US Tax Court Rejects IRS Market Method Valuation and Utilizes Subdivision Development Method to Value Conservation Easement

The United States Tax Court recently determined the value of a conservation easement using a subdivision development method in the case of Schmidt v. Commissioner, TC Memo 2014-159. The case involved a taxpayer who purchased a 40-acre parcel of vacant land in May 2000 for $525,000, with the intention of subdividing and developing it. The taxpayer began the process of obtaining the required permits and approvals to develop the property. The facts indicated that the taxpayer would receive all required permits and approvals to develop the property, but the taxpayer ultimately granted a conservation easement on the property on August 1, 2003 (retaining the right to one homesite). The taxpayer claimed a charitable contribution deduction valuing the conservation easement at $1.6 million.

In November 2011 the IRS issued a notice of deficiency to the taxpayer, determining that the value of the conservation easement was only $195,000. The taxpayer relied on the testimony of his appraiser and a development expert at trial. The IRS relied on the testimony of an expert who valued the conservation easement at $480,000.

The taxpayer's appraiser used the subdivision development method to determine the before value of the conservation easement (also considering other valuation methods, such as the market method). The IRS's appraiser used the market method to determine the before value of the conservation easement (also considering other valuation methods, such as the subdivision method). The Court determined that market method was not appropriate because the comparable sales relied on by the IRS were not comparable to the taxpayer's property because no steps to develop the comparable properties had been taken.

After determining that the market method was not appropriate, the Court set forth the following factors that would be required to determine the before value of the property using the subdivision development method: (1) the number of lots, (2) the retail lot selling prices, (3) the retail lot selling price appreciation rate, (4) the time required to obtain development entitlements, (5) the absorption rate of the lots, (6) development costs, (7) marketing/administrative costs, and (8) the discount rate. The Court then analyzed each of the factors, considering the data contained in each appraiser's report when analyzing each factor, to reach its ultimate conclusion of value, $1,152,445.

Taxpayer Impact

The use of a subdivision development valuation method when valuing a conservation easement often produces a higher value than other valuation methodologies, such as the market method. Taxpayer's should not assume that the IRS will accept a value determined using the subdivision development method. The IRS in fact routinely challenges conservation easement values determined using the subdivision development method.

In addition to setting forth a helpful summary of the factors to be considered using the subdivision development method, the United States Tax Court decision highlights the importance of establishing that the market method is not appropriate when a conservation easement value is reached using the subdivision development method. In Schmidt, the taxpayer took most steps needed to obtain development approval and the Court found that this differentiated the taxpayer's property from other properties on the market. There are undoubtedly other circumstances which may lead to a finding that the subdivision development method is more appropriate than the market method. Taxpayers should ensure that their appraisers document the unique aspects of their property if a subdivision development method is used when valuing a conservation easement. Taxpayers should also be skeptical of appraisers who blithely rely on the subdivision development method when valuing a conservation easement without providing compelling reasons not to use the market method.

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