In an opinion dated Friday, April 24, 2015, the First Circuit Court of Appeals has ruled against Gordon and Lorna Kaufman in their long-running easement fight with the IRS. In its published opinion (which you can read here), the First Circuit held that the Kaufmans could properly be assessed a 40% penalty for claiming $220,800 in charitable deductions for the donation of a façade easement that was later shown to be valueless. Let’s walk through the Kaufman case together and discover how it might be relevant to those wishing to donate conservation easements in Virginia.
Prior History of the Case
The Kaufmans had donated a historic preservation façade easement on their Boston, Massachusetts home to the National Architectural Trust in 2003. (The National Architectural Trust is now known as the Trust for Architectural Easements.) They then claimed charitable deductions for this donation on their 2003 and 2004 federal tax returns. The IRS began investigating this donation in 2007, ultimately disallowing the charitable deductions and spawning years of litigation, including the following cases:
- Kaufman v. Commissioner, 134 T.C. 182 (2010) (“Kaufman I”);
- Kaufman v. Commissioner, 136 T.C. 294 (2011) (“Kaufman II”);
- Kaufman v. Shulman, 687 F.3d 21 (1st Cir. 2012) (“Kaufman III”); and
- Kaufman v. Commissioner, T.C. Memo 2014-52 (2014) (“Kaufman IV”).
In that last case, the U.S. Tax Court had ruled that the Kaufman’s historic preservation façade easement, which essentially imposed no restrictions beyond what existing zoning ordinances already required, had no value for purposes of determining the allowable charitable contribution deduction resulting from the easement donation. The Tax Court had additionally imposed a 40% penalty on the Kaufmans pursuant to Section 6662(h) of the Internal Revenue Code for grossly overstating the value of the easement by more than 400%—$220,800 as compared to $0.
The Appeal to the First Circuit
The Kaufmans then appealed the Tax Court’s decision to the First Circuit Court of Appeals. The Kaufmans appealed only as to the 40% penalty and did not dispute on appeal the Tax Court’s finding that the easement was valueless. The Kaufmans argued that they should be exempt from the 40% penalty because of the “reasonable cause” exception, which protects taxpayers who rely on a qualified appraisal made by a qualified appraiser (as the Kaufmans did) and who also make a good-faith investigation into the value of the easement. The “reasonable cause” exception is codified in Section 6664(c) of the Internal Revenue Code.
However, the First Circuit agreed with the Tax Court that the Kaufmans had failed to make a good-faith investigation into the value of the easement. The First Circuit noted that there were many warning signs that the Kaufmans should have heeded—for example, a statement from a representative of the National Architectural Trust that the donation of the easement would have no effect on the value of the house. (The amount of the donation is determined by how much the easement reduces the value of the house.) It did not matter that the Kaufmans themselves were not experts in valuing easements; the statement regarding the easement’s lack of value, and the other warning signs detailed in the First Circuit’s opinion, should have indicated to the Kaufmans that it was not reasonable to rely on the first appraisal. This was particularly true because the Kaufmans were both fairly well educated. Thus, they should have obtained a second opinion as to the value of the façade easement.
Why Is This Important?
A façade easement is a special type of conservation easement; instead of preserving open space, façade easements focus on preserving the appearance of historic buildings. (Façade easements are thus more common in urban areas, whereas conservation easements preserving open space are more common in rural areas.) Façade easements and regular conservation easements are governed by many of the same federal tax laws, and so cases dealing with the tax treatment of façade easements can also be instructive in the more general context of conservation easements.
In particular, the Kaufman case shows the importance of hiring a competent appraiser, as much of the litigation centered around the valuation of the Kaufmans’ easement. A competent appraiser will be able to provide an unbiased opinion to the landowner and will be able to alert the landowner to any potential valuation issues. As in Kaufman, issues relating to the existing zoning of a property can negatively affect the valuation of an easement. The location of the property in a flood plain is another typical issue that can affect the valuation of an easement. It is preferable to discover these and other issues before going through with the donation of an easement—particularly because an easement cannot be undone even if the IRS denies a charitable deduction for it. Hiring a team of experienced professionals will help to ensure that your easement is acceptable to the IRS.
As always, stay tuned for further updates as courts continue to develop the law governing façade easements and conservation easements.