This month, the Tax Court revived a method to defeat conservation deductions with its October 10 opinion published as Palmolive Building Investors LLC et al. v. Commissioner, No. 23444-14; 149 T.C. No. 18 (Oct. 10, 2017), holding that if a taxpayer donates a conservation easement, the Treasury Regulations’ requirement that any mortgage must be subordinated to the conservation easement includes subordination of the mortgagee’s rights to insurance and condemnation proceeds.
Palmolive Building is in direct contravention of the First Circuit appellate court’s 2012 ruling in Kaufman v. Shulman, 687 F.3d 21 (1st Cir. 2012)(Kaufman III), affirming in part, vacating in part, and remanding in part Kaufman v. Commissioner, 136 T.C. 294 (2011)(Kaufman II), and 134 T.C. 182 (2010)(Kaufman I). Under the Golsen rule, where a tax case is appealable to an appellate court and the appellate court has already ruled on the issue, the Tax Court must follow the appellate decision in that circuit. Because the Palmolive Building decision is appealable to the Seventh Circuit, the Tax Court has signaled that it declines to follow Kaufman III outside of the First Circuit.
Why does this matter?
The decision means that if a taxpayer donates a conservation easement outside of the First Circuit (comprising Maine, Massachusetts, New Hampshire, Puerto Rico, and Rhode Island), then the taxpayer must ensure that any existing mortgage on the property is properly subordinated to the easement and that the mortgagee does not retain any rights to be senior to the easement holder with regard to any insurance or condemnation proceeds. Otherwise, the deduction could be disallowed by the Tax Court.
In both Palmolive Building and Kaufman III, the taxpayer donated a façade easement and subordinated existing mortgages to the easement as required by the applicable Treasury Regulations, 26 C.F.R. 170A-14(g)(2). However, the subordinations were subject to the condition that the mortgagee would have first claim on insurance or condemnation proceeds, prior to the easement holder’s claim. The IRS argued that this condition violated the requirement of 26 C.F.R. 170A-14(g)(6)(ii) that, on extinguishment of the easement, the easement holder must be entitled to its share of the resultant proceeds. The First Circuit disagreed in Kaufman III and held that, to qualify as the “entitlement” required by -14(g)(6)(ii), the easement holder’s claim to the proceeds need only be senior to the property owner, not the mortgagee.
Interestingly, in the IRS’s 2012 Conservation Easement Audit Techniques Guide, the IRS warned several times that any subordination by a lender must include subordination to the division of proceeds clause required by 26 C.F.R. 170A-14(g)(6)(ii), but in the next edition of the Conservation Easement Audit Techniques Guide, which was published after Kaufman III, the IRS removed these warnings, presumably in acknowledgment of Kaufman III.
It looks like the Audit Guide needs to be dusted off and updated again. The Tax Court in Palmolive Building explicitly declined to follow Kaufman III and reaffirmed its own holdings in Kaufman I and Kaufman II. Outside of the First Circuit, a conservation easement deduction will be disallowed by the Tax Court where a mortgagee has retained a right to insurance and condemnation proceeds senior to the easement holder— unless the Seventh Circuit overturns Palmolive Building if it is appealed by the taxpayer.