In Palmolive Building Investors, LLC v. Commissioner, 149 T.C. No. 18, the Tax Court denied a charitable contribution deduction of a donated façade easement because the easement deed failed to satisfy the perpetuity requirement of section 170.
Background – Perpetuity Requirement
A contribution of a qualified real property interest is deductible as a qualified conservation contribution if, among other requirements, the contribution is exclusively for conservation purposes. The “exclusivity” requirement is only satisfied if the conservation purposes are protected in perpetuity. To be protected in perpetuity, the interest in the property retained by the donor must be subject to legally enforceable restrictions that will prevent uses of the retained interest inconsistent with the conservation purposes of the donation. The Regulations provide rules for many of these legally enforceable restrictions.
When donated property is subject to a mortgage, the mortgagee must subordinate its rights in the property to the right of the easement holder to enforce the conservation purposes of the gift in perpetuity. If the mortgagee fails to actually subordinate its rights in the property, the perpetuity requirement is not satisfied. Further, if an unexpected change in conditions makes the property’s continued use for conservation purposes impossible or impractical, then the restrictions required to protect the conservation purpose may be extinguished by judicial proceedings. In the event an easement is extinguished and the donor subsequently conveys the property and receives proceeds for it, the donee organization must be guaranteed to receive a certain portion of the proceeds.
Why Deed Failed to Satisfy Perpetuity Requirement in Palmolive Building Investors
In Palmolive Building Investors, Partnership PB (“Partnership”) transferred a façade easement by executing an easement deed (“Deed”) in favor of the Landmarks Preservation Council of Illinois (“LPCI”), a qualified organization. The purpose of the deed was to preserve the exterior perimeter walls of a building’s façade. At the time of the execution of the Deed, two mortgages encumbered the building. Before executing the Deed, Partnership secured an ostensible agreement from both mortgagees to subordinate their mortgages in the property to LCPI’s rights to enforce the purposes of the easement. However, the mortgagees’ subordination was limited by a provision in the Deed that gave the mortgagees a prior claim to any insurance and condemnation proceeds until the mortgage was paid off. This limitation proved to be fatal, as certain interests of the mortgagees were not actually subordinated to the interests of LPCI.
The IRS filed a motion for partial summary judgment, arguing that the easement deed did not satisfy the perpetuity requirement because it gave the mortgagees prior claims to extinguishment proceeds in preference to LPCI. The Tax Court agreed, holding that the easement deed failed to satisfy the perpetuity requirement for two reasons: (1) the mortgages on the building were not fully subordinated to the easement, and (2) LPCI was not guaranteed to receive its requisite share of proceeds in the event that the easement was extinguished and the donor subsequently conveyed the property and received proceeds for it.
It is worth noting that the Tax Court continued to strictly construe the requirement that the donee must be guaranteed to receive a certain portion of proceeds upon extinguishment, as it did in Kaufman v. Commissioner, 134 T.C. 182 (2010) – if a donee is not absolutely entitled to its requisite share of extinguishment proceeds, then the contribution’s conservation purpose is not protected in perpetuity. The First Circuit Court of Appeals has previously expressed its disagreement with this restrictive interpretation. In Kaufman v. Shulman, 687 F.3d 21 (1st Cir. 2012), the First Circuit explained that if any owner donates a facade easement and thereafter fails to pay taxes, a lien on the property arises in favor of the Government, and such lien would not be subordinated to the easement donee’s interest. Because this is always a possibility, a donee will never have an absolute entitlement to proceeds, so the perpetuity requirement will never be satisfied. The Tax Court refused to follow the First Circuit’s interpretation, explaining that it analyzes “conservation restrictions on the basis of property rights and interests that exist when the easement is granted, rather than conducting an analysis based on speculations of property interests that might arise in the future…”
This case illustrates the importance of ensuring that all requirements of section 170 are satisfied when a conservation easement is granted, as the Tax Court also held that the defects in the easement deed were not cured by a provision that sought to retroactively amend the deed to comply with section 170, because the requirements set forth in section 170 must be satisfied at the time of the gift.