142 T.C. No. 16
UNITED STATES TAX COURT
LOGAN M. CHANDLER AND NANETTE AMBROSE-CHANDLER,
Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 16534-08. Filed May 14, 2014.
Ps granted to a qualified organization facade easements on two
historic homes they owned. They claimed charitable contribution
deductions for 2004, 2005, and 2006 based on fair market value
appraisals of the easements. A portion of each of the 2005 and 2006
deductions resulted from a carryforward of a deduction they first
claimed for 2004. R disallowed the deductions because he
determined the easements were valueless. R imposed gross valuation
misstatement penalties on the underpayments resulting from the
alleged easement overvaluations.
Ps sold one of the homes in 2005 and reported capital gain. In
calculating the gain Ps reported a basis in the home that exceeded
their purchase price. They claim the basis increase resulted from
costs they incurred to improve the home. They failed to substantiate
the full amount of the improvement costs. R disallowed the entire
basis increase and imposed an accuracy-related penalty on the
resulting underpayment.
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Ps contend they had reasonable cause for any underpayments
and thus should not be liable for penalties. R claims that recent
amendments to the gross valuation misstatement penalty preclude Ps
from raising a reasonable cause defense for their 2006 underpayment.
Ps argue that part of that underpayment resulted from a deduction
carried forward from a return they filed before the amended rules took
effect. They argue that applying the amended reasonable cause rules
to their 2006 return would give the penalty amendments retroactive
effect.
Held: Ps failed to prove their easements had any value and
consequently were not entitled to claim related charitable contribution
deductions.
Held, further, Ps adequately substantiated a portion of the basis
increase they claimed on the home they sold and were entitled to
reduce their capital gain by the substantiated amount.
Held, further, Ps are liable for an accuracy-related penalty for
the portion of their 2005 underpayment resulting from
unsubstantiated basis increases they claimed on the home they sold.
Held, further, Ps are not liable for gross valuation misstatement
penalties for their 2004 and 2005 underpayments, because they
underpaid with reasonable cause and in good faith.
Held, further, Ps are liable for a gross valuation misstatement
penalty for their 2006 underpayment because the rules in effect when
they filed their 2006 return did not provide a reasonable cause
exception. Denying Ps’ reasonable cause defense does not amount to
retroactive application of the gross valuation misstatement penalty
amendments.
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Denis J. Conlon, Steven S. Brown, and Mason N. Floyd, for petitioner.
Carina J. Campobasso, for respondent.
GOEKE, Judge: Petitioners owned two single-family residences in
Boston’s South End Historic District. They granted a facade easement on each
property to the National Architectural Trust (NAT) and claimed related charitable
contribution deductions for taxable years 2004, 2005, and 2006. In 2005
petitioners sold one of the properties and reported a capital gain. Petitioners
claimed a basis in the property that reflected $245,150 of improvements.
Respondent disallowed petitioners’ charitable contribution deductions
because he determined the easements had no value. He also found that petitioners
had understated their gain on the property sale because they had overstated their
basis in the property. Finally, respondent determined that petitioners were liable
for accuracy-related penalties under section 6662.1
1
Unless otherwise indicated, all section references are to the Internal
Revenue Code in effect for the years in issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure.
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After concessions,2 the issues remaining for decision are:
(1) whether the charitable contribution deductions petitioners claimed for
granting conservation easements to NAT exceeded the fair market values of the
easements. We hold they did;
(2) whether petitioners overstated their basis in the property they sold in
2005. We hold they did, but they were entitled to increase their basis for
improvement costs they properly substantiated; and
(3) whether petitioners are liable for accuracy-related penalties under
section 6662. We hold they are but in amounts less those respondent determined.
FINDINGS OF FACT
Some facts were stipulated and are so found. Petitioners resided in
Massachusetts when they filed their petition.
A. Background
Petitioners filed joint Forms 1040, U.S. Individual Income Tax Return, for
each of the years in issue. Mr. Chandler has a law degree and a master’s in
2
Petitioners have conceded their liability for a $1,064.85 addition to tax
under sec. 6651(a)(1) for delinquently filing their 2004 return. Respondent has
conceded that petitioners’ donation of the easements complies with the
requirements for deduction under sec. 170. Respondent disputes only petitioners’
valuation of the easements.
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business administration and works as a business consultant. Mrs. Ambrose-
Chandler owns and operates an interior design company.
In 2003 petitioners purchased a home at 24 Claremont Park in Boston,
Massachusetts (Claremont property). In 2005 petitioners purchased another home
in Boston at 143 West Newton Street (West Newton property). Both homes are in
Boston’s South End, which the Federal Government has included in the National
Register of Historic Places and designated a National Historic Landmark District.
B. Conservation Easements
Congress has created the Federal Historic Preservation Tax Incentives
Program to encourage the preservation of historic structures. Under the program,
owners of historic buildings may be entitled to charitable contribution deductions
when they grant conservation easements on their buildings to organizations that
will protect the buildings’ historic character. The National Park Service (NPS)
publicizes the program and assists the IRS in administering it. Mr. Chandler read
about the program in a newspaper, and petitioners decided to grant a facade
easement to NAT on the Claremont property. When they purchased the West
Newton property, they again decided to grant a facade easement to NAT.
Under the terms of each easement, the property owner must obtain NAT’s
approval before beginning any construction that will alter the exterior of the
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building. NAT periodically sends representatives to inspect properties on which
NAT holds easements. If the inspector determines that a property owner has made
unauthorized changes, NAT can order remediation.
Boston’s municipal government has formed nine local historic district
commissions to regulate construction within their jurisdictions. The South End
Landmark District Commission (SELDC) has jurisdiction over the properties at
issue here. The SELDC’s powers closely approximate NAT’s powers under the
easement agreements with some exceptions.
First, the SELDC has no power to regulate construction that is not visible
from a public way and may not require property owners to make repairs. The
easement agreements grant NAT authority to regulate construction and order
repairs on any exterior surface of the home. Second, NAT has staff members who
perform annual site visits, while the SELDC relies on the public to alert it to
potential violations. Finally, NAT has absolute authority to enforce the terms of
its easements, even when doing so would produce substantial economic hardship
for the property owner. Under Massachusetts law, a property owner who faces
significant financial hardship may receive an exemption from the SELDC’s
enforcement. See Mass. Gen. Laws ch. 772, sec. 8 (1975).
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Petitioners claimed charitable contribution deductions related to the
easements on their 2004, 2005, and 2006 tax returns. Petitioners followed
guidance from the NPS and consulted their easement holding organization to find
an appraiser to value their easements. NAT recommended George Riethof and
George Papulis, who valued the Claremont easement at $191,400 and the West
Newton easement at $371,250. Petitioners consulted with their accountant
concerning the appraisals before claiming deductions on their returns. Because of
relevant limitations, petitioners deducted the values of the easements over several
years. For the years in issue (2004, 2005, and 2006) petitioners claimed
deductions for the easements of $73,059, $83,939, and $296,251 respectively.
Respondent determined the easements had no value because they did not
meaningfully restrict petitioners’ properties more than local law. Petitioners have
abandoned their original appraisals, but they have presented new expert testimony
supporting the values they claimed on their returns.
C. Gain on Home Sale
Petitioners purchased the Claremont property for $755,000 in 2003 when it
was in poor condition. They renovated the property and in 2005 sold it for
$1,540,000. On their 2005 return, petitioners reported an adjusted basis in the
property that included $245,150 of improvement costs. During his examination,
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respondent requested documentation substantiating the basis increase, but
petitioners had misplaced their receipts. Later, petitioners produced receipts for
expenses totaling $147,824.
Respondent’s examiner initially concluded that petitioners had substantiated
$60,000 of renovation costs. However, upon closer review, respondent noticed
that petitioners had claimed larger than average cost of goods sold deductions for
Mrs. Ambrose-Chandler’s interior design business for the years during the
renovations. Respondent believed that petitioners had deducted the renovation
expenses on their Schedules C, Profit or Loss From Business, for 2004 and 2005,
and accordingly respondent disallowed the entire $245,150 basis increase.
Respondent did not seek substantiation for petitioners’ Schedule C deductions
during the audit.
OPINION
I. Conservation Easements
A. Background
Congress has provided tax benefits to taxpayers who grant conservation
easements over historic properties they own. A conservation easement allows a
third party, typically a charitable organization, to monitor the owner’s use of
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property. An organization holding an easement may prevent the owner from
changing the property in a way that would destroy its historic character.
Under section 170, if taxpayers meet certain criteria, they may claim
charitable contribution deductions for the fair market value of conservation
easements they donate to certain organizations. See sec. 170(f)(3)(B)(iii); sec.
1.170A-1(c)(1), Income Tax Regs. Respondent concedes that petitioners have
satisfied the technical requirements for the deductions, but he disputes their
valuations of the easements. Petitioners bear the burden of proving their
deductions reflected the easements’ fair market values. See Rule 142(a)(1).
Easements are usually transferred by gift; consequently, we rarely have an
established market on which to rely in determining their value. Simmons v.
Commissioner, T.C. Memo. 2009-208, aff’d, 646 F.3d 6 (D.C. Cir. 2011); see also
Hilborn v. Commissioner, 85 T.C. 677, 688 (1985). We have often used the
“before and after” approach to value restrictive easements for which taxpayers
have claimed deductions. See, e.g., Hilborn v. Commissioner, 85 T.C. at 688-689;
Simmons v. Commissioner, T.C. Memo. 2009-208; Griffin v. Commissioner, T.C.
Memo. 1989-130, aff’d, 911 F.2d 1124 (5th Cir. 1990). Under this approach the
fair market value of the restriction is equal to the difference (if any) between the
fair market value of the property without the restriction (before value) and its fair
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market value with the restriction (after value). Sec. 1.170A-14(h)(3)(I), Income
Tax Regs. When a conservation easement enhances or does not materially affect
the property’s value, the taxpayer may not claim a deduction. Sec. 1.170A-
14(h)(3)(ii), Income Tax Regs.
An appraiser may use the comparable sales method or another accepted
method to estimate the before and after values of the property. Hilborn v.
Commissioner, 85 T.C. at 689-690. An appraiser using the comparable sales
method identifies property sales that meet three criteria: (1) the properties
themselves are similar to the subject property; (2) the sales are arm’s-length
transactions; and (3) the sales have occurred within a reasonable time of the
valuation date. Wolfsen Land & Cattle Co. v. Commissioner, 72 T.C. 1, 19
(1979). The appraiser uses the sale prices of the comparable properties to estimate
the value of the subject property.
Both parties submitted expert reports concerning the values of petitioners’
easements. Petitioners’ expert was Michael Ehrmann, and respondent’s expert
was John C. Bowman III.
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B. The Ehrmann Report
Using the comparable sales approach Mr. Ehrmann calculated before values
for the Claremont property and the West Newton property of $1,385,000 and
$2,950,000 respectively.
To estimate the properties’ after values, he attempted to quantify the effect
of petitioners’ easements. Mr. Ehrmann analyzed sales of seven properties
encumbered with easements similar to petitioners’. He compared those sales with
sales of comparable unencumbered properties to determine whether the easements
diminished property values. Of the seven encumbered properties he chose, four
were in Boston and three were in New York City. Accounting for Mr. Ehrmann’s
adjustments, the encumbered properties in the sample sold for an average of
18.5% less than the unencumbered properties.3
Mr. Ehrmann also included in his report information concerning a
settlement agreement arising from the sale of encumbered property in New
Orleans. The property’s seller did not disclose an existing conservation easement
3
Mr. Ehrmann’s report contains procedural errors. He calculated the
easement values by dividing the difference in sale prices by the encumbered
property’s price. He then applied that percentage to the before value of
petitioners’ properties to calculate the easement values. He should have divided
the difference in sale prices by the unencumbered property’s sale price. We have
adjusted the data in his report to account for this error.
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to the buyer. After the buyer bought the property, he discovered the easement and
sued the seller. The parties settled the dispute for 14.6% of the sale price. Mr.
Ehrmann claims that the settlement represents direct market valuation of the
easement restriction on the property.
On the basis of his data, Mr. Ehrmann estimated that petitioners’ easements
diminished their property values by 16%. Accordingly, he valued the easements at
about 16% of their before values--$220,000 for the Claremont easement and
$470,000 for the West Newton easement.
C. Ehrmann Report Analysis
Although Mr. Ehrmann used an appropriate methodology to isolate the
easements’ effects on property values, certain factors undermine its
persuasiveness. The locations of the sample properties are our first concern. Mr.
Ehrmann chose seven encumbered properties to measure against comparable
unencumbered properties. Of those seven properties, only four are in Boston; the
other three are in New York City. He also provided information concerning a
property settlement in New Orleans. We find Mr. Ehrmann’s analysis of the
properties outside Boston unpersuasive. The values of easements in other markets
tell us little about easement values in Boston’s unique market.
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Our second concern is the size of Mr. Ehrmann’s sample. We recognize
that the lack of encumbered property sales in petitioners’ neighborhood limited the
depth of Mr. Ehrmann’s analysis. Nevertheless, we must adjust our confidence in
his estimates accordingly. Although Mr. Ehrmann reviewed four encumbered
property sales in Boston, only one, “Easement Encumbered Sale #1”, is not
obviously flawed. “Easement Encumbered Sales #s 2 and 4” are flawed because
the “comparable” unencumbered property sales Mr. Ehrmann chose were not
actually comparable. “Easement Encumbered Sale #3” is flawed because one of
the comparable “unencumbered” properties was not actually unencumbered.
1. Easement Encumbered Sale # 1
“Easement Encumbered Sale #1” refers to the sale of the encumbered
Claremont property. Mr. Ehrmann compared this sale to the sale of unencumbered
property at 30 Claremont Park. Mr. Ehrmann determined the properties were in
the same condition and adjusted the comparable property’s sale price by only 1.3%
for other minor differences. The encumbered property sold for 12.5% less than the
unencumbered property.
2. Easement Encumbered Sales #s 2 and 4
“Easement Encumbered Sale #2” refers to the sale of the encumbered West
Newton property. Mr. Ehrmann compared this sale to sales of unencumbered
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properties at 118 West Newton Street and 176 West Canton Street. “Easement
Encumbered Sale #4” refers to the sale of encumbered property at 306
Marlborough Street. Mr. Ehrmann compared this sale to sales of unencumbered
properties at 285 Marlborough Street and 381 Beacon Street. Mr. Ehrmann
significantly adjusted the sale prices of the “comparables” before he compared
them to the encumbered property’s sale price. The adjustments ranged from
11.2% to 20.3% and included significant adjustments based on Mr. Ehrmann’s
subjective evaluation of the properties’ “condition”.4 Because of these significant
subjective adjustments, Mr. Ehrmann’s conclusions flowing from these
comparisons largely reflect his opinion rather than the objective market values of
the easements. When an appraiser makes numerous adjustments to a subject
property’s comparables, the subject property’s valuation becomes less reliable.
See Gorra v. Commissioner T.C. Memo. 2013-254, at *59. Accordingly, we give
these two comparisons little weight.
3. Easement Encumbered Sale #3
“Easement Encumbered Sale #3” refers to the sale of encumbered property
at 3 Cazenove Street. Mr. Ehrmann compared this sale to sales of comparable
4
The “condition” adjustments were: 5% for 118 West Newton, 15% for 176
West Canton, 20% for 285 Marlborough, and 10% for 381 Beacon.
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“unencumbered” properties at 6 St. Charles Street and 139 Appleton Street. After
adjustments, Mr. Ehrmann concluded that the Cazenove Street property sold for
12.8% and 18.5% less than the St. Charles Street and Appleton Street properties
respectively. He attributed these differences to the encumbrance on the Cazenove
Street property. However, the St. Charles Street property’s deed contains
restrictions that are substantially the same as those the Cazenove Street property’s
easement imposes. This indicates that the difference in price resulted from some
other factor that Mr. Ehrmann did not consider. This error undermines Mr.
Ehrmann’s credibility concerning not only this comparison, but the entire report.
D. The Bowman Report
Mr. Bowman did not independently evaluate the properties’ before values,
but he reviewed the appraisals petitioners relied on for their return. Those
appraisals included comparable sales analyses for each property. Mr. Bowman
determined that the appraisals were reasonable aside from one minor error that
resulted in a 10% undervaluation of the Claremont property. Mr. Bowman
corrected that error and assigned before values to the Claremont and West Newton
properties of $1,450,000 and $2,750,000 respectively.
To analyze the impact of petitioners’ easements, Mr. Bowman selected nine
recently encumbered Boston properties that sold between 2005 and 2011. He
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compared their prices in the sales immediately preceding and succeeding the
imposition of their easements. Each property had sold for more after it had been
encumbered. Mr. Bowman annualized the appreciation rates between the sales
and compared them to city wide appreciation rates for upper-tier properties. He
found that the properties in his sample appreciated at a higher-than-average rate.
On the basis of his analysis, he concluded that easements like petitioners’ do not
diminish the values of the properties they restrict and thus have no value. Mr.
Bowman acknowledged that many of the homes in his sample had been
significantly renovated, but he did not try to remove the renovations’ effect on
appreciation from his analysis.
E. Bowman Report Analysis
Mr. Bowman’s sales analysis is not persuasive, because it does not isolate
the effect of easements on the properties in his sample. The properties in his
sample appreciated in spite of their restrictions. However, many of the properties
had been significantly renovated, and Mr. Bowman’s report does not account for
the renovations’ effects on the property values. The report demonstrates that,
combined, the renovations and easements positively affected value, but the report
does not isolate the effect of the easements. To measure one variable’s effect, one
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must hold all other variables constant. Mr. Bowman’s report does not measure
easements’ effect on value, because he has not held other variables constant.
F. Conclusion
We do not find Mr. Ehrmann’s report credible and therefore reject his
conclusion that petitioners’ easements diminished their property values by 16%.
However, Mr. Ehrmann’s failure to persuasively value the easements does not
necessarily mean they had no value. Petitioners cite several cases in which we
have upheld valuations similar to theirs. See, e.g., Whitehouse Hotel Ltd. P’ship
v. Commissioner, 139 T.C. 304 (2012); Dorsey v. Commissioner, T.C. Memo.
1990-242; Griffin v. Commissioner, T.C. Memo. 1989-130; Losch v.
Commissioner, T.C. Memo. 1988-230. However, each of those cases involved
commercial property. Restrictions on construction impair the value of commercial
property more tangibly than they impair the value of residential property.
Commercial property derives its value from its ability to generate cashflows. For
commercial property, development generally correlates with increased future
cashflows. More retail space, more space for tenants, and more room for
customers generally increase profitability. Restrictions on the development of
commercial property reduce potential for increased future cashflows and thus
diminish value.
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Construction restrictions affect residential property values more subtly.
People do not buy homes primarily to make money, and personal rather than
business reasons usually motivate any construction on their homes. The loss of
freedom to make changes to the exterior of one’s home has a price, but it is
difficult to quantify. The task becomes even more difficult when we consider the
already existing restrictions on the property. Even if petitioners had not granted
the easements, local law would have prevented them from freely altering their
homes. The easements had value only to the extent their unique restrictions
diminished petitioners’ property values.
Petitioners have identified several differences between the easement
provisions and local law. The differences concern the scope, monitoring, and
enforcement of the construction restrictions.
The easements have a broader scope than local law because they restrict
construction on the entire exterior of the home and require property owners to
make repairs. Local law restricts construction only on portions of the property
visible from a public way, and local law does not require property owners to make
repairs.
Petitioners also were subject to different monitoring procedures under the
easement agreements. NAT inspects each of its properties annually for
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compliance with applicable standards. The SELDC relies on the public to report
violations. NAT’s historical compliance standards are also slightly different from
the SELDC’s.
Finally, NAT has greater power to enforce the terms of its easements than
the SELDC has to enforce local law. Unlike the SELDC, NAT has a right to enter
property to inspect for compliance, and NAT can require corrective action. NAT
can also enforce its easement terms even when doing so would impose substantial
economic hardship on the property owner. Under State law an owner may obtain
an exemption from local standards if compliance would cause a substantial
economic burden.
We must determine the value diminution resulting from these additional
restrictions. We recently performed this analysis under identical circumstances.
In Kaufman v. Commissioner, T.C. Memo. 2014-52, we reviewed a NAT
easement on a property in the South End Historic District. There we determined
that the differences outlined above do not affect property values, because buyers
do not perceive any difference between the competing sets of restrictions. Id. at
*57. We see no reason to break with that result here. Mr. Ehrmann’s report,
which petitioners exclusively rely on to demonstrate their easements’ values, was
not credible. Respondent has persuasively argued that a typical buyer would
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perceive no difference between the two sets of applicable restrictions here. We
recognize technical differences between the easements and local law, but we agree
with respondent’s conclusion that the restrictions were practically the same.
Because petitioners have not proved that the easements they donated had value,
we sustain respondent’s disallowance of the charitable contribution deductions
they claimed.
II. Gain on Home Sale
Taxpayers must recognize gain when they sell property for more than its
adjusted basis. Sec. 1001(a); sec. 1.61-6(a), Income Tax Regs. Taxpayers may
increase their adjusted basis in property for costs they incur to improve the
property, but they generally bear the burden of proving basis increases they claim.
See sec. 1016(a); Rule 142(a); sec. 1.1016-2(a), Income Tax Regs. The burden
may shift to the Commissioner if the taxpayer introduces credible evidence
supporting a basis increase. See sec. 7491(a)(1). If taxpayers cannot produce
records of actual expenditures, we may estimate the amounts of expenses if they
provide credible evidence that provides a factual basis for the estimate. See
Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930).
Petitioners increased their basis in the Claremont property by $245,150 for
improvement costs they claim they incurred. Petitioners concede that they bear
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the burden of proving they were entitled to the basis increase. They have
presented documentary evidence that proves they incurred costs of at least
$147,824 in improving the property. They have also submitted before and after
photos of the home that demonstrate they made significant renovations.
Respondent acknowledges that petitioners made improvements to the home.
However, he contends petitioners had likely already received tax benefits for the
improvement expenses. In particular respondent notes that for the years during the
renovations (2004 and 2005), petitioners reported unusually high costs of goods
sold on their Schedules C for Mrs. Ambrose-Chandler’s interior design business.
Respondent believes that petitioners included their renovation expenses in the
business’ costs of goods sold, which would have prevented them from also
increasing their basis in the property. See Thrifty Oil Co. v. Commissioner, 139
T.C. 198, 205, 217 (2012) (holding that taxpayer was not entitled to a double
deduction for the same economic loss).
Petitioners have presented credible documentary evidence supporting
$147,824 of their basis increase. Respondent contends that petitioners may have
included the improvement costs in their Schedule C costs of goods sold for 2004
and 2005. This argument, first made at trial, raises a new matter for which
respondent bears the burden of proof. See Rule 142(a)(1). Respondent cites the
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abnormally high costs of goods sold petitioners reported for those years, but he
has presented no evidence concerning the expenses underlying the total. Without
more specific evidence, we cannot conclude that petitioners included the
renovation expenses in their costs of goods sold. Respondent had ample
opportunity to investigate petitioners’ costs of goods sold during the examination,
but he chose not to. He has failed to persuade us that petitioners included
renovation expenses on their 2004 and 2005 Schedules C. Accordingly, we hold
that petitioners were entitled to increase their basis in the Claremont property by
$147,824.
Petitioners urge us to allow the full $245,150 basis increase they claimed
despite their inability to produce documentary evidence for the full amount. They
claim that pictures of the home before and after the renovations demonstrate that
they made improvements beyond those for which they could produce receipts.
The pictures indicate that petitioners made significant renovations, but we cannot
say for sure that they cost more than $147,824. Accordingly, we decline to
estimate further basis increases. Petitioners have failed to prove their entitlement
to basis increases beyond those for which they produced documentary evidence.
Petitioners’ claim that they had receipts but lost them does not affect our result,
because they have not shown that the loss was beyond their control. We hold that
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petitioners were not entitled to basis increases beyond the $147,824 they
substantiated.
III. Accuracy-Related Penalties
Under section 6662, taxpayers may be liable for penalties for underpaying
their income tax. A 20% penalty applies when the underpayment resulted from
certain causes including negligence, a substantial understatement of income tax, or
a substantial valuation misstatement. Sec. 6662(a) and (b)(1), (2), and (3). A 40%
penalty applies when the underpayment resulted from a gross valuation
misstatement. Sec. 6662(h). Although an underpayment may trigger the penalty
for more than one reason, the Commissioner may not impose more than one
penalty on a single portion of the underpayment. Sec. 1.6662-2(c), Income Tax
Regs.
The Commissioner bears the burden of production with respect to penalties.
Sec. 7491(c). To meet this burden, he must produce evidence regarding the
appropriateness of imposing the penalty. Higbee v. Commissioner, 116 T.C. 438,
446 (2001); Raeber v. Commissioner, T.C. Memo. 2011-39. Once the
Commissioner carries his burden, the taxpayer bears the burden of proving the
penalties are inappropriate because of reasonable cause or otherwise. Higbee v.
Commissioner, 116 T.C. at 446.
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A. Underpayments Resulting From Easement Misvaluations
The Pension Protection Act of 2006 (PPA), Pub. L. No. 109-280, sec.
1219(a)(2)(B), 120 Stat. at 1083, amended the rules for the 40% gross valuation
misstatement penalty. Before the PPA the penalty applied when taxpayers
misstated the value of their property by 400% or more, and taxpayers could avoid
the penalty under certain circumstances if they made the misstatement in good
faith and with reasonable cause. The PPA lowered the threshold to 200% and
eliminated the reasonable cause exception for gross valuation misstatements of
charitable contribution property. See secs. 6662(h), 6664(c). The new rules apply
to all returns filed after July 25, 2006.5 PPA sec. 1219(e)(3), 120 Stat. at 1086.
The years in issue here straddle the PPA’s effective date--petitioners filed their
2004 and 2005 returns before July 25, 2006, but they filed their 2006 return after.
Petitioners misvalued their easements. They claimed deductions of
$191,400 and $371,250, but they have failed to prove the easements had any
value. Under either version of section 6662(h) the valuation misstatements are
“gross” and trigger the 40% penalty. However, the facts raise a novel issue
concerning petitioners’ right to raise a reasonable cause defense for their 2006
5
For charitable contributions of property other than facade easements, the
effective date is August 17, 2006.
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underpayment. Petitioners note that a portion of the underpayment resulted from
the carryover of charitable contribution deductions they first claimed on their 2004
return, which they filed before the PPA’s effective date. Accordingly, they argue,
denying their right to raise a reasonable cause defense would amount to
retroactively applying the PPA.
Petitioners acknowledge that, by its plain language, the statute applies for
their 2006 return, but they urge us to look beyond the plain language because of its
retroactive effect. We disagree with petitioners that applying the amended
reasonable cause rules for their 2006 return amounts to retroactively applying the
PPA. Accordingly, we need not look beyond the statute’s plain language, and we
apply the amended reasonable cause rules to petitioners’ 2006 underpayment.
When taxpayers file a return that includes carryforward information, they
essentially reaffirm that information. The amended reasonable cause rules were in
effect when petitioners filed their 2006 return, which reaffirmed the Claremont
easement’s grossly misstated value. Applying those rules does not amount to
retroactive application. The plain language of the statute makes the rules
applicable for all returns filed after July 25, 2006. Petitioners filed their 2006
return after that date and consequently may not raise a reasonable cause defense
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for their 2006 underpayment, which resulted exclusively from gross valuation
misstatements.
We evaluate petitioners’ reasonable cause defense for their 2004 and 2005
underpayments under the pre-PPA rules. Even before Congress enacted the PPA,
more rigorous reasonable cause rules applied to taxpayers who substantially or
grossly misvalued charitable contribution property. Under pre-PPA rules such
taxpayers could raise a reasonable cause defense only if: (1) the property value
they claimed on their return was based on a qualified appraiser’s qualified
appraisal and (2) they made a good-faith investigation of the property’s value.
Sec. 6664(c). Respondent concedes the appraisal requirement but argues that
petitioners have not met the good-faith investigation requirement. We disagree.
Respondent’s chief criticism of petitioners’ efforts appears to be their
failure to independently assess the easements’ values. Respondent contends that
because Mr. Chandler had a law degree and worked as a business consultant, he
should have known his appraiser had overvalued the easements. Petitioners are
well educated, but they have no experience valuing easements. Even experienced
appraisers find valuing conservation easements difficult because they are not
bought and sold in established markets. Average taxpayers would not know where
to start to value a conservation easement, and even well-educated taxpayers like
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petitioners must rely heavily on the opinions of professionals. Petitioners retained
an appraiser to value their easements. To choose the appraiser, petitioners relied
on the National Park Service’s advice and consulted their easement holding
organization, NAT. We have identified flaws in the initial appraisals, but they
would not have been evident to petitioners. Although petitioners could not rely
exclusively on the appraisals, they were entitled to give them substantial weight.
Petitioners corroborated the appraisals with advice from an experienced
accountant. We think these actions represent a good-faith attempt to determine the
easements’ values. Accordingly, petitioners may raise a reasonable cause defense
for their 2004 and 2005 underpayments resulting from gross valuation
misstatements.
In Kaufman v. Commissioner, at *72-*75, we held that taxpayers whose
investigation approximated petitioners’ had not established reasonable cause for
their gross misvaluation of a conservation easement. However, the taxpayers’
investigation of value in Kaufman took place under different circumstances. In
Kaufman, after the taxpayers had received their initial appraisal they became
worried that the easement would devalue their home too much. They expressed
their concern to a representative of NAT, and he assured them that the easement
would have no effect on the resale value of their home. The taxpayers’ continued
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reliance on the initial appraisal in the face of the representative’s comments led in
part to our conclusion that the taxpayers’ investigation of value was in bad faith.
Here there is no evidence that petitioners relied on the appraisals in bad faith, and
we hold that their investigation was sufficient to allow them to raise a reasonable
cause defense.
Taxpayers can establish reasonable cause by demonstrating they reasonably
and in good faith relied on the advice of a tax professional or appraiser. Sec.
1.6664-4(b), Income Tax Regs. To determine whether a taxpayer’s reliance on
professional advice was reasonable and in good faith we consider all facts and
circumstances, including “the taxpayer’s education, sophistication and business
experience”. Sec. 1.6664-4(c), Income Tax Regs.
Petitioners have established reasonable cause for misvaluing their
easements. Mr. Chandler has a law degree and significant business experience,
but he has no valuation experience. Even without valuation experience most
taxpayers can evaluate the reasonableness of an appraisal for most forms of real
property. But easements are different because most taxpayers have never bought
or sold an easement. Petitioners followed the NPS’s suggestion for choosing an
appraiser and relied on his report. The report was not so deficient on its face that
petitioners should have reasonably discounted it. They obtained their accountant’s
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assurances before they claimed the easement deductions. On these facts we
believe petitioners have established reasonable cause, and we hold they are not
liable for accuracy-related penalties on the portions of their 2004 and 2005
underpayments that resulted from misvaluing their easements.
B. Underpayments Resulting From Unsubstantiated Basis Increases
Respondent imposed a 20% accuracy-related penalty on the portion of
petitioners’ 2005 underpayment resulting from unsubstantiated basis increases in
the Claremont property. Respondent argues that the penalty applies because that
portion of the underpayment resulted both from a “substantial understatement” of
income tax and from petitioners’ negligence. We hold that petitioners are liable
for the 20% accuracy-related penalty because this portion of the underpayment
resulted from their negligence.
“Negligence * * * includes any failure by the taxpayer to keep adequate
books and records or to substantiate items properly.” Sec. 1.6662-3(b)(1), Income
Tax Regs. Petitioners have not retained records supporting the full amount of the
basis increase they claimed for the Claremont property. They have failed to
properly substantiate $97,326 of the basis increase they reported. The reasonable
cause exception applies to penalties for negligence, but petitioners have not
established reasonable cause. They claim they kept records but that some were
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lost when they moved from the Claremont property to the West Newton property.
They have not proved that the loss resulted from circumstances beyond their
control, and they have failed to offer a reasonable reconstruction of the lost
records. Cf. Mears v. Commissioner, T.C. Memo. 2013-52. Section 6001 requires
taxpayers to keep records long enough to properly substantiate items they claim on
their returns. Petitioners have failed to do so and are accordingly liable for the
20% penalty on the portion of their 2005 underpayment resulting from the
unsubstantiated basis increase.
To reflect the foregoing,
Decision will be entered under
Rule 155.