07/07/2014 03:49 pm ET Updated Sep 06, 2014

The IRS Challenges Tax Deductions for Facade Conservation Easements

Conservation easements preserve ecosystems, open spaces, and appearances. Almost all states have legislation allowing a landowner to donate or sell described developmental rights to entities such as land trusts or government. When donated, a taxpayer may seek a charitable tax deduction. Three June 2014 court decisions illustrate successful IRS challenges to the taxpayer's claimed value of a donated facade (street face) conservation easement.

A federal Court of Appeals for the Fifth Circuit case involved a conservation easement for the facade of a historic New Orleans building (Whitehouse Hotel Limited Partnership v. Commissioner of Internal Revenue). The property owner claimed a $7.445 million charitable contribution deduction but the IRS allowed a deduction of $1.15 million and also assessed a penalty for the underpayment of tax. There was conflicting testimony of real estate appraisers before the Tax Court. In brief summary, the Fifth Circuit upheld the Tax Court's rejection of the reproduction cost and income valuation methods of appraising the historic conservation easement. The proper valuation method considers comparable sales with the conservation easement valued at $1,857,716. Since the taxpayer had in good faith relied upon the advice of tax professionals, no underpayment penalty would be assessed.

A U.S. Tax Court decision considered exterior and interior conservation easements for a historic mosque in Denver (Seventeen Seventy Sherman Street, LLC v. Commissioner of Internal Revenue). The current owner wanted to develop condominium units on the property and granting the conservation easement was one way of obtaining regulatory approval for this project. After consulting an appraiser and tax professional, the owner claimed a charitable tax deduction of $7.150 million. The IRS disallowed the entire deduction and assessed an underpayment penalty. In brief summary, the Tax Court upheld the IRS because the taxpayer had not listed all of the consideration that it received in exchange for the conservation easement as tax regulations require. The regulatory approval and related variance that were granted impacted the value of the property. The Court upheld a tax penalty for negligent disregard of the regulations.

A federal Court of Appeals for the Second Circuit opinion addressed a facade conservation easement for a Brooklyn townhouse (Scheidelman v. Commissioner of Internal Revenue). The owner paid $255,000 for the townhouse and claimed an appraised charitable deduction of $115,000. The Second Circuit upheld a Tax Court determination that the easement did not diminish the fair market value of the property. Hence, no deduction was allowed. The appraisal had numerous flaws including the determination of a percentage reduction in the townhouse's value based upon unrelated IRS cases. The conservation easement in fact had no impact on the fair market value of the townhouse.

As these decisions illustrate, conservation easement deductions are a technical area of tax law. Conservation easements generally have many desirable features. However, they are typically perpetual and restrict the uses of the property by both current and future owners. A related challenge is determining precisely what entity will hold and enforce the terms of the easement. Someone must monitor compliance by examining the property. This is a long-term responsibility. Do "outsiders" have the legal right (standing) to challenge non-compliance with the terms of the conservation easement? When they are created, all existing title and mortgage holders, or anyone else with a legal interest in the property, must agree to be subordinate to the terms of the easement. If and under what circumstances an easement may be terminated is equally complex. Charitable tax deductions have been controversial for many years.

The detailed statutory and regulatory requirements to successfully create a conservation easement and claim a charitable tax deduction for it are beyond the scope of this brief comment. Consequently, always consult an experienced attorney, tax professional, and appraiser of conservation easements before acting.