No Deduction Because Easement Not in Perpetuity
The Tax Court in Palmolive Building Investors1 denied a taxpayer's charitable contribution for a facade easement on the basis that the deed granting the easement failed to satisfy the "in perpetuity" requirement of Section 170(h)(5).
Palmolive Building Investor, LLC owned a building in Chicago, Illinois. Palmolive executed an easement deed in favor of the Landmarks Preservation Council of Illinois (LPCI), an Illinois not-for-profit corporation and a qualified organization within the meaning of Section 170(h)(3). The purpose of the deed was to preserve the exterior perimeter walls of the building's facade. The deed obligated Palmolive and any subsequent owner of the building to maintain in perpetuity the facade of the building. The deed prohibited Palmolive from demolishing, removing, or altering the protected elements, from making any horizontal or vertical expansion of the building, and from performing any chemical cleaning or sandblasting of the protected elements without LPCI's permission.
At the time of the donation, the property was subject to two mortgages. Although the mortgagees each granted a subordination of their mortgage to the easement, the subordinations stated that they were subject to the terms of the easement. The easement provided that in the event the facade easement was extinguished, the mortgage holders would have claims prior to that of the donee organization to any proceeds received from the condemnation proceedings, until the mortgage was satisfied in full.
The IRS examined the tax return of Palmolive on which it claimed a charitable contribution deduction for its donation of the facade easement. Following the examination, the IRS disallowed the claimed charitable deduction on the grounds that the deed did not meet the requirements of Section 170. Palmolive petitioned the Tax Court, challenging the determination of the IRS, and both parties submitted motions for summary judgment.
Under Section 170(a)(1), a taxpayer is allowed a deduction for any charitable contribution made during the tax year. Section 170(f)(3)(A) generally disallows a charitable contribution deduction for a gift of property consisting of less than an entire interest in that property. Section 170(f)(3)(B)(iii), however, provides an exception for a "qualified conservation contribution." Section 170(h)(1) requires that a qualified conservation contribution must be a contribution: (1) of a qualified real property interest, (2) to a qualified organization, and (3) exclusively for conservation purposes.2 The IRS's motion for summary judgment addressed the third requirement-whether Palmolive's contribution of the conservation easement to LPCI was exclusively for conservation purposes.
A contribution is made exclusively for conservation purposes only if, at the time of the contribution, it meets the requirements of Section 170(h)(5). Section 170(h)(5)(A) provides that "a contribution shall not be treated as exclusively for conservation purposes unless the conservation purpose is protected in perpetuity." Reg. 1.170A-14(g)(1) provides that, in order for the conservation purpose of a donation to be enforceable in perpetuity, the interest in the property retained by the donor must be subject to legally enforceable restrictions that will prevent uses of the retained interest inconsistent with the conservation purposes of the donation.
With respect to mortgages, Reg. 1.170A-14(g)(2) provides "in the case of conservation contributions made after February 13, 1986, no deduction will be permitted under this section for an interest in property which is subject to a mortgage unless the mortgagee subordinates its rights in the property to the right of the qualified organization to enforce the conservation purposes of the gift in perpetuity."
With respect to extinguishment and extinguishment proceeds, Reg. 1.170A-14(g)(6)(i) recognizes that after the donee organization's receipt of an interest in property, an unexpected change in the conditions surrounding the property may make impossible or impractical the continued use of the property for conservation purposes, and a court may "extinguish" the conservation restrictions. Reg. 1.170A-14(g)(6)(i) provides if such circumstances occur, the conservation purpose can nonetheless be treated as protected in perpetuity if the restrictions are extinguished by judicial proceeding and all of the
donee's proceeds from a subsequent sale or exchange of the property are used by the donee organization in a manner consistent with the conservation purposes of the original contribution. Reg. 1.170A-14(g)(6) requires that, at the time of the gift, the donor must agree that the donation of the perpetual conservation restriction gives rise to a property right, immediately vested in the donee organization, with a fair market value that, at the time of the gift, is at least equal to the proportionate value that the perpetual conservation restriction bears to the value of the property as a whole.
The IRS argued that Palmolive's easement deed did not satisfy the perpetuity requirements of Section 170(h)(5)(A) and Reg. 1.170A-14(g)(6)(ii) because the deed provided that Palmolive's mortgagees had prior claims to any extinguishment proceeds in preference to LPCI and that this priority violated the requirement that LPCI have a guaranteed right to a proportionate share of future proceeds. The IRS also argued that those same provisions in the deed render the subordination insufficient to satisfy Reg. 1.170A-14(g)(2), which requires that if the underlying property of a donated conservation easement is subject to a mortgage, then that mortgage must be subordinated to the right of the donee to enforce the conservation purposes of the gift in perpetuity.
Palmolive argued that the Tax Court should follow the decision of the First Circuit in Kaufman v. Shulman,3 that expressly rejected the position taken by the IRS in this case. In the alternative, Palmolive argued that even if the deed otherwise violated the proceeds requirement of Reg. 1.170A-14(g)(6)(ii), the deed contained a saving clause that retroactively reformed the deed to comply with the regulation.
The court held for the IRS and granted its motion for summary judgment. First, the court found that the mortgage on Palmolive's property was not actually subordinated to the easement. The deed to LPCI provided that the mortgagee has a prior claim to the insurance and condemnation proceeds in preference over LPCI until the mortgage was paid off and discharged notwithstanding that the mortgage was subordinated to LPCI. The court stated that where an owner of property subject to a mortgage and covered by insurance seeks to donate a facade easement, the owner may not hold back an interest in the facade by using it as collateral for mortgage loans and exploiting insurance coverage on it to repay the owner's mortgage debt. Rather, the court stated, the mortgagee's rights in the property as collateral for its loans and its right to insurance proceeds must be subordinated to the interests of the donee charitable organization.
The provisions of the deed provided that the charitable organization would not receive any proceeds unless and until the mortgages have been fully satisfied. The court stated that receiving proceeds in the event of a condemnation is a critical right and interest of the mortgagee. If that right and interest is not subordinated, the charitable organization's property right to the proceeds is undermined, and the arrangement does not reflect an actual subordination of the mortgage.
Next, the court stated that because this case was not appealable to the First Circuit, the court was not required to follow the decision of the First Circuit in Kaufman. In addition, the court stated that it disagreed with the reasoning and holding in Kaufman and therefore declined to follow that decision.
The court also rejected Palmolive's argument based on Reg. 1.170A-14(g), which provides that a deduction for a facade easement will not be disallowed merely because the interest that passes to, or is vested in, the donee organization may be defeated by the performance of some act or the happening of some event, if on the date of the gift it appears that the possibility that such act or event will occur is so remote as to be negligible. Palmolive argued that the chances of the building being destroyed by a casualty and LPCI's not receiving its proportionate share of insurance proceeds are slim enough to render them "so remote as to be negligible."
The court found that this regulation was not an alternative provision on which taxpayers may rely if they otherwise fail to satisfy the express requirements applicable to mortgage subordination and extinguishment proceeds. The court stated that regularly occurring circumstances that are expressly foreseen and are explicitly provided for in the regulations, such as mortgages and extinguishment proceeds, are by their nature not remote, and the specific requirements in the regulations as to those contingencies must be satisfied.
Finally, the court rejected Palmolive's argument that the saving clause in the deed applied to retroactively reform the deed to comply with the regulations. The court rejected this argument because the savings clause in the deed provided that it would be applicable only if the mortgagee consented. In addition, the court stated that the savings clause could not be used to have the deed conform to the regulations because the requirements of the regulations must be satisfied at the time of the gift-not at a later date.
This case is another in a long line of recent cases brought by the IRS challenging conservation and facade easements. It is evident that the IRS views facade easements as an area of abuse and is, therefore, examining more closely returns claiming charitable contribution deductions for conservation and facade easements. Consequently, advisers must be knowledgeable of the deduction rules applicable to these easements to ensure all the requirements are satisfied. Hypertechnical compliance is the key. If there is any doubt whether a requirement is satisfied, seeking a private letter ruling may be an advisable step.
1 149 TC No. 18 (2017).
2 Reg. 1.170A-14(a) .
3 687 F.3d 21 110 AFTR2d 2012-5278 (CA-1 2012).
Frank Baldino is an estates and trusts attorney who helps people throughout the greater Washington, DC area protect assets for their families and future generations through careful estate tax planning. For more information, contact Frank at 301-657-0175 or firstname.lastname@example.org.
This article originally appeared in the February 1, 2018 edition of Estate Planning Journal, a monthly periodical with a national circulation directed to estate planning professionals such as lawyers, accountants, financial advisers, and trust officers that offers readers the newest and most innovative strategies for saving taxes, building wealth, and managing assets.