In Zarlengo, et al v. Commissioner (T.C. Memo. 2014-161) (Vasquez, J.), the Tax Court issued a limited “win” for the taxpayer, holding that substantial compliance with the substantiation regulations was sufficient to support the taxpayer’s claim for a façade easement donation.  The Tax Court did, however, disallow the charitable deductions claimed in the year the easement was granted because the easement deed was not recorded until the following year, holding that the perpetuity requirement was not met until the deed was recorded, thus only a portion of the carryover deductions could be claimed.  In addition, the Tax Court slashed the value of the easement and imposed penalties for gross valuation misstatement in the later years.

The taxpayers, a divorced couple, donated a façade easement on a townhouse that they jointly owned to the National Architectural Trust (the “Trust”).  The husband deducted the full amount of his half of the charitable contribution in 2004, the year the taxpayers donated the property to the Trust.  The wife deducted only a portion of the charitable contribution in 2004 and carried the remainder over into 2005 through 2007.  Though the conservation easement deed was signed in September 2004, the Trust did not record the deed until January 2005.  The IRS claimed the “contribution date” of the conservation easement was not until January 2005, when the deed was recorded.  The IRS also argued that the taxpayers failed to properly substantiate the value of their donation pursuant to the Treasury Regulations.

Applying New York law, the Tax Court held that the contribution did not occur until the following year when the deed was recorded (and therefore legally enforceable against subsequent purchasers) because prior to that time the easement was not protected in perpetuity.  As a result, the deductions taken in 2004 were disallowed.  The Tax Court then concerned whether deductions carried over into 2005 through 2007 could be taken by the wife taxpayer.

The IRS argued that the deductions in the later years should be disallowed because the appraisal filed with the return failed to comply with several of the substantiation requirements outlined in the Treasury Regulations, including (1) the appraisal was prepared more than 60 days prior to the contribution (2) the appraisal failed state the date or expected date of the contribution, (3) the appraisal failed to provide the terms of any agreement or understanding, (4) the appraisal failed to determine the “fair market value,” and (5) the appraisal was not prepared by a qualified appraiser because an employee of the appraisal assisted in the drafting of the report.

While the appraisal arguably failed to comply with each of these requirements, the Tax Court held that the appraisal substantially complied with the requirements in Treasury Regulation 1.170A-13(c)(3) where (1) the date of the appraisal was within 60 days of the signing of the deed in September 2004 (as opposed to the January 2005 recording date), (2) in the appraisal summary the Trust acknowledged that it received the easement on September 22, 2004, (3) the appraisal report attached a copy of a sample deed, (4) the term “market value” as defined in the appraisal report was close to the definition of “fair market value” in the regulations, and (5) there was no indication that the opinions or conclusions in the appraisal report were those of anyone other than the appraiser who signed the report.  Accordingly, the taxpayer satisfied the requirement to substantiate her conservation easement.

The Tax Court then considered the expert testimony as to value, finding that both experts were not completely reliable and that each expert report served as more of an advocacy piece.  Of note, the Tax Court dismissed the Service’s expert, finding that his “conclusory analysis demonstrates his preconceived notion that conservation easements have no value.”  Instead of adopting the value proposed by either expert, the Tax Court chose a value between the two, finding that the easement caused a 3.5% diminution in value of the property, reducing the claimed easement value from $660,000 to $157,500.

With respect to penalties, the Tax Court found that the taxpayers established reasonable cause for the claimed deduction, thus penalties did not apply for the 2004 and 2005 tax years.  However, the 2006 changes to the penalty provisions by the Pension Protect Act converted the gross valuation misstatement penalty (i.e., claiming the value of property is 200% or more than the amount determined to be correct) to a strict liability penalty.  As a result, any understatement in the wife’s 2006 and 2007 return was subject to the 40% gross valuation misstatement penalty.  This is a good reminder to taxpayers that valuation problems in post-2005 returns can lead to hefty penalties.