Last week, the Tax Court issued an opinion that stands as another warning to taxpayers that they may only deduct donations of historic façade easements if they can support the value of the easements.
We all know that taxpayers are generally entitled to deduct the value of property that is donated to charity. In the world of real estate, this can include donations of easements on façades of historic buildings. Essentially, this involves the owner of an historic building giving up the right to make changes to the exterior of the building that would be inconsistent with the preservation of the historic nature of the façade. This provides the public benefit of preserving the historic exterior features of the building, while allowing the owner of the building a tax deduction for the reduced value of the building resulting from the restrictions.
In a typical façade easement donation, the owner of a building will find a charitable organization whose purpose is the preservation or conservation of historical buildings. Then, the owner will donate to that organization a perpetual easement on the outer shell of the building that will only allow modifications to the exterior that are consistent with the preservation of its historic nature. The organization is then tasked with monitoring the building to ensure that no improper modifications are made. Ordinarily, the organization will ask for a concurrent cash donation to assist it in this enforcement function. Also as part of the arrangement, the owner usually covenants to perform the maintenance on the exterior of the building. There are rules that will even allow an owner to make such a donation when the building is subject to a mortgage, provided the mortgagee agrees to subordinate its rights to the enforcement of the easement.
Once the façade is donated, the owner is still entitled to do anything it desires to the interior of the building (provided it maintains the structural support for the exterior), including complete renovations of the interior, changing the use of the building, or subdividing the interior into condominium units. Moreover, the owner is entitled to sell or lease the building with the only caveat that the restrictions on modifications to the exterior will continue to apply to the building. Consider, for example, the Roosevelt Building at 727 West Seventh Street in Los Angeles. A 1927 high-rise that was formerly a commercial building was converted into a residential condominium complex with retail space before a façade easement was donated to the Los Angeles Conservancy.
Although the owner retains significant latitude with what it can do to the interior of the building, the easement does result in limitations on what it can do to the outside of the building. Most obviously, the owner cannot demolish the building or change the exterior look of the building. In addition, it must provide access for the general public to view the historic features of the façade. This means that there will be limitations on its ability to cover the exterior or place billboards or similar advertising on the outside of the building. And, if the building is not visible from the street, the owner will need to provide reasonable access to the building to allow the general public to view the façade.
When the donation is made, the donor’s deduction is limited to the value of the easement (unless other general rules would further limit the deduction). To establish that value, the donor will need to obtain a contemporaneous written appraisal of the easement from a qualified appraiser. The value of a façade easement depends on a number of considerations, but on a very basic level, it will be approximately the difference between the value of the building before the easement was donated and the value of the building after it was donated. This means that if the building is already at its highest and best use or if it is subject to local historic preservation rules or zoning rules that would already prohibit modifications that would be proscribed under the easement, the easement may not have any value. Because of the nature of easements, it is very difficult to appraise them properly. So, it is very important that taxpayers obtain appraisals with sound methodology and analysis.
This is where the taxpayers in Dunlap v. Commissioner (TC Memo 2012-126) went wrong. There, a condominium association in New York City donated a façade easement to a charity called the National Architectural Trust. Since each of the owners of the condominium units had an undivided interest in the common areas of the building, which included the façade, each of the owners claimed a deduction for its allocable share of the value of the façade. In addition, they were each required to make a cash donation to the Trust to defray the costs of administering the easement, which they also deducted.
At trial, the original appraiser of the easement was not included by the taxpayers as an expert and did not testify, so his appraisal was not accepted by the court as evidence. Instead, the taxpayers presented two other appraisers to support the valuation of the easement. The Tax Court, however, was not persuaded by the analyses of those appraisers, so it found that the taxpayers did not satisfy their burden of establishing the value of the easement being donated. Accordingly, it disallowed their deductions for the value of the easement.
But, the taxpayers did have a silver lining. The court agreed with them that their cash donations were fully deductible. Moreover, it denied the Internal Revenue Service’s attempt to impose 20% penalties on them for claiming the deduction. Although their original appraisal was not allowed as evidence supporting the valuation of the easement, the court agreed that the taxpayers reasonably relied on it when taking their deductions.
The lesson to be learned from Dunlop is that prospective donors need to be careful that the value they intend to deduct on the donation of an historic façade easement can be supported. If an appraisal sounds too good to be true, it just might be.