Last week a collective sigh of relief could be heard from many preservation easement donors who have found themselves in recent years as targets of aggressive IRS investigations over the validity of their easement donations. On July 19, 2012 the United States Court of Appeals for the First Circuit issued its ruling in Kaufman v. Commissioner of the Internal Revenue. This long anticipated case is a victory for donors of easements and preservation organizations around the country.
In 2003, the Kaufmans donated an easement to the Trust for Architectural Easements (formally known as the National Architectural Trust) on a mid-1850s rowhouse in Boston’s South End National Register District. Like many Tax Court cases, the IRS focused on invalidating the donation on technical grounds.
The court reviewed three main points in its opinion:
- Whether the easement met the “perpetuity” requirements of the Treasury Regulations because the mortgage subordination used in the transaction gave the mortgage company a priority interest to insurance and condemnation proceeds if the easement was ever extinguished;
- Whether the easement holder’s discretion to give its consent to changes to the property or abandon the easement was inconsistent with the perpetual nature of the donation; and
- Whether the donor’s easement appraisal summary was sufficient enough to meet regulatory requirements.
The first issue addressed by the court was the most contentious; it also had the potential to impact a large number of easement donations around the country. Specifically the court focused on the IRS’ interpretation of the treasury regulations and whether easement holding organizations must have a priority interest to insurance and condemnation proceeds in the event the property that is subject to the easement is somehow destroyed or condemned. As a general matter, extinguishing an easement is a very rare occurrence that most likely would only occur following a total loss of the property (e.g., a major fire destroying the entire building) or upon the state exercising its eminent domain powers and taking the property. The court rejected the IRS’s interpretation, finding that such an interpretation would “doom practically all donations of easements” and was contrary to the purpose of the statute that Congress intended. In explaining its rationale, the court used the example of tax liens, arguing that an easement donor could rarely satisfy the IRS’s interpretation of the regulations because tax liens almost always have greater priority.
The second issue related to whether the easement holder’s discretion to consent to changes to the property or abandon the easement failed to satisfy the regulatory requirement that easements must prevent uses that are inconsistent with the preservation of the property. This issue was squarely addressed in Simmons, and the court found that easement holding organizations must be allowed flexibility in the oversight of their easements. Moreover, the court found that abandonment of the easement was a remote possibility, one that the IRS could directly control in its regulation of tax-exempt organizations.
The final issue addressed by the court was the technical noncompliance of the appraisal summary submitted by the donor. By focusing on the minor deficiencies of the appraisal summary, the court stated that the IRS, in avoiding the valuation issues, was attempting to “convert an inherently factual issue into a set of violations of the procedural requirements [of the regulations] … in disregard of their language and purpose.” The court stated that the technical deficiencies of the donor’s documentation did not “doom the appraisal summary.” The court then vacated the Tax Court’s ruling, rejected the IRS’ alternative grounds for invalidating the donation, and remanded the case back to the Tax Court for a ruling on the valuation of the easement.
Also of interest from this case are the court’s observations about the long controversy surrounding easement donations. In particular, the court stated that it “[did] not question the IRS’s concern … that individuals and organizations have been abusing the conservation statutes ‘to improperly shield income or assets from taxation’’’ but that the IRS’s “overly aggressive … interpretations of existing regulations” was not the way to address these concerns. Instead the court indicated that the IRS should focus on new regulations to curtail “dubious deductions.”