Tax Court Again Rules That Mortgage On Underlying Property Defeats Facade Easement Deduction

1982 East, LLC, TC Memo 2011-84

The Tax Court has again held that the gift of a facade easement did not result in a charitable contribution deduction because a bank held a mortgage on the underlying property and would have preference to insurance proceeds in the event of a casualty. As a result, the facade easement was not protected in perpetuity. The Tax Court also said the donation didn't preserve the structure, and thus wasn't deductible, because the underlying building was already protected by its location in a historic district. However, the Tax Court refused to hit the taxpayer with an accuracy-related penalty.

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))

Under Reg. §1.170A-14(g)(2), no deduction is allowed for an interest in property which is subject to a mortgage unless the mortgagee subordinates its rights in the property to the right of the qualified organization to enforce the conservation purposes of the gift in perpetuity.

Under Reg. §1.170A-14(g)(6)(ii), at the time of the gift, the donor must agree that the donation of the perpetual conservation restriction gives rise to a property right, immediately vested in the donee organization, with a fair market value that, at the time of the gift, is at least equal to the proportionate value that the perpetual conservation restriction bears to the value of the property as a whole. When a change in conditions results in the extinguishment of a perpetual conservation restriction, the donee organization, on a subsequent sale, exchange, or involuntary conversion of the property, must be entitled to a portion of the proceeds at least equal to that proportionate value of the perpetual conservation restriction.

Under Code Sec. 170(h)(4), a contribution is for a conservation purpose if it preserves a historically important land area or a certified historic structure.

In Kaufman I (134 TC No. 9) and Kaufman II (136 TC No. 13), the Tax Court ruled that the gift of a facade easement wasn't deductible where a bank held a mortgage on the underlying property and would have preference to insurance proceeds in the event of a casualty. Those cases dealt with taxpayers who granted a conservation easement to the same organization that was the donee in the new case.

Facts. In 2002, 1982 East, LLC (LLC), bought for $8 million a 5-story townhouse located within the New York City Metropolitan Museum Historic District. LLC intended to renovate and then sell the townhouse. Because of its location, the property was subject to New York City's landmark and zoning laws, which set the maximum building capacity for each square foot in a lot by reference to a formula known as the “floor area ratio.” The laws also set a maximum height at which a structure may be built on the lot. The building also was certified as by the National Park Service as a certified historic structure.

In 2003, LLC entered into a preservation restriction agreement with the National Architectural Trust (NAT) under which it granted NAT a facade easement restricting the use of the property and agreed to be prevented from adding exterior improvements to, or build above, the townhouse. The bank that held a mortgage on the townhouse agreed to subordinate its rights in the property to NAT's rights to enforce the conservation purpose of the donated property in perpetuity. However, the bank had a prior claim to all insurance proceeds as a result of any casualty, hazard or accident occurring to the townhouse, and was entitled to such proceeds in preference to NAT until the mortgage was paid off, notwithstanding that the mortgage was subordinate in priority to the easement.

Late in 2004, LLC donated the easement to NAT, and, per their agreement, paid NAT a total of $452,500 for assisting in setting up the easement and for monitoring and maintaining it.

On its 2004 return, LLC claimed a charitable contribution equal to the $6.57 million appraised value of its easement. IRS disallowed it on the ground that the donated property was not protected in perpetuity because of the bank's mortgage on the townhouse. It said NAT was not guaranteed a proportionate share of proceeds in the event of a casualty or condemnation before the mortgage held by the bank was satisfied. LLC countered that the terms of the deed of easement and New York law guaranteed NAT's right to receive a proportionate share of future proceeds in the event of a casualty or condemnation.

No deduction for easement. The Tax Court sided with IRS, pointing to its holding in Kaufman, that as a matter of law that the facade easement was not protected in perpetuity because the donee organization was not guaranteed a proportionate share of proceeds in the event of casualty or condemnation as required by Reg. §1.170A-14(g)(6)(ii). In that case, the Court noted that the taxpayers could not avoid the unconditional requirement that the donee organization must be entitled to its proportionate share of future proceeds by showing that they would most likely be able to satisfy their mortgage and their obligations to the donee organization.

As in Kaufman, the lender agreement in LLC's case made it clear that the lender retained a “prior claim” to all condemnation and insurance proceeds “in preference” to NAT “until” its mortgage was satisfied and discharged. Thus, at any point before the mortgage was repaid, the possibility existed for the lender to deprive NAT of value that should have otherwise been dedicated to the conservation purpose. That could happen if the townhouse was substantially or completely destroyed and no significant value remained in the property after the mortgage was satisfied. Thus, the Tax Court held that the donation failed to satisfy Reg. §1.170A-14(g)(6)(ii).

Another ground for disallowance. The Tax Court also said the donation didn't pass muster under Code Sec. 170(h)(4), because the townhouse was already a certified historic structure located in an historic district. LLC was barred by New York City law from altering the property without permission, so the townhouse was preserved by local law, and the New York City Landmarks Preservation Commission, not the rights which NAT possessed under the deed of easement.

No penalties. On the facts, the Tax Court held that LLC was not liable for a 20% accuracy-related penalty under Code Sec. 6662(a) for underpayment of tax attributable to the deduction disallowance.

References: For charitable contribution deduction for qualified conservation contributions, see FTC 2d/FIN ¶K-3501; United States Tax Reporter ¶1704.47; TaxDesk ¶331,619; TG ¶19201.