Recent Cases Denying Charitable Income Tax Deduction Provide Reminder of Need to Strictly Adhere to Statutory Requirements for Deductibility of Facade Easements

Recent Cases Denying Charitable Income Tax Deduction Provide Reminder of Need to Strictly Adhere to Statutory Requirements for Deductibility of Facade Easements

Article posted in Intangible Personal Property on 14 May 2015| comments
audience: National Publication, Richard L. Fox, Esq. | last updated: 14 May 2015
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Richard Fox explores recent cases to clarify our understanding of the deductibility of the donation of various types of easements.

By: Richard L. Fox, Esq.

SUMMARY:

Under IRC § 170(f)(3)(A), a taxpayer generally may not take a charitable deduction for the contribution of a partial interest in property.  However, under IRC §170(h)(1) and the regulations promulgated thereunder, there is an exception for "a qualified conservation contribution," which is a contribution of a "qualified real property interest" to a "qualified organization" that is made "exclusively for conservation purposes." Under §170(h)(4)(A)(iv), one conservation purpose, "the preservation of a historically important land area or a certified historic structure," encompasses facade conservation easements.

However, §170(h)(4)(B) provides that a contribution that consists of an easement on the exterior of a certified historic structure is not exclusively for conservation purposes unless the interest: (i) includes a restriction which preserves the entire exterior of the building (including the front, sides, rear, and height of the building) and (ii) prohibits any change in the exterior of the building which is inconsistent with the historical character of such exterior. Further, IRC § 170(h)(5)(A) provides that a “contribution shall not be treated as exclusively for conservation purposes unless the conservation purpose is protected in perpetuity.”  Therefore, absent the purpose of an easement donated to charity being protected in perpetuity, a donated easement will not be deductible.

In two recent cases involving the contribution of facade easements to the National Architectural Trust or NAT (now known as the Trust for Architectural Easements), the taxpayers’ claimed charitable income tax deduction was denied because of the failure to satisfy the statutory requirements for the deductibility of the contributed facade easement.  In Zarlengo,[1]  because the facade easement deed on a townhouse donated in 2004 was not recorded in that year, but instead was recorded on January 26, 2005, the Tax Court held that the perpetuity requirement was not met and the claimed charitable income tax deduction in 2004 was therefore disallowed.  In making its determination, the court looked to local law, which provided that an instrument purporting to create, convey, modify, or terminate a conservation easement is not effective unless recorded.

Because New York law provides that conservation easements in the state are not effective unless they are recorded, the facade easement was not effective until January 26, 2005, the date on which it was recorded. The Tax Court then explained that, even assuming the easement had been legally enforceable by NAT against the taxpayers in 2004 because both parties signed the deed that year, the easement still would not have satisfied the perpetuity requirements in 2004 “because neither the use restriction nor the conservation purpose of the conservation easement was protected in perpetuity until January 26, 2005.” The court explained that if a “buyer had purchased the townhouse and had recorded the deed of conveyance before January 26, 2005, that buyer could have taken the townhouse free and clear of the conservation easement.” 

In 61 York Acquisition, LLC, [2] York Acquisition granted a facade easement to NAT, claiming a $10.7 million charitable income tax deduction for the donation on its 2006 partnership tax return.  At the time of the contribution of the facade easement, ownership of the structure subject to the easement was divided into two parts.  York Acquisition owned the first 14 floors and a third-party owned the top 6 floors. 

The IRS disallowed the taxpayer’s claimed deduction on the grounds that the Partnership could not have granted a valid easement restricting the entire exterior of the structure (front, sides, rear, and height) because the taxpayer did not own the entire exterior of the building. The taxpayer argued that the terms of the easement and an agreement with the owner of the top 6 floors collectively imposed enforceable restrictions on the entire exterior of the property, and that, under the applicable Illinois law, ownership of the entire exterior is not required to grant an easement that imposes enforceable restrictions on the entire exterior.  The Tax Court sided with the IRS, finding that under the taxpayer owned only portions of two sides of the structure, not the entire exterior of the building, and therefore did not meet the statutory requirements for deductibility.

Although valuation issues have been the major source of controversy in cases involving the donation of facade easements, the value of the easements is irrelevant unless the requirements for deductibility are met in the first place. The Zarlengo and 61 York Acquisition, LLC cases reinforce the importance of ensuring the adherence to the requirements for deductibility of a facade easement and the consequences of failing to meet such requirements.

DISCUSSION:

Under IRC §170(f)(3)(A), a taxpayer generally may not take a charitable deduction for the contribution of a partial interest in property.  However, under IRC §170(h)(1) and the regulations promulgated thereunder, there is an exception for "a qualified conservation contribution," which is a contribution of a "qualified real property interest" to a "qualified organization" that is made "exclusively for conservation purposes." Under §170(h)(4)(A)(iv), one conservation purpose, "the preservation of a historically important land area or a certified historic structure," encompasses facade conservation easements.

However, §170(h)(4)(B) provides that a contribution that consists of an easement on the exterior of a certified historic structure is not exclusively for conservation purposes unless the interest: (i) includes a restriction which preserves the entire exterior of the building (including the front, sides, rear, and height of the building) and (ii) prohibits any change in the exterior of the building which is inconsistent with the historical character of such exterior.  Further, IRC § 170(h)(5)(A) provides that a “contribution shall not be treated as exclusively for conservation purposes unless the conservation purpose is protected in perpetuity.”   Therefore, absent the purpose of an easement donated to charity being protected in perpetuity, a donated easement will not be deductible.

Zarlengo: Facade Easement Didn’t Qualify for Deduction Because It Didn’t Protect Conservation in Perpetuity as Required Under IRC § 170(h)(4)(B)

In Zarlengo,  the taxpayers had purchased the subject property, a four-story townhouse built in 1890 located on the Upper West Side of Manhattan, in 1975 and completely renovated the property using materials designed to preserve its historic character. The Zarlengos’ neighbors followed suit, and the New York City Landmarks Preservation Commission “took notice” and designated the neighborhood an historic district in 1985.  In the early 2000’s, the Zarlengos learned about the possibility of donating a facade easement to  the National Architectural Trust (NAT) from neighbors. Before meeting with NAT representatives, however, Dr. Zarlengo contacted his CPA to see if such a deduction would be legitimate. It was only after hearing back from the CPA that the deduction was, indeed, legitimate that Dr. Zarlengo pursued the donation.

For the tax year 2004, the Zarlengos submitted an application to NAT regarding a proposed easement contribution and the NAT obtained the necessary approvals.  The Zarengos obtained an appraisal from an appraiser recommended by NAT estimating that the easement had a value of $660,000 (11% of the townhouse’s estimated $6 million prior to the contribution).  On September 10, 2004, the Zarlengos signed the conservation deed and had it notarized. On September 22, 2004, a duly authorized representative of the NAT signed the conservation deed on behalf of the NAT.    Although the deed conveying the easement was executed in September 2004, it was not recorded until January 26, 2005.   Dr. Zarlengo filed a joint return for 2004 reporting a deduction for the value of the easement. Due to gross income limitations imposed on charitable contribution deductions, they claimed only a portion of the deduction on their 2004 return and carried the excess forward to subsequent returns. The only year at issue in this case was 2004.

The IRS argued that the taxpayers were not entitled to any deduction in 2004 because the facade easement was not protected in perpetuity during that year because of the failure to record the deed until the year 2005. In analyzing the issue, the Tax Court first stated the well settled rule that, “[i]n a Federal tax controversy, State law controls the determination of a taxpayer’s interest in property while the tax consequences are determined under Federal law.” Accordingly, New York law governed when the taxpayers’ donation of the facade easement was regarded as complete, but Federal tax law determined the tax consequences.  Under New York law, an instrument purporting to create, convey, modify, or terminate a conservation easement is not effective unless recorded. N.Y. Envtl. Conserv. Law (NYEC Law) sec. 49-0305(4) (McKinney 2008 & Supp. 2014). In Rothman, TC Memo. 2012-163, the court stated that "[i]nsofar as New York law does not regard an easement contribution as effective until the recordation date, we conclude that the contribution date for an easement on real property in New York is the recording date."

Because New York law provides that conservation easements in the state are not effective unless they are recorded, the facade easement was not effective until January 26, 2005, the date on which it was recorded. The Tax Court then explained that, even assuming the easement had been legally enforceable by NAT against the taxpayers in 2004 because both parties signed the deed that year, the easement still would not have satisfied the perpetuity requirements in 2004 “because neither the use restriction nor the conservation purpose of the conservation easement was protected in perpetuity until January 26, 2005.”  The court explained that if a “buyer had purchased the townhouse and had recorded the deed of conveyance before January 26, 2005, that buyer could have taken the townhouse free and clear of the conservation easement.”  The court further stated that the possibility that this could have occurred was not “so remote as to be negligible.”  Accordingly, the Tax Court determined that the Zarlengos were not entitled to a deduction for the donation of the facade easement in 2004, the only year at issue with respect to the doctor and his wife in this case, because the easement did not satisfy the perpetuity requirement.

61 York Acquisition, LLC: Facade Easement Didn’t Qualify for Deduction Because It Didn’t Preserve the Entire Exterior of the Building As Required Under IRC § 170(h)(4)(B)

IRC § 170(h)(4)(B) provides that a contribution that consists of an easement on the exterior of a certified historic structure is not exclusively for conservation purposes unless the interest: (i) includes a restriction which preserves the entire exterior of the building (including the front, sides, rear, and height of the building) and (ii) prohibits any change in the exterior of the building which is inconsistent with the historical character of such exterior.  The requirement that the easement must include a restriction that preserves the entire exterior of the building, as opposed to one that protects only the front facade of the building, was imposed under the Pension Protection act of 2006.

In 61 York Acquisition, LLC,  York Acquisition granted a facade easement on December 18, 2006 with respect to a certified historic structure located in the Historic Michigan Boulevard District of Chicago to NAT, claiming a $10.7 million charitable income tax deduction for the donation on its 2006 partnership tax return.  At the time of the contribution of the facade easement, ownership of the structure subject to the easement was divided into two parts.  York Acquisition owned the first 14 floors and a third party owned the top 6 floors. The two owners had entered into an agreement pursuant to which:

  • York Acquisition owned the “Facade,” defined as including only portions of two sides of the building;
  • York Acquisition reserved the right to grant an easement with respect to the Facade,
  • York Acquisition was responsible for maintenance of the Facade as well as maintenance of other portions of the facade of the structure, and
  • Any owner who wished to make an addition, improvement, or alteration that materially altered the Facade had to obtain prior written consent of the other owner.

The IRS disallowed the taxpayer’s claimed deduction on the grounds that the Partnership could not have granted a valid easement restricting the entire exterior of the structure (front, sides, rear, and height) because the taxpayer did not own the entire exterior of the building. The taxpayer argued that the terms of the easement and the agreement collectively imposed enforceable restrictions on the entire exterior of the property, and that, under Illinois law, ownership of the entire exterior is not required to grant an easement that imposes enforceable restrictions on the entire exterior. 

The Tax Court sided with the IRS. The court first reiterated the well-established rule that, while “[s]tate law determines the nature of property rights, … Federal law determines the appropriate tax treatment of those rights.” Accordingly, to determine whether the easement complied with the federal requirement that a facade easement restrict the entire exterior of a structure, the court looked to state law to determine the effect of the easement. The court determined that, under Illinois law, “a person can grant only a right which he himself possesses,” Accordingly, York Acquisition did not grant an easement in the entire exterior of the structure, as required under federal law, because it had rights only to the “Facade,” which included only portions of two sides of the structure, not the entire exterior of the building.



[1] TC Memo 2014-161.

[2] TC Memo 2013-266.

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