Tax Court Rejects First Circuit's View of Limits on Need to Subordinate Mortgages for Conservation Easement

The Tax Court, in the case of Palmolive Building Investors LLC et al. v. Commissioner, 149 TC No. 18, refused to follow the holding of the First Circuit Court of Appeals in the case of Kaufman v. Commissioner.  The Court continued to very strictly apply the subordination requirement in Reg. §1.170A-14(g), finding that the taxpayer in this case had not managed to satisfy the perpetuity requirement of IRC §170(h)(5).

The First Circuit and the Tax Court had disagreed on the extent to which a mortgage must be subordinated to meet the requirements of Reg. §1.170A-14(g)(2).  That regulation provides:

(2) Protection of a conservation purpose in case of donation of property subject to a mortgage.

In the case of conservation contributions made after February 13, 1986, 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 to the right of the qualified organization to enforce the conservation purposes of the gift in perpetuity.

In the case before the Tax Court, the lender had agreed to generally subordinate the debt to the claims of the charity, but the deed provided that the lender would have priority in access to any insurance proceeds on the property (assuming the donor had such insurance on the property) and to any condemnation proceeds.  The Tax Court found that, despite applying the label of “subordinated” to the notes, these clauses effectively provided for just the opposite, giving the lender a priority in these situations.

In the view of the Court, the fact the mortgages had superior rights in specific situations meant the mortgages were not subordinated in accordance with Reg. §1.170A-14(g) and, therefore, the donation was not in “perpetuity” as required by IRC §170(h)(5).

The First Circuit had rejected the view that a subordination must remove any preferential treatment of the lender in unusual but possible situations, finding that such a broad reading of what is necessary to grant an easement in perpetuity meant there could be no donation of an easement, since it represents only a partial interest and it was always possible that, say, a tax lien on the property that might arise if the donor failed to pay property taxes as due could result in loss of the property without the charity receiving a prorata portion of the value.

The Tax Court rejected that view.  The Court pointed out that this case, if it is appealed, would go to the Seventh Circuit Court of Appeals.  The Tax Court is only bound by the decision of a Court of Appeals if the case would be appealed to that circuit under the Golsen rule (Golsen v. Commissioner, 54 TC 742).  The Court also pointed out that other Circuits had agreed with the Court’s generally strict interpretation of the subordination rule in the years since Kaufman was decided.

The Court then went after the First Circuit’s logic, arguing there was a key difference in what must be done to subordinate an already existing liability at the time of the donation (the mortgage) as opposed to a possible future liability that currently did not exist.  The Court also pointed out that the regulations specifically mentioned mortgages in outlining requirements to meet the perpetuity requirement, but did not mention any issues with getting taxing agencies to agree to give up rights to a priority interest that might arise in the future for delinquent taxes when the taxes were not delinquent.