Rights of Mortgage Must Be Subordinated to Charity's Right to Protect Conservation Easement Before Gift is Made

The Ninth Circuit in the case of Minnick v. Commissioner, 116 AFTR 2d ¶ 2015-5137, CA9, affirming TC Memo 2012-345 agreed with the Tax Court’s conclusion that in order to claim a deduction for a conservation easement under the provisions of IRC §170, holding that Reg. §1.170A-14(g)(2)’s requirement that any mortgage must be subordinated at the time of the gift.

IRC §1.170(b)(5)(A) permits a deduction for a conservation easement only if that interest is protected in perpetuity.  The IRS regulation interpreting this rule holds that the protected in perpetuity rule may only be satisfied (and thus a deduction allowed) only if the mortgage holder subordinates its rights in the property to the rights of the donee organization to enforce the conservation easement.

In 2006 the taxpayers had donated a conservation easement to a charity.  However, they failed to inform the mortgage holder of this donation or get the mortgage holder’s agreement to subordinate its rights under the mortgage to those of the charity to enforce the easement.

The IRS examined the taxpayer’s returns in 2009 and disallowed the deduction.  In 2011, just before the Tax Court trial began, the taxpayers contacted the mortgage holder to obtain such a subordination agreement.  Following negotiations and appraisals, the mortgage holder agreed to subordinate its rights in September of 2011.  However, in October the Tax Court ruled in favor of the IRS, holding that the mortgage holder had no subordinated its rights at the time the contribution was made.

The taxpayers argued that the statute did not require the subordination and that the regulation should be held to be invalid to the extent that it did impose such a requirement.

The Ninth Circuit panel disagreed on both counts.  First, the Court found that the plain language of the statute required that the subordination occur before the donation is made.  As the Court held:

To begin, the plain language of the regulation supports the Tax Court’s interpretation. See Mitchell II, 775 F.3d at1250 (“[The taxpayer’s] interpretation is foreclosed by the plain language of the regulation.”). The regulation specifies that “no deduction will be permitted under this section for an interest in property which is subject to a mortgage unless the mortgagee subordinates its rights in the property.” Treas. Reg. § 1.170A–14(g)(2). Strictly construed, this language makes clear that “subordination is a prerequisite to allowing a deduction.” Mitchell II, 775 F.3d at 1250. In 2006, when Taxpayers made the donation and requested a deduction, there is no dispute that U.S. Bank had not subordinated its rights in the property. Thus, under the plain meaning of the regulation, no deduction is permitted.

The Court goes on to point that even the statute could be read not to require subordination before the donation, the IRS’s interpretation would need to be shown to be not a reasonable interpretation.  And, as the panel notes:

Further, the IRS’s interpretation is reasonable and is not “plainly erroneous or inconsistent with the regulation.” Id. at 461. As the Tenth Circuit held, “[b]ecause a conservation easement subject to a prior mortgage obligation is at risk of extinguishment upon foreclosure, requiring subordination at the time of the donation is consistent with the Code’s requirement that the conservation purpose be protected in perpetuity.” Mitchell II, 775 F.3d at 1251. An easement can hardly be said to be protected “in perpetuity” if it is subject to extinguishment at essentially any time by a mortgage holder who was not a party to, and indeed (as here) may not even have been aware of, the agreement between the Taxpayers and a conservation trust.

The Ninth Circuit thus agreed with the 10th Circuit’s holding in the case of Mitchell v. Commissioner, 775 F.3d 1243 (10th Cir. 2015) on the same issue.