Back in early June, we discussed the latest in a string of cases in which the IRS successfully attacked a taxpayer’s charitable deduction for failing to properly substantiate the contribution. From our earlier write-up:
During 2004, Steve and Rory Rothman executed a conservation deed of easement to the National Architectural trust, a donee that likely doomed the taxpayers from the start. The Rothmans engaged Mitchell, Maxwell & Jackson, Inc. (MMJ) to perform the qualified appraisal supporting the contribution. (For more on the qualified appraisal rules, see here).
This is where the problem started.
In determining the value of the conservation easement, MMJ set out to perform a “before and after valuation,” a commonly accepted methodology. This required MMJ to first determine the value of the Brooklyn home without the easement, then the value of the home after the easement, with the reduction in value representing the value of the conservation easement.
In attempting to value the home with the easement, MMJ looked to a series of previous court cases that generally valued the loss in value caused by a conservation easement at 10-15% of the total value. MMJ then “backed in” to the loss in value of the Brooklyn property, multiplying the $2.6M “before” value by 11.5% to determine a value for the conservation easement of $290,000.
The IRS denied the charitable contribution deduction, and the Tax Court upheld the deduction. Relying heavily on its 2010 decision in a case with similar facts called Scheidelman – in which MMJ was also the appraiser — the Tax Court held that MMJ merely estimated the value of the conservation easement by applying a set percentage to the property’s “before” value. In both cases, this percentage was not determined through a detailed analysis of the easement’s terms and covenants relative to the specific contribution, but rather on a review of previously approved relative values of conservation easements to gross values. This, the court determined, did not constitute a valuation method approved under I.R.C. § 170 for determining the property’s “after” value, and thus the Tax Court agreed with the IRS that the appraisal failed to contain the required method of valuation.
Similarly, the court sided with the IRS that the appraisal did not include the specific basis for the valuation. While MMJ ‘s appraisal generally cited elements that may affect the value of eased properties, it never expounded upon how, if at all, the factors affected the fair market value of the encumbered Brooklyn property. Thus, the appraisal did not specifically mention what restrictions supported the proffered 11.15% reduction in value.
Four days after the Tax Court published Rothman, the Court of Appeals for the Second Circuit ruled on the taxpayers appeal in Scheidelman, holding that MMJ’s appraisal in that case did indeed satisfy the “method and basis for valuation” requirements of Section 170 [see a great write-up on the appeals court decision here.] The taxpayers in Rothman immediately filed with the Tax Court to vacate its previous decision, since Rothman would also be appealable to the Second Circuit.
In response, the Tax Court agreed to vacate the portion of Rothman concluding that the appraisal was not qualified because it lacked a valuation method and a specific basis for the underlying value. a victory for the taxpayer.
It wasn’t all good news for the Rothman taxpayers, however. Unlike the taxpayer in Scheidelman, there were initial defects in the Rothman appraisal that prevented it from meeting the definition of a qualified appraisal. From our initial post:
Citing numerous other missed appraisal requirements — for example, the appraisal was performed more than 60 days prior to the contribution – the court concluded that the appraisal was not a “qualified appraisal,” and denied the full deduction.
In reconsidering its initial decision in Rothman, the Tax Court remained steadfast in its belief that these deficiencies continue to doom the appraisal:
The cumulative effect of the defects discussed in Rothman… deprives the Internal Revenue Service of sufficient information to evaluate the deductions claimed. The appraisal describes (and values) a property right different from the one petitioners contributed, and in doing so, fails to describe the easement accurately or in sufficient detail for a person unfamiliar with the property to ascertain whether the appraised property and the contributed property were one and the same…Moreover, the appraisal values a property interest greater than the one petitioners contributed, and it applies the wrong measure of value. Against this backdrop, even when we view the appraisal in the light of the Court of Appeals’ decision in Scheidelman, we decline to conclude the appraisal is qualified…[the court originally ruled that] the appraisal failed to satisfy 10 of 15 regulatory requirements, and following reconsideration, we conclude that the appraisal still fails to satisfy 8 of 15 requirements.
So what happens now? The Rothman’s failure to meet the appraisal requirements is not deadly, because the charitable contribution deduction can still be allowed if the failure was due to reasonable cause and not to willful neglect, an issue the Tax Court must now reconsider in a future trial.