Yesterday, the Tenth Circuit issued its opinion in Mitchell v. CIR, 2015 WL 64927 (10th Cir. 2015).
The background: The Mitchells purchased a 105-acre ranch in Colorado in 1998 and an additional 351 acres in 2001. They bought both parcels from the same seller and entered into a multi-year payment plan with the seller (making the seller a mortgagee). They called their 456 acre parcel the Lone Canyon Ranch and formed a LLP. The partnership donated a conservation easement over 180 acres of the Ranch to the Montezuma Land Conservancy. The use of the property was restricted to open space, wildlife use, and agricultural purposes. When entering into this perpetual conservation easement, the Mitchells neglected to subordinate the mortgage.
In 2004, the Mitchells claimed a $504,000 tax deduction based on the donation. We have seen cases like this before. The IRS does not like conservation easements subject to unsubordinated mortgages because the IRS sees them as not meeting the perpetuity requirement. If the property can be foreclosed upon and the conservation easement theoretically terminate, then it isn’t perpetual.
In 2005, the mortgagee agreed to subordinate his interest. In 2010, the IRS told Mrs. Mitchell (Mr. M had passed away) that it hadn’t met the conservation easement donation requirements because the interest was unsubordinated at the time of the donation. Mrs. M appealed. The Tax Court sided with the IRS. Mrs. M appealed again.
While the Tax Code requires donations of conservation easements to be perpetual, it does not further explain what it means by perpetual. The IRS did so, however, in its implementing regulations. In 26 C.F.R. § 1.170A-14(g)(2), the regulations explain that no deduction will be permitted for property “which is subject to a mortgage unless the mortgagee subordinates its rights in the property.” The regulations further explain that a deduction will not be disallowed based on remote possible future events if the possibility of it occurring is “so remote as to be negligible.” Deferring to the agency’s interpretation of perpetuity, the Tenth Circuit did not examine the validity of the regulations but instead discussed whether Mrs. M could get the deduction despite the delay in the subordination. She based her argument on both the lack of a specific statement regarding when subordination needed to occur and the argument that the possibility of termination of the conservation easement was so remote as to be negligible. The IRS argued that the subordination requirement was a bright line rule and must occur by the time of the donation.
The Tenth Circuit agreed with the IRS Commissioner, stating that while the regulations didn’t expressly say when the subordination was to occur, the language of the provision made it clear because it said that “no deduction will be permitted … unless the mortgagee subordinates its rights.” The timing here indicates that the subordination must occur before one takes the deduction. I was quite excited to see the 10th Circuit citing and quoting friend of the blog Nancy McLaughlin.
Note, this doesn’t actually mean that Mrs. M can’t take a tax deduction here, but she couldn’t have taken it in 2003. It would have to wait until she got subordination in 2005. The court here doesn’t address what level of penalties she may face.