IRS Cracks Down on Breaks Tied to Rich Americans' Land
Behind the glazed white terra cotta facade of the Ritz-Carlton hotel in New Orleans is a 16-year legal battle with the Internal Revenue Service.
The developers of the hotel, which is housed in a former department store on the edge of the French Quarter, say their promise to preserve the century-old facade entitles them to a $7.4 million deduction. The U.S. tax agency disagrees.
In this case and dozens like it, the IRS is challenging a complex and obscure tax break that benefits some of the nation’s wealthiest property owners. Without giving up land, they donate the hard-to-calculate value of a perpetual promise to leave the property undisturbed. For that, they claim a big tax deduction.
“They’re overwhelmingly to high-end individuals and provide little to no benefit to the public,” said Dean Zerbe, who examined easement donations as a Republican aide on the Senate Finance Committee. “I don’t know if I could design a tax break that’s more targeted toward the millionaire set.”
The conservation easement break is one of hundreds scattered throughout the tax code that members of Congress are reviewing as they consider making the most significant revisions since 1986. The lawmakers are looking for ways to curtail breaks that benefit the richest Americans to offset the revenue that would be lost through lower tax rates.
In 2010, 2,933 U.S. taxpayers deducted $766 million in easement donations from their taxes, according to the most recent IRS data. While that’s down from a $2.2 billion peak in 2007, the conservation easement break is more valuable than ever this year because of tax-rate increases for top earners and a temporary incentive that expires on Dec. 31.
The break’s bipartisan defenders include wildlife groups, conservationists and a mini-industry of appraisers, lawyers and land trusts that’s grown up around it over four decades.
That coalition and the break’s relatively small size in a U.S. tax system that raised $2.8 trillion last year demonstrates how narrow interests can keep targeted provisions anchored in the code.
Between 2003 and 2006, taxpayers saved an estimated $4 billion through easement donations, about 6 percent of the revenue that the U.S. government will forgo because of the mortgage interest deduction next year alone.
The IRS has been litigating dozens of easement cases, challenging deductions taken by an Idaho congressman, the National Golf Club of Kansas City and the co-founder of a New York investment firm managing $1.4 billion.
In the case of the Ritz-Carlton Hotel, which advertises its “traditional Southern ambience,” the developers initially said their inability to alter the historic facade of the Maison Blanche building was worth $7.4 million.
The IRS said it was worth about 15 percent of that, and the lawyers and appraisers have been arguing ever since. The case is heading to a federal appeals court for the second time.
Congress first specifically allowed tax deductions for conservation easements in 1976 and made the rule permanent in 1980, even with concerns from the Treasury Department.
After numerous court decisions and congressional changes that tightened rules for appraisers in 2006, the break is still open to golf-course developers who promise not to build houses on fairways, owners of historic townhouses who pledge not to build skyscrapers, and rural landowners who donate development rights on 20-acre backyards they don’t intend to sell.
In a typical transaction, a property owner receives an appraisal of the value of land if developed with houses and a second appraisal of the value with restrictions. The landowner then signs a legal document assigning the development rights to a land trust and claims a tax deduction for the difference between the two appraisals.
Conservation easements are different from cash or stock donations where easy-to-value liquid assets change hands. In these cases, the benefit to the public is often far less than the amount claimed as a charitable deduction, said Daniel Halperin, a Harvard Law School professor.
The IRS, even with diminishing resources and added responsibilities to implement the 2010 health-care law, is trying to curb taxpayers’ ability to take advantage of the conservation easement tax break.
The provision is susceptible to abuse because the definition of what qualifies as conservation can be vague and subjective. It includes preserving the “harmonious variety of shapes and textures” and “the degree of contrast and variety provided by the visual scene.” Furthermore, it’s difficult to value transactions with few, if any, comparable deals.
“It’s putting the IRS in the awkward position of trying to determine what’s a conservation purpose,” said Roger Colinvaux, who analyzed the issue when he was at the nonpartisan Joint Committee on Taxation. “You don’t really know what you’re getting for your money.”
The Ritz-Carlton case is an extreme example of the legal complexities and time that can be spent on a conservation easement case. It dates to 1997, three years before the hotel opened, when the developers claimed a deduction for their contribution to the Preservation Resource Center of New Orleans.
The project’s originator was Stewart Juneau, a New Orleans developer who kept a hotel penthouse as his own residence. He left the ownership group -- Whitehouse Hotel Limited Partnership -- several years ago, said Gary Elkins, the partnership’s attorney.
Juneau now runs a nonprofit African village and safari camp in central Louisiana for underprivileged children. He didn’t respond to a request for comment.
The case wound its way through the IRS and the appeals process before the developers sued the agency in the U.S. Tax Court in 2003. They cited appraisals supporting the deduction.
Five years later, the court rejected most of the developers’ arguments, declared the deduction worth $1.8 million and upheld a penalty for a “gross valuation misstatement.” The court last year adjusted the value to $1.9 million.
The IRS’s aggressive enforcement ignores the fact the hotel’s owners have already spent more than the value of the donation restoring and maintaining the facade as required by the easement, said Elkins, of Elkins PLC in New Orleans. The agency’s approach has also curtailed donations against Congress’s intent, he said.
“No one wants the Internal Revenue Service to become their best friend and move into their house for a period of 16 years,” he said. “And so people will not utilize an incentive when the use of it is so uncertain and the consequences of the use of it have potentially punitive results.”
The IRS didn’t respond to questions about its enforcement of the tax break or requests to interview officials.
“These are hard to administer and very expensive to administer,” Ruth Madrigal, an attorney-adviser in the Treasury Department, said at an American Bar Association conference in May, according to a transcript provided by EO Tax Journal. “If you step back a minute and look at it from a policy perspective, how much charitable benefit are we really getting out of those easements that are put on golf courses anyway?”
The tax benefit’s backers say it has helped preserve historic buildings and millions of acres of land across the country. According to the Land Trust Alliance, state and local land trusts held 8.8 million acres under easements in 2010, up from 2.3 million a decade earlier.
An expanded benefit for conservation easements expires on Dec. 31, and lawmakers are focusing more on a long-term change than on a routine extension. Representative Dave Camp of Michigan, the Republican chairman of the House Ways and Means Committee, plans to push a bill revamping the tax code through his panel this year. His Senate counterpart, Max Baucus, said he will release “discussion drafts.”
Any limits on the charitable deduction would shrink the value of this specific break. President Barack Obama has proposed limiting all deductions to the value they would have in the 28 percent bracket. That means a $1 million donation would save someone in the top bracket $280,000 instead of $396,000.
“There is a real state of awareness that we may have no more than until the end of the year,” said Stephen Small, a former IRS official who is now a real estate lawyer in Massachusetts.
“It’s very unlikely that the incentives are going to be extended into 2014,” he said. “When more people realize that, I think we are likely to see a flurry of easement donations.”
A coalition of preservationists and wildlife groups is lobbying to extend the expanded break, and they’ve largely been successful in Congress.
The temporary break lets people deduct up to 50 percent of their adjusted gross income, instead of 30 percent. It allows some farmers and ranchers to deduct all of their adjusted gross income and lets donors spread their deductions over 16 years instead of having just six years to generate enough income to take the entire break.
Congress last extended the deduction in January as part of an agreement to let top tax rates increase. The extension covered 2012 and 2013 and will cost the government an estimated $254 million over the next decade in forgone revenue.
The main Senate bill to make the expanded tax break permanent is sponsored by Baucus, a Montana Democrat who heads the Senate Finance Committee, and Orrin Hatch of Utah, the panel’s top Republican. They introduced the measure on March 12, setting down a marker for their priorities. Their bill would ban golf-course easements, responding to an administration proposal.
In the House, the two lead sponsors are members of the Ways and Means Committee -- Democrat Mike Thompson from the California wine country and Republican Jim Gerlach from the suburbs and farmland northwest of Philadelphia.
They’ve attracted 144 co-sponsors -- more than 33 percent of the House -- and will be in position to protect the break when the panel weighs a bill to revamp the tax code.
Gerlach said the break would be “well-received” as a way to preserve the “environmental quality of life” as Congress examines the tax system. “These are very popular programs in suburban districts like mine,” he said.
Conservation easements are a tiny part of the tax code, benefiting people with valuable property and tax lawyers, in cases where the potential tax benefit outweighs the transaction costs. The 2010 donations represented less than 2 percent of non-cash contributions and less than 0.5 percent of all charitable deductions.
That small size relative to the tax system demonstrates how many breaks are embedded within the code. Its persistence also shows how an industry can develop around a tax break.
The deduction’s relatively small fiscal effect is one of the arguments for keeping it, says Russ Shay, director of public policy at the Land Trust Alliance in Washington, a trade association for conservation groups that accept easement donations. It’s less expensive than direct government purchases of land, he said, and eliminating the enhanced incentive would pay for cutting tax rates by only 0.001 percent.
“In the context of needing trillions and trillions of dollars,” he said, “our proposal is not a big deal.”
On facade easement donations, which have declined in recent years, the IRS was particularly aggressive with those in New York, Washington and Boston that Small called an “organized assault on the tax code.” In some cases, which were mass-marketed to homeowners, advisers used simple formulas, not appraisals, to determine the deduction’s amount.
Small said the IRS should find a way to stop the abusive transactions and let the other ones go forward.
“It would be nice if there were a way to get the IRS to understand in their audits that there are two different kinds of transactions,” Small said. “That makes it very hard on honest, above-board donors who really get put through the grinder.”
Among those audited was Walt Minnick, who filed his case in the U.S. Tax Court in 2009 while he was a Democratic congressman representing Idaho. He donated an easement on some of his property near Boise as part of a plan to develop seven houses on 10-acre lots on another section of the land.
The IRS said his contribution was invalid and assessed him $183,184 in back taxes and $73,273 in penalties.
The court in 2012 ruled against Minnick because he hadn’t filed paperwork that subordinated a loan against his property to the land trust’s claims. Minnick, who said he has spent more than $100,000 on legal fees, is appealing over a technical question about when the paperwork should be filed.
“Where there’s been abuse, the IRS should attack either the substance of the easement or the amounts being claimed,” said Minnick, who lost his re-election bid in 2010 and is now a Washington lobbyist. “In this case, they painted with too broad a brush.”
The developers of the National Golf Club of Kansas City lost portions of their case and are awaiting a decision after a trial. Lisa Hansen, an attorney representing the club, didn’t respond to a request for comment.
Barry Friedberg, co-founder of investment manager FriedbergMilstein LLC in New York, lost his first attempt to donate the facade of his six-story townhouse on the Upper East Side of Manhattan and claim a $3.8 million deduction.
The Tax Court in 2011 ruled against Friedberg, citing his appraiser’s use of properties in Washington and New Orleans as comparable transactions and saying it didn’t meet the standards of a “qualified appraisal.” After an appeals court ruling in a similar case, the Tax Court on Sept. 23 reversed itself, declaring that the appraisal met the law’s standards and reserving further issues for a trial.
The Obama administration has made little headway in its effort to push lawmakers to prevent golf courses and air rights above historic buildings from qualifying for the break. Limits backed by supporters of the broader break haven’t gone anywhere.
David Wooldridge, an Alabama tax lawyer, won the first major golf club case against the IRS in 2009 for the Kiva Dunes course, which shares a peninsula with the Bon Secour National Wildlife Refuge between Mobile Bay and the Gulf of Mexico.
After Wooldridge presented exhibits and witnesses showing how the course preserved habitats for migratory birds and open views, the IRS conceded that golf-course donations were allowed. It contested only the value.
Tax Court Judge Thomas Wells reduced the value of the donation to $28.7 million from $30.6 million.
Ridiculing the tax break, Wooldridge says, misses the fact that perpetual easements on golf courses preserve green space in fast-developing areas.
“You’re looking at what’s going to happen 50 years now,” he said. “It’s a way really of preserving that property out well into the future.”
The Baucus-Hatch bill is S. 526. The Gerlach-Thompson bill is H.R. 2807.
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