Partnership Can't Deduct Contribution of Remainder Interest in Property to University

(Parker Tax Publishing July 2017)

The Tax Court held that a partnership was not entitled to a deduction for the charitable contribution of a remainder interest in real property because it failed to substantiate the value of the property on its tax return. The partnership was liable for a gross valuation misstatement penalty because its valuation of the property exceeded the correct value by more than 400 percent and the partnership did not have reasonable cause for the misstatement. RERI Holdings I, LLC v. Comm'r, 149 T.C. No. 1 (2017).

Background

In March 2002, RERI Holdings I, LLC (RERI) paid $2.95 million to acquire a remainder interest in land and a web hosting facility in Hawthorne, California (Hawthorne property). The Hawthorne property, consisting of 288,000 square feet, was leased in 2000 by its then owner, Intergate.LA II LLC (Intergate) to AT&T Corp. The annual rent ranged from approximately $3.8 million to $5.6 million. In 2001, Red Sea Tech I, Inc. (Red Sea) acquired the Hawthorne property from Intergate.

Red Sea assigned to RS Hawthorne, LLC (Hawthorne) its interest in the property in 2002. Hawthorne then acquired the property from Intergate, subject to the AT&T lease, for approximately $42 million. Hawthorne financed the acquisition with a bank loan of approximately $43.6 million. An appraisal for the bank valued the property at $47 million as of August 16, 2001, based on a discounted cash flow analysis.

Hawthorne's sole member at the time of the acquisition was RS Hawthorne Holdings, LLC (Holdings). Red Sea was the sole member of Holdings. After Hawthorne acquired the property, Red Sea assigned its member interest in Holdings to RJS Realty Corp. (RJS) but kept an estate for years in the Hawthorne property with a scheduled expiration in December 2020. RERI purchased the remainder interest from RJS in March 2002 for $2.95 million. Under the agreement, Holdings continued to own all of the beneficial interest in Hawthorne, and Hawthorne continued to own the property.

In August 2003, RERI assigned the remainder interest to the University of Michigan. The assignment of the remainder interest included no language to the effect that Holdings continued to own the sole member interest in Hawthorne and Hawthorne continued to own the property. However, a transfer by Holdings of its interest in Hawthorne or of the property would have breached conditions provided in the assignment that created the remainder interest. RERI's assignment to the university identified the transferred property as the remainder interest rather than a fee simple interest in the sole member interest in Holdings. Therefore, on the date of the assignment, Holdings continued to own the sole member interest in Hawthorne, and Hawthorne continued to own the property. Holdings had no material liabilities as of the date of the assignment to the university, and Hawthorne had no material liabilities other than its obligation under the bank loan.

RERI had an appraisal of the remainder interest prepared in September 2003. The appraisal valued the Hawthorne property at $55 million and applied an actuarial factor in order to determine the investment value of the remainder interest. RERI claimed a deduction of approximately $33 million on its 2003 tax return. The amount of the deduction equaled the appraiser's investment value, increased by appraisal and professional fees. RERI attached to its return a Form 8283, Noncash Charitable Contributions, with an appraisal summary. The Form 8283 showed no amount in the space provided for RERI's cost or other adjusted basis in the remainder interest.

The IRS audited RERI and issued a final partnership administrative adjustment (FPAA) in 2008. The FPAA reduced RERI's deduction for the remainder interest on the ground that the contributed property was worth only $3.9 million. A substantial valuation misstatement penalty under Code Sec. 6662(e)(1) was also applied. RERI filed a petition for readjustment of partnership items with the Tax Court in April 2008. In response, the IRS asserted that RERI was not entitled to any deduction for the contribution because it was part of a sham transaction or lacked economic substance. Alternatively, the IRS argued that the deduction should be limited to approximately $1.9 million, the amount which the university realized when it sold the contributed property. The IRS also stated that RERI's claimed deduction resulted in a gross valuation misstatement under Code Sec. 6662(h)(2).

Analysis

Under Reg. Sec. 1.170A-13(c), a charitable donation of property worth more than $5,000 must be substantiated with a fully completed appraisal summary which provides, among other things, the cost or other basis of the donated property. A taxpayer may substantially comply with these requirements if the filings provide enough information for the IRS to evaluate the reported contributions and be alerted to a potential overvaluation. An accuracy related penalty applies under Code Sec. 6662 if an underpayment of tax is due to a substantial or gross valuation misstatement. The substantial valuation misstatement penalty applies if the reported value or basis is 200 percent or more of the correct value or basis. The gross valuation misstatement penalty applies if the claimed value or basis is 400 percent or more of the correct amount. Under Code Sec. 6664(c), a reasonable cause exception applies if a charitable deduction is supported by both a qualified appraisal and a good faith investigation of the value of the contributed property.

The Tax Court held that RERI was not entitled to a charitable deduction because it failed to report its basis in the Hawthorne property on the Form 8283 submitted with its 2003 tax return as required by Reg. Sec. 1.170A-13(c)(2). It also found that RERI was liable for a gross valuation misstatement penalty and that the reasonable cause exception provided in Code Sec. 6664(c) did not apply.

In order to determine whether RERI's liability for either the substantial or gross valuation misstatement penalty under Code Sec. 6662 applied, the Tax Court had to determine the fair market value of the remainder interest as of the date of the contribution to the university. First, the court found that the remainder interest should be valued based on all of the facts and circumstances and not by reference to the standard actuarial factors provided in Code Sec. 7520. According to the Tax Court, because of the limitation on remedies available to the holder of the remainder interest for breaches of protective covenants, the agreement that created the remainder interest did not provide adequate protection to its holder for purposes of Reg. Sec. 1.7520-3(b)(2)(iii). Therefore, the Code Sec. 7520 actuarial factors did not apply and the value of the interest was its actual fair market value, determined without regard to Code Sec. 7520, on the basis of all the facts and circumstances.

The Tax Court determined that, based on the facts and circumstances, the fair market value of RERI's remainder interest in the property on the date of the contribution was approximately $3.4 million. The court calculated the present value of the remainder interest by projecting the cash flows from the property after 2020 and applying a discount rate that reflected the investment risk in the property and the long term applicable federal interest rate for August 2003. Having determined the value, the Tax Court held that RERI's claim of a charitable contribution of approximately $33 million therefore resulted in a gross valuation misstatement because it exceeded the correct value by more than 400 percent. The underpayment of tax resulting from the disallowance of RERI's charitable deduction was attributable to a gross valuation misstatement, according to the Tax Court, to the extent that it reflected the excess of the $33 million value RERI claimed for the remainder interest over the $3.4 million value determined by the court.

RERI's argument that it had reasonable cause for the underpayment was rejected by the Tax Court. In the court's view, RERI did not have good cause for, or act in good faith because RERI's appraisal was based on the February 2002 sale of the Hawthorne property, which was 18 months before the August 2003 assignment to the university. The Tax Court concluded that such a valuation was not sufficient as a matter of law to qualify as a good faith investigation into the value of the property at the time of the gift. Therefore, regardless of whether RERI had relied on a qualified appraisal, it did not meet the requirements for the reasonable cause exception.

For a discussion of the substantiation requirements for noncash contributions over $5,000, see Parker Tax ¶84,190. For a discussion of the accuracy related penalty for substantial or gross valuation misstatements, see Parker Tax ¶262,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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