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Tax Court Upholds Denial of Conservation Easement Deduction

(Parker Tax Publishing May 2020)

The Tax Court held that a conservation easement did not satisfy the protected-in-perpetuity requirement in Code Sec. 170(h)(5)(A) and Reg. Sec. 1.170A-14(g)(6) because the easement deed provided that, in the event the property were sold following a judicial extinguishment of the easement, (1) the donee organization would be entitled to proceeds based on a fixed historical value of the conservation area rather than a proportionate share of the proceeds, and (2) the donee's proceeds would be reduced by the value of any improvements made by the donor. In a separate opinion, the Tax Court upheld the validity of Reg. Sec. 1.170A-14(g)(6) as a permissible interpretation of Code Sec. 170(h)(5)(A). Oakbrook Land Holdings, LLC v. Comm'r, T.C. Memo. 2020-54; Oakbrook Land Holdings, LLC v. Comm'r, 154 T.C. No. 10 (2020).


In 2007, Oakbrook Land Holdings, LLC, a real estate development company, purchased 143 acres of undeveloped land near Chattanooga, Tennessee. In 2008, Oakbrook donated a conservation easement over 106 acres of the property to the Southeast Regional Land Conservancy (SRLC), a qualified organization under Code Sec. 170(b)(3).

The easement deed contained an extinguishment provision that specified how Oakbrook and SRLC would divide the proceeds if changed circumstances made it impossible at some point in the future to protect the conservation area and the property was sold following a judicial extinguishment of the easement. The deed stated that the fair market value (FMV) of SRLC's interest in the easement was the difference between the value of the conservation area as if not burdened by the easement and the value of the conservation area burdened by the easement, less the value of any post-donation improvements made by Oakbrook in the conservation area.

On its 2008 tax return, Oakbrook claimed a charitable contribution deduction of $9,545,000 for its donation of the conservation easement. The IRS disallowed the deduction and asserted an accuracy-related penalty under Code Sec. 6662 for negligence, disregard of regulations, or substantial understatement. Oakbrook took its case to the Tax Court.

Under Code Sec. 170(f)(3)(B)(iii), a deduction is allowed for a qualified conservation contribution. A qualified conservation contribution is defined in Code Sec. 170(h)(1) as a contribution (1) of a qualified real property interest, (2) to a qualified organization, (3) exclusively for conservation purposes. Under Code Sec. 170(h)(5), the conservation purpose of the easement must be protected in perpetuity. Reg. Sec. 1.170A-14(g)(6)(i) provides that, if a subsequent unexpected change in the conditions surrounding the property makes the it impossible or impractical to use the property for conservation purposes, the conservation purpose will be nonetheless treated as protected in perpetuity if the restrictions are extinguished a judicial proceeding and all of the donee's proceeds, as determined under Reg. Sec. 1.170A-14(g)(6)(ii), from a subsequent sale are used by the donee organization consistently with the conservation purposes of the original contribution. Reg. Sec. 1.170A-14(g)(6)(ii) provides that the donation of the perpetual conservation restriction "gives rise to a property right, immediately vested in the donee organization, with a FMV that is at least equal to the proportionate value that the perpetual conservation restriction at the time of the gift, bears to the value of the property as a whole at that time." The regulations do not address whether the donor of an easement may subtract the value of improvements the donor makes in the conservation area after the donation of the easement.

In Coal Property Holdings, LLC v. Comm'r, 153 T.C. No. 7 (2019), the Tax Court held that Reg. Sec. 1.170A-14(g)(6) requires the grantee's proportionate share on extinguishment of a conservation easement to be a percentage that is determined by dividing the FMV of the easement by the FMV of the property as a whole, both valued as of the date of the gift. In PBBM-Rose Hill, Ltd. v. Comm'r, 2018 PTC 269 (5th Cir. 2018), the Fifth Circuit held that the "proportionate value" is a fraction equal to the value of the conservation easement at the time of the gift, divided by the value of the property as a whole at that time. The Fifth Circuit also held that Reg. Sec. 1.170A-14(g)(6) does not allow a donor to subtract the value of improvements from extinguishment proceeds. It reasoned that "proceeds" means the total amount brought in, such as "the proceeds of a sale." It also noted that Reg. Sec. 1.170A-14(g)(5)(i) contemplates that a donor may reserve the right to make improvements, but does not carve out an exception for the allocation of proceeds in the event of extinguishment when such improvements have been made, suggesting that no such carveout was intended.

Oakbrook argued that the regulation says "proportionate value," not "proportionate share," and that "proportionate value" means a fixed value - a whole number equal to the difference between the FMV of the property before and after the easement goes into effect. According to Oakbrook, the regulation required that SRLC be entitled on extinguishment to at least that fixed value as of the donation date. Oakbrook further argued, based on this interpretation of the regulation, that SRLC was not entitled to any proceeds attributable to the value of post-donation improvements. Oakbrook said that it would be unfair for the donee to receive proceeds from the value of improvements made solely by the donor because it would amount to an unintended charitable contribution for which the donor would receive no deduction.

Alternatively, Oakbrook challenged the validity of Reg. Sec. 1.170A-14(g)(6). Oakbrook contended that the IRS did not comply with the Administrative Procedure Act (APA) in promulgating the regulation because it failed to provide a statement of the basis and purpose of the extinguishment provision. In addition, Oakbrook asserted that the regulation was substantively invalid because it (1) does not cap the donee's share of extinguishment proceeds at the FMV of the easement at the time it was granted, and (2) does not allow the donee's share of the proceeds to be reduced by the value of any improvements made by the donor.

Tax Court's Analysis

In Oakbrook Land Holdings, LLC v. Comm'r, T.C. Memo. 2020-54, the Tax Court upheld the denial of Oakbrook's deduction. The court found that the easement deed failed to satisfy the requirements of Reg. Sec. 1.170A-14(g)(6) because (1) SRLC had to be entitled to a proportionate share of the proceeds, not a fixed dollar amount keyed to the easement's initial value, and (2) the deed could not reduce SRLC's proceeds by the value of any improvements made by Oakbrook.

Deductibility of Oakbrook's Easement Donation

The Tax Court found that the IRS's position was correct based on the language in Reg. Sec. 1.170A-14(g)(6). The court noted that the regulation contains a reference to Reg. Sec. 1.170A-14(h)(3)(iii), which relates to the allocation of basis, and that regulation says that the amount of the basis that is allocable to the qualified real property interest bears the same "ratio" to the total basis of the property as the FMV of the qualified real property interest bears to the FMV of the property before the granting of the qualified real property interest. The court found that this language establishes a ratio, expressed as a fraction, the numerator of which is the FMV of the easement, and the denominator of which is the FMV of the property unburdened by the easement. The court also noted that the regulation uses the words "bears to," further supporting its holding that "proportionate value" means a fraction, not a whole number. Thus, the court found that the regulation requires a fraction multiplied by future proceeds, and the deed therefore did not comply with the regulation.

On the issue of the proceeds from improvements made by Oakbrook, the Tax Court agreed with the Fifth Circuit's holding in PBBM-Rose Hill that Reg. Sec. 1.170A-14(g)(6) unambiguously requires the donee to be entitled to a proportionate share of the full extinguishment proceeds, not the amount as reduced by the value of improvements. The court said it might otherwise be sympathetic to Oakbrook's argument that this interpretation amounted to an unintended, nondeductible charitable donation, but concluded that the purpose of the regulation is the avoidance of windfalls to donors, not donees, if an easement is extinguished.

The Tax Court did not uphold the imposition penalties, however, because it found that Oakbrook had reasonable cause for its position. The court noted that in PLR 200836014, the IRS took the position that the value of improvements could be subtracted from extinguishment proceeds, and although letter rulings are not precedential, the court noted that, under Reg. Sec. 1.6662-3(b)(3), a return position may satisfy the reasonable basis standard if it is based on, among other authorities, private letter rulings. The court also noted that its disagreement as to the validity of Reg. Sec. 1.170A-14(g)(6) suggested the objective reasonableness of Oakbrook's position.

Validity of the Regulation

In a separate opinion, Oakbrook Land Holdings, LLC v. Comm'r, 154 T.C. No. 10 (2020), a divided Tax Court upheld the procedural and substantive validity of Reg. Sec. 1.170A-14(g)(6). The Tax Court held that the procedural requirements of the APA were met in the issuance of Reg. Sec. 1.170A-14(g)(6) and that the regulation was substantively valid under the test provided in Chevron, U.S.A., Inc. v. Nat. Res. Def. Council, 467 U.S. 837 (1984). The court found that, contrary to Oakbrook's argument, the IRS was not required under the APA to provide a specific statement of the basis and purpose of the extinguishment provision, but only a statement containing enough information for a court to exercise judicial review. The court found that the broad statements of purpose contained in the preambles to the final and proposed regulations, coupled with obvious inferences drawn from the regulations themselves, were more than adequate to comply with the requirements of the APA.

As to the substantive validity of the regulation, the court applied the Chevron test and found that (1) Congress did not speak directly to the question of extinguishment proceeds in Code Sec. 170(h)(5)(A) and (2) the regulation was a permissible interpretation of the statute. The court reasoned that if the donee's share of proceeds were limited to the value at the time of the easement donation, its property right could be eviscerated in real dollar terms as a result of inflation in property values, which would give the donor a windfall. The court found that to be at odds with the goal of the statute to supply the donee with an asset that replaces the easement in the event of an extinguishment. The court further reasoned that the absence of a provision addressing whether a donor may subtract the value of improvements did not render the regulation arbitrary, capricious, or manifestly contrary to the statute. The court noted that, in response to the proposed regulations, the IRS received only one comment on donor improvements, and that comment notably did not suggest any text to address the problem. In the court's view, declining to address the issue in the final regulations was a policy decision for the IRS, not the court, to make. In addition, the court observed that Congress has amended Code Sec. 170 more than 30 times since the regulation was issued and never expressed any disagreement with the construction of the statute in the regulation.

Observation: In a dissenting opinion, Judge Holmes said he believed the regulation is procedurally invalid because the IRS's statement of basis and purpose did not mention the extinguishment proceeds clause, did not address the proportionate share or improvements problems, and did not provide a reasoned response to comments on those provisions. Judge Holmes also thought that even if procedurally valid, the regulation may be substantively invalid under the standard provided in Motor Vehicle Mfrs. Ass'n v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29 (1983), because, in his view, the IRS failed to provide contemporaneous reasons for adopting the proportionate value approach, and could not rely on post-hoc rationalizations to defend its decisionmaking.

For a discussion of the deductibility of conservation easement contributions, see Parker Tax ¶84,155.

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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