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Failure to Subordinate Mortgages Precludes Conservation Easement Deduction

(Parker Tax Publishing October 2017)

The Tax Court held that the grant of a facade easement by the owner of a building was not a qualified conservation contribution because the mortgages on the building were not properly subordinated to the donee's right to enforce the conservation purposes of the easement. In finding for the IRS, the Tax Court declined to follow the First Circuit's decision in Kaufman v. Shulman, 2012 PTC 204 (1st Cir. 2012), which held that a mortgagee's priority claim to extinguishment proceeds did not cause a conservation contribution to fail to qualify as such under Code Sec. 170(h). Palmolive Building Investors, LLC v. Comm'r, 149 T.C. No. 18 (2017).


Palmolive Building Investors, LLC owns the Palmolive Building in downtown Chicago. In 2004, Palmolive granted an easement in favor of the Landmarks Preservation Council of Illinois (LPCI), an Illinois nonprofit corporation and qualified organization under Code Sec. 170(h)(3). Palmolive filed a deed stating that the purpose of the easement was to preserve the exterior perimeter walls of the building's facade. Palmolive, and any subsequent owner of the building, was required under the deed to maintain the building's facade and could not alter it without LPCI's permission.

There were two mortgages on the building when the deed was filed. One was owed to Corus Bank and the other to the National Electrical Benefit Fund. Before executing the deed, Palmolive secured agreements with both lenders to subordinate their mortgages to LPCI's rights to enforce the easement. Each mortgage had a balance of approximately $55 million as of December 2004. When Corus made its loan in 2003, the building was worth approximately $190 million. At the time of the easement donation in 2004, the building was appraised at $257 million, of which around $33 million was attributable to the easement.

The easement deed included a section titled "Subordination of Mortgages." That section contained a clause stating that, notwithstanding the subordination, the mortgagees had a prior claim to any insurance and condemnation proceeds over LPCI until the mortgages were discharged. The deed also provided that the lien of any mortgage on the property was superior to the LPCI's right to any insurance proceeds or condemnation awards. In the event that the easement was extinguished, LPCI was entitled under the deed to the net insurance or other proceeds, excluding any preferential mortgagee claim. The deed specified that a foreclosure would not extinguish LPCI's conservation right. A savings clause stated that if the deed conflicted with any tax regulations governing qualified conservation contributions, the deed would be deemed amended to bring it into full compliance. However, if a deemed amendment adversely affected a mortgagee's rights, then the mortgagee's consent was required.

The IRS audited Palmolive's 2004 return and determined that the deed did not meet the requirements of Code Sec. 170. The IRS disallowed the claimed deduction for the donation of the facade easement and determined that Palmolive was liable for either a gross valuation misstatement or a substantial understatement penalty. Palmolive challenged the IRS's determination in the Tax Court.

Perpetuity Requirement for Conservation Easement Contributions

In order to deduct the value of a conservation easement contribution, Code Sec. 170(h)(5) requires that the conservation purpose must be protected in perpetuity. If the property is subject to a mortgage, then Reg. Sec. 1.170A-14(g)(2) requires the mortgage must be subordinated to the donee's right to enforce the conservation purposes of the gift. Reg. Sec. 170A-14(g)(6)(ii) provides that the easement must give the donee a property right and that, if the easement is extinguished, the donee must be entitled to proceeds at least equal to the value of the easement. Under Reg. Sec. 1.170A-14(g)(3), a deduction is not disallowed if the donee's interest can be defeated by an event not otherwise addressed in the regulations that is so remote as to be negligible.

Taxpayer and IRS Arguments

Before the Tax Court, the IRS argued that the deed did not qualify under Code Sec. 170(h)(5)(A) because it gave the mortgage lenders prior claims to any extinguishment proceeds in violation of the mortgagee subordination requirement.

Palmolive argued that, notwithstanding the prior claim provisions, the purpose of the subordination requirement was satisfied because the deed prohibited the extinguishment of the easement by foreclosure. Palmolive contended that the lenders' priority as to insurance proceeds in the event of extinguishment did not interfere with LPCI's property right and that nothing in the regulations specifically gave a donee the right to share in insurance proceeds. Palmolive also contended that the deed qualified under Kaufman v. Shulman, 2012 PTC 204 (1st Cir. 2012), where the First Circuit held a mortgagee's prior claim to extinguishment proceeds did not disqualify a conservation easement. Palmolive further argued that the chain of events necessary for a priority problem to affect LPCI's interest was so remote as to be negligible. Finally, Palmolive asserted that if the deed failed to properly subordinate the mortgagees' interests, the deed was retroactively reformed by the savings clause.

Tax Court's Analysis

The Tax Court held that the deed failed to qualify under Code Sec. 170(h)(5) because the mortgages were not fully subordinated to the easement, LPCI was not guaranteed to receive proceeds if the easement was extinguished, and the deed's defects were not cured by the savings clause. According to the Tax Court, the deed did not subordinate the mortgages because the mortgagees had prior claims to the insurance and condemnation proceeds and were entitled to those proceeds in preference to LPCI. Although the deed prohibited the extinguishment of the easement by foreclosure, the Tax Court found that the language Reg. Sec. 1.170A-14(g)(2) required the subordination of the mortgagees' rights in the property, not just their right to foreclose. Further, the lenders' prior claim with respect to insurance proceeds was at odds with true subordination, the Tax Court said.

The Tax Court also rejected Palmolive's argument that the regulations do not explicitly require the donee to have priority as to insurance proceeds. In the Tax Court's view, Palmolive borrowed money and used the entire property, including the facade, as collateral for the loans. The Tax Court reasoned that an owner cannot grant an easement in a facade and then hold back an interest in it by using it as collateral and exploiting insurance coverage on it to repay the mortgage. Rather, the lender's rights in the property (as collateral for its loans and as a predicate for insurance proceeds) must be subordinated to the donee's interests.

The Tax Court declined to the follow the First Circuit's decision in Kaufman v. Shulman, 2012 PTC 204 (1st Cir. 2012). In that case, the First Circuit reasoned that if a donee's entitlement to extinguishment proceeds took priority over all other parties, then almost no easement contributions would qualify because a tax lien could arise and give the government priority over the donee's interest. The Tax Court's response was that a hypothetical tax lien was different from the actual security interest of a lender that exists at the time of the donation. The easement had to be analyzed based on the rights and interests existing when the easement was granted, in the Tax Court's view, not on speculations of interests that could arise in the future. The Tax Court also noted that the regulations are silent with respect to tax liens and taxpayers could not be expected to imagine and comply with nonexistent regulations requiring subordination of tax liens which do not exist at the time of the contribution. The Tax Court found that the legislative history supported its conclusion by showing that Congress intended for the donee to stand at the head of the line against all other parties in interest, including mortgage lenders.

Palmolive's argument that the likelihood of the building being destroyed and LPCI not receiving its proportionate share of insurance proceeds was so remote as to be negligible was rejected by the Tax Court. The Tax Court found that Reg. Sec. 1.170A-14(g)(3) is not an alternative provision for taxpayers to use if a deed otherwise fails the subordination and extinguishment provisions in the regulations. The fact that mortgages and extinguishment proceeds are regularly occurring circumstances that are expressly provided for in the regulations, and that were explicitly addressed by the parties in the deed, meant that they could not be considered events not specified in the regulations, and were not so remote as to be negligible.

Finally, the Tax Court determined that the savings clause in the deed did not correct the subordination issue. According the Tax Court, the mortgagees' right to consent to a deemed amendment meant that LPCI had only a contingent right to recover if either the value of the property permitted it or if the lenders agreed to suffer a loss and gratuitously allow LPCI to move to the front of the line. The Tax Court further found that the requirements of Code Sec. 170 must be satisfied at the time of the contribution, and the savings clause therefore could not retroactively modify the deed to comply with the statute and regulations.

For a discussion of qualified contributions of conservation easements, see Parker Tax ¶84,155.25.

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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