no opinion on whether the easement valuation was reasonable.
Probably the most important lesson to be learned from this case is that in preparing an appraisal report for a facade easement, it is imperative that the report seriously evaluate any existing zoning restrictions applicable to the property. The appraiser may very well need to work with a local land use and zoning attorney so as to fully understand the applicable zoning rules and regulations and to take them into account in preparing the appraisal report. That does not appear to have been done in this case. The case also illustrates that an appraisal alone is not enough when other extrinsic factors suggest it is flawed.
1 115 AFTR 2d 2015-1629 784 F3d 56 2015-1 USTC ¶50280 (CA-1, 2015).
Frank Baldino is an estate planning attorney who co-chairs Lerch, Early & Brewer’s Estate Planning & Probate group in Bethesda, Maryland. His focus is on protecting the assets his clients have accumulated and minimizing federal and state tax liability. These clients range from homeowners whose property has appreciated to people with significant investment, retirement, business, and real estate holdings. For more on charlitable deductions, contact Frank at (301) 657-0175 or firstname.lastname@example.org.
This article originally appeared in the August 2015 edition of Estate Planning, a monthly periodical directed to estate planning professionals that offers readers the newest and most innovative strategies for saving taxes, building wealth, and managing assets.