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Tax Court Denies Deduction Over Mortgage Subordination and Proceeds Clause

Land trusts should review their standard easement and mortgage subordination language in light of a recent Tax Court holding that a façade easement contributed by a Boston couple was not perpetual because the lender retained first priority to condemnation and insurance proceeds up to the amount of its mortgage.

Summary

The Kaufman v Commissioner (2010) 134 TC No. 9 summary judgment decision on April 26 held for the IRS on the disallowance in full of the claimed deduction because the façade easement contribution failed to satisfy Treasury Regulation Section 1.170A-14(g)(6)(ii). Note that the relevant section is about proceeds distribution following extinguishment and not about mortgage subordination (Section 1.170A-14(g)(2)).  The Kaufmans had a subordinated mortgage in compliance with the regulations.  The subordination, however, also gave the lender the first priority to insurance and condemnation proceeds.  

IRS field agents have already called attorneys with tax cases in audit or court to demand to see any mortgage subordination.  The message is that any proceeds priority clause will now be challenged based on Kaufman.  If present the deduction will be denied and all settlement discussions halted.  Reports indicate that lenders routinely require this clause in historic preservation easements with a mortgage on the property.  Reports on the use for land conservation easements are mixed.  If you are using a proceeds clause in your mortgage subordinations, you might reevaluate that practice in light of this case.

Judge Halpern’s summary judgment order also appears to touch on the allocation of condemnation and insurance proceeds, requiring similarly that the donee organization must be “entitled” to - or “guaranteed” - its proportionate share of those proceeds.   It seems that Judge Halpern assumed that insurance or condemnation proceeds would necessarily follow an extinguishment and that the donee organization would always be entitled to such proceeds.  This may not always be the case.

Finally Judge Halpern denied summary judgment to the IRS on the issue of whether a cash gift to cover monitoring costs would qualify for the charitable income tax deduction.  The Judge felt that it was a factual determination of whether the deduction for the cash gift should be denied because it was conditional on the appraisal of the easement having some value and was required for the holder to accept the easement.   The IRS asserts that the gift was required.  The Kaufmans and TAE assert that the cash gift was part of the voluntary contribution.  This was a fact at issue and was tried along with the penalties issue the week of May 17, 2010.     

The summary judgment order, read expansively, may affect not only subordination agreements but also the proportionate share provisions commonly included within the “extinguishment” and “condemnation” sections of conservation and preservation easements and the insurance proceeds provisions commonly used in preservation easements.

The Kaufmans, their easement holder, The Trust for Architectural Easements, as well as the National Trust for Historic Preservation filed motions to reconsider and filed briefs explaining how the proceeds clause in the subordination complies with the regulations.   The opinion and various motions and briefs are linked below.

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 such as 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)(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 conservation easement is extinguished in full, 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.   Judge Halpern read the word “entitled” in the regulations to mean “guaranteed”.  This reading is disputed by some.  The dictionary definitions are different but to other experts focusing on that nuance gives a strained reading of the regulations.

Under Reg. § 1.170A-1(e) , if, as of the date of a gift, a transfer for charitable purposes is dependent on the performance of some act or the happening of a precedent event for it to become effective, no deduction is allowable unless the possibility that the charitable transfer won't become effective is so remote as to be negligible.   Judge Halpern rejected this argument in the summary judgment hearing focusing on any risk of full extinguishment without compensation to the qualified easement holder, no matter how remote or negligible, as violating the perpetuity requirement.   For example, assume that a home subject to a façade easement is completely destroyed by a fire and that the façade easement does not restrict future redevelopment in case of a full casualty. The parties petition a court to extinguish the easement and to sell the lot.  The lender must rely on the sale of the lot without the house to repay the mortgage in excess of the insurance proceeds which are also insufficient.  In the depressed real estate market the lot does not sell for the remaining amount of the outstanding mortgage.  The lender pursues the landowner for the deficiency and the land trust pursues the landowner for payment of its share of the now fully extinguished façade easement.  The landowner has no other assets and is judgment proof.  The land trust has no first lien on the property to satisfy its right to compensation for the loss because the lender has first priority to all the proceeds.  The easement is extinguished and the land trust has not received any compensation.  It does seem like a remote scenario of unfortunate happenstance, but could occur when a number of factors coincide.

Not included in the summary judgment opinion but important to understand the full issue is Reg. § 1.170A-14(g)(2).   This regulation prohibits any deduction for an interest in property subject to a mortgage unless the mortgagee subordinates its rights to the right of the qualified organization to enforce the conservation purposes of the gift in perpetuity.  This narrow language is often repeated in limited subordinations and is at the root of the dilemma that the Kaufman decision causes land trusts.

Facts

The easement involved a single-family row house located in a historic preservation district in Boston owned by Gordon and Lorna Kaufman. In 2003, they granted a façade easement and preservation restrictions to the National Architectural Trust (now the Trust for Architectural Easements (TAE)). TAE also asked petitioners to contribute cash calculated as a percentage of the estimated value of the facade easement, to provide for monitoring and administration. The Kaufmans contributed $16,840 to TAE, which accepted the agreement. A bank held a mortgage on the property.  On their 2003 return, the Kaufmans claimed a charitable contribution deduction of $220,800 for the contribution of the facade easement and claimed a charitable contribution deduction in 2003 for the cash gift.

On audit, IRS disallowed both deductions. It also assessed accuracy related penalties under Code Sec. 6662. IRS moved for summary judgment which the Tax Court granted with respect to the facade easement contribution but denied for the cash contribution and penalties. The mortgage subordination provided that in certain events, such as a casualty, the bank was entitled to the proceeds in preference to TAE until the mortgage was satisfied and discharged. The Tax Court held that because of the proceeds priority on the property, TAE’s right to its proportionate share of future proceeds was thus not guaranteed. Thus, the facade easement contribution failed as a matter of law to comply with the enforceability in perpetuity requirements under Reg. § 1.170A-14(g). As a result, the Tax Court held that the facade easement contribution was not protected in perpetuity and thus was not a qualified conservation contribution under Code Sec. 170(h).   The Court construed “entitled” to mean “guaranteed” and rejected the “so remote as to be negligible” argument.

The briefs filed by the taxpayer, the easement holder and NTHP dispute this interpretation as overreaching and incorrect.  The taxpayers relied on the exception in Reg. §1.170A-1(e), arguing that the possibility for the charitable transfer to not become effective (that the possibility that the easement would be fully extinguished and that no assets of any kind would remain to compensate the land trust after the bank took all the proceeds to pay the mortgage)  was so remote as to be negligible.  And additionally that this inquiry was inherently factual and therefore not appropriate for summary judgment.

Cash contribution and penalties

IRS denied the Kaufmans' cash contribution to TAE on the ground that the gift was conditional and as a result violated Reg. § 1.170A-1(e). Alternatively, IRS argued that the cash contribution was part of a quid pro quo and didn't give rise to a deduction. Among other arguments, the Kaufmans argued that the possibility that the charitable transfer would not become effective, i.e., the possibility that an appraisal would find the facade easement to have no value, was so remote as to be negligible. They argued that the inquiry in arriving at the “conditional” determination was inherently factual. The Tax Court agreed with the Kaufmans. The Judge stated in his summary judgment order that “even if NAT (TAE) required petitioners to make the cash contribution….we are not convinced that that is sufficient to deny a charitable deduction under R.L. Hernandez, SCt, 89-1 USTC ¶9347.”  The court dismissed the IRS's argument that the cash contribution was part of a quid pro quo and, as such, violated the rule under, because, even if the donee organization required the taxpayers to make the cash contribution, this was not sufficient to deny the charitable contribution deduction under R.L. Hernandez.   Some observers are perplexed about the Court’s view that the cash contribution requirement is a factual inquiry but that the proceeds clause determination of so remote as to be negligible is not.

The Tax Court also refused summary judgment as to the 20% accuracy-related penalty for negligence and substantial understatement of income tax under Code Sec. 6662(a) because the Kaufmans raised genuine issues of material fact regarding the applicability of the reasonable cause defense to those penalties.


May 17 Hearing

At the May 17 hearing on reconsideration motions of the summary judgment decision Judge Halpern asked counsel to argue the proceeds and subordination issue in their post-trial briefs. He also suggested that taxpayer counsel include the proposed amice in the taxpayer’s brief.  The trial was held the week of May 17.   The post trial briefs will be important.   Remember that Tax Court reverses the usual practice of briefs prior to trial.   We don’t know whether the briefing will be expedited or under the usual rules – 60-70 days for initial briefs and 20-30 days for reply briefs.  Counsel for the Kaufmans indicated they would coordinate the preparation of the single brief with the attorneys for the National Trust and the Trust for Architectural Easements.  The brief would cover all outstanding issues (subordination, proceeds, quid pro quo, cash gift, and penalties).

View additional motions and affidavits.

Subordination Forms and Easement Template

Land trusts should review their form subordination agreement, and possibly revise it, in light of the Kaufman holding.  Land trusts may also want to review their standard conservation easement proceeds clause.    Some observations:

  1. Until the Kaufman summary judgment decision is reversed, if ever, we now need to address the proceeds issue in more detail.
  2. Subordinations that are limited only to statements about the ability of the land trust to enforce the easement and the survival of the easement in the event of foreclosure may be too limited in light of Kaufman.
  3. Every land trust should discuss its form subordination agreement and easement template with its legal counsel immediately.
  4. Legal counsel should carefully read the Kaufman decision and the relevant Treasury Regulations.
  5. The experts are divided about whether the classic full subordination agreement that subjects the lender to all the terms of the conservation easement is sufficient to pass the Kaufman test. 
    a.    State law may affect this answer as the law may provide a lender with first priority to proceeds.  
    b.    Nonetheless if the full subordination submits the lender to all the terms of the easement including the land trust entitlement to proceeds in the event of condemnation, this may trump the state law requirement.
    c.    Having explicit proceeds language in the subordination may result in more lenders refusing to sign.  
    d.    In some very high value cases where the donor is very likely to be audited it may be necessary to be explicit in order to avoid an IRS challenge based on Kaufman.   
    e.    Land trusts must obtain qualified legal counsel on these issues.
  6. Land trust counsel should review their standard extinguishment and condemnation provisions, and for preservation easements, the insurance proceeds provisions, and consider explicitly stating that the land trust is entitled to its full share of proceeds especially in the circumstance of a full condemnation regardless of any amount owing to a lender or other creditor as suggested by an expansive reading of Kaufman.
  7. Partial release of mortgages where possible to obtain, even if requiring loan pay down, may be an alternative worth considering.
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