Earlier today, August 12, 2015, the Ninth Circuit Court of Appeals released its decision in Minnick v. Commissioner, a conservation easement case that had been appealed from the U.S. Tax Court to the Ninth Circuit. The verdict? The landowner’s tax deduction for the donation of the conservation easement was denied because the mortgage on the property had not been subordinated to the easement at the time of the donation. Let’s walk through the case together to get a better understanding of this ruling. You can read the full text of the Minnick opinion here.
How Did This Case Come About?
The landowner’s property in this case was located in Ada County, Idaho. In 2005, the landowner mortgaged the property to obtain funds to develop the property, which at the time was vacant land. The landowner ultimately decided to subdivide and develop only part of the property and to donate a conservation easement on the remaining part of the property. The landowner donated this conservation easement in September 2006.
Importantly, the mortgage encumbering the property was not subordinated to the conservation easement when the donation was made in 2006, even though the easement deed that the landowner signed stated that there were no outstanding mortgages encumbering the property. In fact, the landowner apparently never discussed the conservation easement with the bank until years later.
The landowner and his wife (who filed joint tax returns) claimed charitable deductions totaling $941,000 for the donation of the easement on their 2006, 2007, and 2008 federal tax returns. In September 2009, the IRS notified them that it had disallowed the deductions that they had claimed on their 2007 and 2008 federal tax returns. (The Ninth Circuit’s opinion issued today does not mention why the IRS did not also dispute the 2006 tax return, but the Tax Court’s 2012 opinion indicates that the IRS had originally disputed the deductions for lack of documentation of the easement’s value and not because of the mortgage.) The landowner and his wife appealed this decision to the U.S. Tax Court.
Somewhat belatedly, the landowner contacted the bank in July 2011 to request subordination of the mortgage to the conservation easement. The bank, after some negotiating, eventually signed a subordination agreement in September 2011. Despite this subordination, the Tax Court upheld the IRS’s denial of the deductions for the donation of the conservation easement in an opinion issued in December 2012 (linked above). The landowner and his wife appealed the Tax Court’s decision to the Ninth Circuit Court of Appeals, which issued its decision today.
What Happens When a Conservation Easement Is Donated without First Subordinating a Mortgage to It?
In upholding the Tax Court’s decision, the Ninth Circuit agreed with the Tax Court’s reasoning that the conservation easement was not protected in perpetuity at the time of the donation in 2006. This “perpetuity requirement” applies to all conservation easements. Simply put, the perpetuity requirement means that, if the conservation easement can be revoked or terminated, the donation of the easement does not qualify for a charitable deduction. (There are a few very limited exceptions to this requirement which were not relevant in this case.)
One way of terminating a conservation easement is for a bank with a preexisting mortgage to foreclose on the property; a bank with a preexisting mortgage is not bound by the conservation easement unless it agrees to be bound by it. This type of agreement is called a subordination agreement. Thus, the IRS regulations governing conservation easements require that such a bank subordinate its mortgage to a conservation easement so that, if the bank forecloses on the property, the conservation easement will remain in effect. At the time that the landowner and his wife filed their 2007 and 2008 tax returns, the bank had not subordinated its mortgage to the conservation easement, and so the donation of the conservation easement did not qualify for a charitable deduction at that time. As the Ninth Circuit explained, the relevant IRS regulation clearly indicated that subordination was a prerequisite to allowing a deduction.
Not only does the mortgage have to be subordinated to the easement before a deduction is claimed, but the mortgage has to be subordinated to the easement at the time of the donation. Even though the relevant IRS regulation does not expressly state “at the time of the donation,” the IRS has consistently interpreted the regulation to mean that. The Ninth Circuit agreed with this interpretation of the regulation because this interpretation was consistent with the requirement that a conservation easement be protected “in perpetuity,” noting:
An easement can hardly be said to be protected “in perpetuity” if it is subject to extinguishment at essentially any time by a mortgage holder who was not a party to, and indeed (as here) may not even have been aware of, the agreement between the Taxpayers and a conservation trust.
Thus, the bank’s 2011 subordination agreement was ineffective to cure the issues with the conservation easement, and the claimed charitable deductions were properly denied.
The landowner and his wife were actually very lucky in this case. Because the IRS did not timely challenge their 2006 tax return, the landowner and his wife were still able to claim $389,517 in charitable deductions from the donation of the conservation easement. This is not normal. Ordinarily, the failure to subordinate a mortgage to a conservation easement would result in no charitable deductions being available at all. The landowner and his wife benefited greatly from the IRS’s mistake.
Why Is This Case Important?
Today’s decision, first of all, is important because it underscores the importance of making sure that all mortgages are properly subordinated to the conservation easement before the easement is donated. Selecting a properly qualified team of professionals to guide you when donating a conservation easement will help ensure that this requirement is met.
Secondly, today’s decision is important because the Ninth Circuit is the latest circuit to announce that it will adhere to the Tax Court’s 2012 ruling in Mitchell v. Commissioner. Mitchell specifically held that a mortgage must be subordinated to a conservation easement at the time of the donation in order for the donation to qualify for a tax deduction. The Tenth Circuit had also announced earlier this year that it would adhere to this ruling. As more circuits adopt this ruling, the tax treatment of conservation easements becomes that much clearer, and it becomes more likely that this ruling will be adopted by the Fourth Circuit, which governs the tax treatment of conservation easements donated in Virginia. The Ninth Circuit’s decisions affect the tax treatment of conservation easements donated in California, Arizona, Nevada, Oregon, Washington, Idaho, Montana, Alaska, Hawaii, and the U.S. territories in the Pacific. The Tenth Circuit’s decisions affect the tax treatment of conservation easements donated in Utah, Wyoming, New Mexico, Colorado, Kansas, and Oklahoma.
As always, stay tuned for more coverage of court cases affecting land conservation in Virginia as they happen.