Tax Court Rejects Valuations of Conservation Easement
Trout Ranch, LLC, TC Memo 2010-283, RIA TC Memo 2010-283, 100 CCH TCM 581
In Trout Ranch, LLC, 1 the Tax Court rejected both the taxpayer's and the Service's valuation reports regarding a conservation easement and arrived at its own valuation.
The taxpayer was a limited liability company that elected to be taxed as a partnership. The LLC owned 454 acres of land in Colorado. The LLC sought to create 21 residential lots, in addition to a lot for a clubhouse, and exclusive shared amenities—including a guest house, fishing, a riding arena and stable, ponds, a boathouse, duck blinds, and an archery range. The LLC donated a conservation easement encumbering 388 acres to a land trust. The conservation easement allowed the construction of three open horse shelters, three duck blinds, two corrals, three ponds with docks, a tent platform, and a skeet trap wobble deck on land the conservation easement encumbered. The remaining 66 acres were divided into 21 residential lots and one lot for the clubhouse, with each lot being three acres. On its tax return, the LLC claimed a charitable contribution of approximately $2,180,000 for the contribution of the conservation easement. The IRS issued a notice of deficiency, allowing a charitable contribution for the conservation easement of only $485,000. The Tax Count permitted the IRS to amend its answer to disallow the entire charitable contribution.
Section 170 allows a deduction for charitable contributions. In general, Section 170(f)(3) denies a deduction for a charitable contribution of an interest in property that is less than the taxpayer's entire interest in the property. Section 170(f)(3)(B)(iii) , however, provides an exception to that general rule for a qualified conservation contribution. The IRS conceded that the donation of the conservation easement in this case was a qualified conservation contribution. The only issue before the court was the value of the donation.
Reg. 1.170A-14(h)(3)(i) states in pertinent part:
The value of the contribution under Section 170 in the case of a charitable contribution of a perpetual conservation restriction is the fair market value of the perpetual conservation restriction at the time of the contribution. * * * If there is a substantial record of sales of easements comparable to the donated easement (such as purchases pursuant to a governmental program), the fair market value of the donated easement is based on the sales prices of such comparable easements. If no substantial record of market-place sales is available to use as a meaningful or valid comparison, as a general rule (but not necessarily in all cases) 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.
The two IRS appraisers both determined independently that the conservation easement was worth nothing. Both appraisers determined the value of the conservation easement applying the income approach before and after the imposition of the conservation easement. The income approach of valuing real property involves discounting to present value the expected cash flows from the property.
The taxpayer's appraiser determined that the conservation easement was worth $2.2 million. The original report of the taxpayer's appraiser determined the value of the conservation easement by calculating the value of the property before the imposition of the conservation easement using sales of similar properties and then estimating the percentage by which the conservation easement likely decreased the value of the property. The taxpayer's appraiser calculated that percentage by dividing the sale prices of encumbered property by the contemporaneous sale prices of similar unencumbered property.
To correct certain errors in his original report and to provide two additional estimates of the value of the conservation easement (using the sales comparison analysis and the income approach), the taxpayer's appraiser later produced for trial a supplemental report. His ultimate conclusion regarding the value of the conservation easement remained the same.
The court rejected the comparable sales analysis of the taxpayer's appraiser. The court found that three of the conservation easements he relied on in his report restricted development rights to a much greater extent than the restrictions contained in the conservation easement granted by the taxpayer:
- In the first comparable sale used by the taxpayer's appraiser, the conservation easement restricted development from four residential lots to none (a reduction of potential development of 100%).
- The second comparable restricted development from nine residential lots to one lot (a reduction of potential development of 89%).
- The third comparable restricted development from 27 residential lots to one lot (a reduction of potential development of 96%).
The court stated that in all three instances, the conservation easements all but eliminated residential development. In contrast, the taxpayer's conservation easement restricted development from at least 40 residential lots to 22 lots (a reduction in potential development of 45%).
With respect to the fourth comparable conservation easement relied on by the taxpayer's appraiser, the court found that the easement restricted all development across a block of 315 acres, while the taxpayer's conservation easement restricted the land surrounding the river but was designed to allow the LLC to develop the entire parcel. Thus the court found that the two conservation easements had greatly different effects on the surrounding land. The court therefore concluded that the use of the income approach to value the property before and after the donation of the easement was the proper method to be used.
While both of the reports of the two appraisers for the IRS as well as the report of the taxpayer's appraiser used the income approach, the court found none of the three reports entirely convincing. Therefore, the court constructed its own discounted cash flow analyses to calculate the value of the property before and after the donation of the easement. The factors the court used in its income approach included:
- The total number of lots (40 before and 21 after the donation of the easement).
- The price of each lot ($200,000 per non-river lot and $350,000 per river lot before and $490,000 per lot after the donation of the easement).
- The absorption rate (i.e., the number of lots that would be sold each year).
- 10% annual appreciation in the price of the lots until all the lots were sold.
- The actual expenses incurred by the LLC in developing the property.
- Annual marketing and advertising expenses of 10% of gross sales revenue.
- Sales commissions and expenses of 8% of gross revenue.
- The developer's profit of 15%.
Applying these factors, the court concluded that the value of the property was $4.5 million before the conservation easement and $3.89 million after the conservation easement. Thus, the value of the conservation easement was the difference of $560,000.
This case illustrates the importance of a sustainable and defensible appraisal. An appraisal that does not withstand a challenge by the IRS can be costly in terms of taxes, interest, penalties, and additional professional fees incurred during the course of the audit and appeals process—as well as litigation costs. In addition, to some extent, the anticipated tax savings from the planned charitable contribution of the conservation easement was incorporated into the business model for the development. With a significant portion of those tax savings disallowed by the Tax Court, the assumptions underlying the business model may have materially changed and adversely affected the profitability of the development and its profit margin.
The Tax Court seemed to arrive at a compromise valuation—probably concluding that the taxpayer did not give up much, but gave up something of value.
1 TC Memo 2010-283 , RIA TC Memo ¶2010-283 , 100 CCH TCM 581.
Frank Baldino is an attorney at Lerch, Early & Brewer in Bethesda, Maryland who practices in the areas of estate planning and probate administration and who co-chairs the firm's Estate Planning and Probate Group. He has extensive experience in the areas of estate planning, charitable giving, estate planning for non-U.S. citizens, tax planning with respect to retirement plans and stock options, asset protection planning, business succession planning and estate and trust administration. Frank may be contacted at 301-657-0715 or email@example.com.