Tax Court Rejects $22 Million Easement Deduction Based on "Lost Development Rights"

(Parker Tax Publishing August 2024)

The Tax Court upheld the disallowance of a charitable contribution deduction claimed by a partnership based on its "lost development rights" resulting from an easement it granted over an historic office building that prohibited it from constructing a 34-story vertical addition on top of the building. The 34-story tower was in the court's view an unrealistic concept created to support a wildly inflated appraisal, and the court imposed a 40 percent gross valuation misstatement penalty after finding that the value of the easement claimed by the partnership exceeded its actual value by more than 200 percent. Corning Place Ohio, LLC v. Comm'r, T.C. Memo. 2024-72.

Background

Corning Place Ohio, LLC (Corning Place), is an Ohio limited liability company (LLC). Corning Place Ohio Investment, LLC (CP Investment), is its tax matters partner. In 2015, Corning Place acquired the Garfield Building, a historic 11-story building in downtown Cleveland, Ohio, for $6 million. Corning Place proceeded to renovate the building pursuant to a rehabilitation plan approved by the National Park Service (NPS) and the State of Ohio, both of which awarded historic preservation tax credits. Corning Place used the tax credits to finance the renovation.

On May 25, 2016, Corning Place granted a conservation easement over the Garfield Building to Historic Gateway Neighborhood Corp. (Gateway), a qualified organization under Code Sec. 170(h). The easement covered the entire facade of the Garfield Building. The parties stated that their intention was that the facade would be maintained forever in its rehabilitated condition, exclusively for conservation and preservation purposes.

Corning Place filed a return on Form 1065, U.S. Return of Partnership Income, for "the tax year beginning 07-07-2016 [and] ending 12-31-2016." This filing period reflected the fact that, immediately before July 7, 2016, Corning Place became a single-member LLC on May 18, 2016, when all of its investors other than CP Investment surrendered their membership interests. Corning Place ceased to be a disregarded entity on July 7, 2016, when Corning Place Master Tenant (Tenant) acquired a 10 percent interest in it.

On its 2016 return, Corning Place reported a charitable contribution deduction of $22,601,000 for the easement granted to Gateway. The amount of the deduction corresponded to an appraisal prepared by Claud Clark III, an appraiser who was well known for performing "lost development rights" appraisals. This type of appraisal uses a discounted cashflow methodology to calculate the supposed development potential of real estate, often with an assumed highest and best use as a residential subdivision. By placing an easement on the property, the developer assertedly becomes entitled to a charitable contribution deduction equal to the property's alleged "before" value - hypothetically built out into a multimillion-dollar subdivision - minus the value of the property (often de minimis) after being encumbered by the easement. In preparing his appraisal, Clark performed his usual residential subdivision analysis, but he hypothesized a development that was vertical rather than horizontal. Clark's analysis assumed a 34-story vertical addition on top of the Garfield Building. Clark calculated that the addition would add 415 apartments with an average monthly rent of $2,216, and concluded that the "value of lost development" as a result of the granting of the easement was $22,128,045.

The IRS audited Corning Place's 2016 return. In 2020, the IRS issued a Notice of Final Partnership Administrative Adjustment (FPAA) disallowing Corning Place's claimed charitable contribution deduction in its entirety. The FPAA determined that Corning Place had failed to establish that (1) it had made a "contribution or gift" during its 2016 tax year, (2) the contribution satisfied all the requirements of Code Sec. 170 or (3) the value of the contributed property was greater than $0. The IRS also imposed a 40 percent penalty under Code Sec. 6662(h) for a gross valuation misstatement. Corning Place petitioned the Tax Court to review the FPAA.

Analysis

The Tax Court sustained both the disallowance of the charitable contribution deduction and the imposition of the 40 percent gross valuation misstatement penalty.

In the court's view, the 34-story tower was a "chimerical concept ginned up solely to support a wildly inflated appraisal." The found that, apart from being structurally implausible and economically unsound, adding 34 floors of steel and concrete atop the Garfield Building would have required Corning Place to forfeit the tax credits upon which it relied to finance the renovation. The court noted that as a condition of receiving those credits, Corning Place had pledged that the renovation would entail no rooftop improvements "visible from the street" and needless to say, a 34-story addition on top of the building would have been visible from the street.

The court noted that the IRS offered ten distinct and sufficient grounds for the denial of Corning Place's deduction, but it was sufficient to address just one - namely, that Corning Place did not make any charitable contribution deduction during the 2016 tax year for which its return was filed. The court observed that Corning Place became a single-member LLC on May 18, 2016, and it remained a single-member LLC until July 7, 2016. Corning Place was not a per se corporation under Reg. Sec. 301.7701-2(b), and it did not elect to be classified as a corporation under Reg. Sec. 301.7701-3. Thus, Corning Place during this period was disregarded as an entity separate from its owner, CP Investment. As a result, all items of income, gain, loss, deduction, or credit relating to Corning Place between May 18 and July 6, 2016, were directly attributable to and reportable by CP Investment.

The return on which Corning Place claimed the deduction was for the short year beginning July 7, 2016, and ending December 31, 2016. The contribution to Gateway, however, was made on May 25, 2016. The court found that, by its terms, Code Sec. 170(a) allows a deduction only for a charitable contribution "payment of which is made within the taxable year." Because Corning Place did not make payment of the contribution within its taxable year beginning July 7 and ending December 31, 2016, as claimed on its 2016 return, the court concluded that the IRS correctly denied that deduction.

Although Corning Place was entitled to a charitable contribution deduction of zero, the court had to determine the proper valuation of the easement for purposes of determining whether penalties applied. The court determined the value of the easement by comparing the value of the Garfield building immediately before the granting of the easement and immediately after. In the court's view, the value of the Garfield building on May 25, 2016, the day before the easement was granted, was $6 million based on the price at which Corning Place purchased the building. Next, the court determined that on May 27, 2016, the day after the granting of the easement, the building was worth $5.1 million using a sales comparison approach. Therefore, the value of the easement was $900,000. The court concluded that the claimed value of $22 million exceeded the correct value by approximately 2,400 percent, meaning that the valuation misstatement was "gross" under Code Sec. 6662(h) because it exceeded 200 percent of the correct amount.

For a discussion of historic preservation easement deductions, see Parker Tax ¶84,155. For a discussion of valuation misstatement penalties, see Parker Tax ¶262,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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