First Circuit Upholds 40% Penalty for Grossly Overvalued Historic Preservation Easement.

(Parker Tax Publishing May 8, 2015)

The First Circuit affirmed a Tax Court's ruling that taxpayers were liable for the 40 percent gross valuation misstatement penalty because they claimed a deduction for their donation of a historic preservation easement that had no value. The taxpayers were unable to avoid the penalty because, despite obtaining a qualified appraisal, they ignored signs that the valuation may have been incorrect. Kaufman v. Comm'r, 2015 PTC 132 (1st Cir. 2015).

Background

In 1999, Lorna Kaufman bought a single-family residence for herself and her husband Gordon in a historic preservation district in the South End neighborhood of Boston, MA. In 2003, she and her husband learned about a tax incentive program promoted by the National Architectural Trust (the Trust) allowing the couple to qualify for a charitable deduction if they granted the Trust a historic preservation easement on their home, which would restrict alterations to the property's facade.

The Trust recommended that the Kaufmans receive an appraisal of their easement from Timothy Hanlon, a certified professional appraiser who frequently worked with the Trust. Hanlon estimated that the burdens imposed by the grant of the easement would reduce the property's fair market value by 12 percent, and calculated the value of the easement to be $220,800.

Concerned that the reduction in the resale value of the property from the easement would outweigh the tax savings from the donation, the Kaufmans contacted Mory Bahar, a representative of the Trust. Bahar told the Kaufmans that he did not anticipate the easement would reduce the value of the property because properties in the historic preservation district were already subject to restrictions on alterations. The taxpayers were skeptical of Bahar's opinion, given his interest in convincing the couple to donate the easement.

Nonetheless, the Kaufmans decided to go forward with the easement donation. They spread the $220,800 deduction over 2003 and 2004, deducting $103,377 in 2003 and taking a carryover charitable contribution deduction of $117,423 in 2004. In 2009, the IRS issued deficiencies and penalties, disallowing the deductions and imposing a 40 percent gross valuation misstatement penalty.

The Kaufmans petitioned the Tax Court, which upheld the IRS's disallowance, holding that the easement was invalid as a matter of law because the conveyance did not comply with enforceability requirements in relevant regulations. The Kaufmans then appealed to the First Circuit, which found that the Tax Court erred in its evaluation of the regulations' enforceability requirements and vacated the decision.

On remand, the Tax Court found that the easement's value was zero. The court rejected Hanlon's appraisal methodology, instead finding the testimony of the IRS's expert persuasive. The IRS expert testified that the donation of the facade easement would not result in a diminution in property value, concluding that the easement was worthless. The tax court sustained the IRS's disallowance of the Kaufmans' charitable deduction and found the taxpayers liable for a 40 percent penalty for a gross valuation misstatement.

The Kaufmans again appealed to the First Circuit, challenging the Tax Court's finding that they were liable for the gross valuation misstatement penalty, but did not appeal the court's finding that the actual value of the easement was zero.

Analysis

A 20 percent accuracy-related penalty generally applies to any portion of an underpayment of tax that is attributable to a substantial valuation misstatement (Code Sec. 6662(a)). The penalty is increased to 40 percent in the case of a gross valuation misstatement, defined as an overstatement of 400 percent or more of the true value of any property claimed on a return (Code Sec. 6662(h)(1)). The value claimed on a return of any property with a correct value of zero is considered to be 400 percent or more of the correct amount, triggering the 40 percent gross valuation misstatement penalty (Reg. Sec. 1.6662-2(c)). There are exceptions to these penalties where the underpayment does not exceed a certain amount or where the taxpayer had reasonable cause and acted in good faith.

In the case of a substantial or gross valuation misstatement with respect to charitable deduction property, the reasonable-cause-and-good-faith exception does not apply unless the taxpayer can show that:

(1) the claimed value of the property was based on a qualified appraisal made by a qualified appraiser; and

(2) in addition to obtaining such appraisal, the taxpayer made a good-faith investigation of the value of the contributed property (Code Sec. 6664(c)(2)).

The Tax Court had found the Kaufmans liable for a 40 percent penalty for a gross valuation misstatement because the true value of the facade easement was zero. The tax court further determined that the "reasonable cause" exception did not apply because, although the reported value of the easement was based on a qualified appraisal made by a qualified appraiser, the Kaufmans had not made a good faith investigation of the easement's value.

The First Circuit Court agreed with the Tax Court's findings that the Kaufmans should have recognized obvious warning signs indicating that the appraisal was subject to serious question, and should have undertaken further analysis in response. After receiving Hanlon's appraisal, the taxpayers, expressly concerned that the easement might hurt the market value of the house, contacted Bahar for reassurance, and Bahar unequivocally told them that he did not expect the easement would decrease the home's value. The circuit court commented that this should have immediately raised red flags as to whether the value of the easement was zero, but the Kaufmans instead chose to move forward with the donation.

The Kaufmans argued that obtaining a qualified appraisal automatically constituted a good-faith investigation. The circuit court disagreed, however, noting that Code Sec. 6664(c)(2) explicitly sets forth two separate requirements that must be met in order for the reasonable cause exception to apply to a gross valuation overstatement. The court stated that the Kaufmans' reading of the statute would make the second requirement meaningless, violating the rule of statutory interpretation that no clause be rendered superfluous.

The circuit court also noted that simply obtaining an appraisal is not the same as reasonably relying on that appraisal, and determined that although the Kaufmans obtained a qualified appraisal, other facts, such as Bahar' evaluation that the easement restrictions were similar to local zoning restrictions, should have alerted them that it was not reasonable to rely on that appraisal.

Because the First Circuit agreed with the Tax Court's analysis, finding no clear error, the court upheld the imposition of the 40 percent gross valuation misstatement penalty.

For a discussion of charitable easement contributions, including for historical preservation purposes, see Parker Tax ¶84,155.25. (Staff Editor Parker Tax Publishing)

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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