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Tax Court reverses holding that façade easement appraisal wasn’t qualified

Barry S. Friedberg and Charlotte Moss, TC Memo 2013-224

The Tax Court, based on an intervening change in the law resulting from a subsequent appellate court decision, has granted the taxpayers’ motion to reconsider its prior holding that an appraisal was not a qualified appraisal. It now concludes that the appraisal was qualified and that the taxpayers shouldn’t have been denied a charitable contribution deduction for a façade easement solely on the ground that they failed to submit a qualified appraisal. However, the Tax Court did not address the reliability and accuracy of the appraisal, which it will do later at trial.

Background. In general, Code Sec. 170(f)(3) bars a charitable contribution deduction for a contribution of an interest in property that is less than the taxpayer’s entire interest in the property, but an exception is made for a qualified conservation contribution, i.e., the contribution of a qualified real property interest exclusively for conservation purposes. The interest in property conveyed by a facade easement must be protected in perpetuity for the contribution of the easement to be a qualified conservation contribution. (Code Sec. 170(h), Reg. § 1.170A-14(b)(2))

A qualified conservation contribution resulting from the creation of a conservation restriction in favor of a qualified organization yields a charitable contribution deduction if the value of the property burdened by the restriction is reduced on account of the creation of the restriction. A conservation restriction’s value is determined by measuring the impact of the restriction on the value of the property affected by the restriction; i.e., the reduction (or enhancement) in value of that property resulting from the creation of the restriction. This involves determining the difference between the fair market value of the affected property before and after the restriction is imposed. (Reg. § 1.170A-14(h)(3)(i))

Under Code Sec. 170(f)(11)(C), a deduction claimed for a noncash contribution of property valued at more than $5,000 will be denied unless the taxpayer obtains a qualified appraisal of the donated property and attaches it to the return for the tax year in which the contribution is made. However, the deduction won’t be denied if it’s shown that the taxpayer’s noncompliance was due to reasonable cause and not willful neglect. (Code Sec. 170(f)(11)(A)(ii)(II))

Facts. During 2002, Barry Friedberg purchased a residential townhouse in New York City on East 71st Street between Park Avenue and Lexington Avenue (subject property) for $9.4 million, and then spent an additional $4 million for extensive renovations. The subject property is in Manhattan’s Upper East Side Historic District. In 2003, the National Park Service determined that the subject property is a certified historic structure “for a charitable contribution for conservation purposes in accordance with the Tax Treatment Extension Act of 1980.” During 2003, the National Architectural Trust (NAT) contacted Mr. Friedberg to ask him to donate an easement on the subject property.

After reviewing NAT’s materials, Mr. Friedberg decided to donate to NAT a facade easement and all of the development rights associated with the subject property. He followed NAT’s recommendation and engaged Michael Ehrmann to appraise the subject property. Mr. Ehrmann found that the “sales comparison approach” was the most appropriate valuation method for estimating the market value of the subject property before and after the donation. He calculated that the total value of the unused development rights associated with the subject property was $2,335,000. He then added that value to his “before” estimate of the value of the subject property to arrive at a total value for the subject property of $15,425,000.

The second half of the Ehrmann appraisal provides an estimate of the value of the subject property after the facade easement. Mr. Ehrmann estimated that the facade easement on the subject property decreased its value by 11%.

On the basis of his 11% estimate, Mr. Ehrmann calculated that the facade easement would reduce the value of the subject property by $1,439,000, which he rounded to $1,440,000. He stated that, after the easement, the unused development rights would have no value. He therefore estimated that the “after” value of the subject property was $11,650,000. Mr. Ehrmann concluded that the loss in value due to the facade easement was $3,775,000.

On their timely filed 2003 return, Mr. Friedberg and his wife, Charlotte Moss (Taxpayers), deducted $3,775,000 for the donation of the facade easement and development rights on the subject property. They appended Form 8283, Noncash Charitable Contributions, signed by Mr. Ehrmann and by the president of NAT. They also attached to their tax return a copy of the Ehrmann appraisal.

IRS issued a statutory notice of deficiency, and Taxpayers timely filed a petition with the Tax Court. During December 2010, each party filed a motion for partial summary judgment. Relying in part on Scheidelman, TC Memo 2010-151 (Scheidelman I), the Tax Court held, in Barry S. Friedberg, TC Memo 2011-238, that the Taxpayers were not entitled to a deduction for the donation of the facade easement because the Ehrmann appraisal was not a “qualified appraisal” under Reg. § 1.170A-13(c)(3), with respect to its valuation of the facade easement. Accordingly, it granted IRS’s motion for partial summary judgment with respect to that issue. However, with respect to the valuation of the development rights, the Tax Court concluded that disputed issues of material fact remained as to whether the Ehrmann appraisal was a qualified appraisal. Accordingly, it denied both parties’ motions for partial summary judgment with respect to that issue.

On June 15, 2012, the U.S. Court of Appeals for the Second Circuit vacated the Tax Court’s decision in Scheidelman I and remanded the case. See Scheidelman v. Comm., (CA 2 6/15/2012) 109 AFTR 2d ¶ 2012-886, discussed at Weekly Alert ¶  7  06/21/2012. Specifically, in this Scheidelman II decision, the Second Circuit held that the taxpayer’s percentage-based appraisal of the value of the façade conservation easement at issue was sufficiently detailed so as to meet the requirements of Reg. § 1.170A-13(c)(3).

Subsequently, Mr. Friedberg and his spouse moved the Tax Court to reconsider its prior holding.

Prior holding affected by Second Circuit decision. The Tax Court noted that in its prior decision, it determined Mr. Ehrmann’s approach to valuing the subject property after the facade easement donation diverged significantly from the accepted comparable sales method, which was the method Mr. Ehrmann claimed to apply. The Court determined that Mr. Ehrmann instead used sale and nonsale transactions of eased properties in locations other than New York City, which is the site of the subject property, to estimate a percentage diminution in value associated with a facade easement. Mr. Ehrmann then multiplied the before value of the subject property, the calculation of which IRS did not contest, by the percentage diminution that he purported to derive from the referenced transactions to estimate the loss in value on account of the facade easement.

The Tax Court observed that, in Scheidelman I, it held that the mechanical application of a percentage diminution to the fair market value before donation of a facade easement does not constitute a method of valuation as contemplated under Reg. § 1.170A-13(c)(3). Accordingly, consistent with that, its prior opinion in the current case held that the Ehrmann appraisal was not a qualified appraisal with respect to the facade easement because it lacked a method and specific basis for the determined value. In remanding Scheidelman I , the Second Circuit, in Scheidelman II, stressed that IRS’s interpretation, that an unreliable method is no method at all, went beyond the wording of Reg. § 1.170A-13(c)(3), which imposes only a reporting requirement.

In their motion for reconsideration, the Taxpayers contended that the Ehrmann appraisal included a method of valuation because it supplied enough information to enable IRS to evaluate his methodology and showed how he applied the method. They acknowledged that the Tax Court previously concluded that Mr. Ehrmann’s stated method was improperly applied and unreliable, but contended that reliability is not a factor for purposes of determining whether the Ehrmann appraisal was a qualified appraisal.

IRS opposed the motion for reconsideration contending that (1) Taxpayers misstated the proper standard articulated by the Court of Appeals in Scheidelman II, (2) the Ehrmann appraisal was not a qualified appraisal even if the Tax Court applies the standard that Taxpayers advocate, and (3) the Ehrmann appraisal failed to include a specific basis for valuation.

The Tax Court disagreed with all three of IRS’s contentions and agreed with Taxpayers. Consequently, pursuant to Scheidelman II, the Tax Court concluded that the Ehrmann appraisal was a qualified appraisal under Reg. § 1.170A-13(c)(3)(ii) with respect to the façade easement. However, it rendered no opinion on the reliability and accuracy of the methodology and specific basis of valuation in the Ehrmann appraisal, which will be decided at trial.