Valuations Misstatements and the IRS Accuracy Penalty (IRC Section 6664(c))

I have been watching the tax cases dealing with building facade easements for insight into how the IRS and the courts are reacting to the significant deductions being taken by partners in real estate partnerships. These partnerships generally buy a building, develop it, and contribute a restrictive easement to an historic preservation nonprofit organization. (See Historic Preservation Conservation Easements – A Good Tax Shelter? for more general information). There is a correct way to do this, and if done correctly, the tax deductions can be generous. Unfortunately, taxpayers sometimes push these deductions too high with inflated values.

In a recent United States Tax Cout case, Whitehouse Hotel Limited Partnership, QRH Holding-New Orleans, LTD v. Commissioner of Internal Revenue, 139 T.C. No. 13 (October 23, 2012), a partnership acquired a building for $9,000,000 and just three years later received an appraisal of $7,555,000 for the restrictive facade easement it contributed to a nonprofit organization. That was 83% of the original price. The appraiser had assumed, with no evidence presented to the court, that the new value for the property, three years after it was purchased, was $87,300,000. That is an increase of 970%. The Court accepted that the property had appreciated and the easement had a value, just not as much as the taxpayer had claimed.

The interesting part of the case involved the penalty assessed against the taxpayer for using such high numbers for the values of the property and the restrictive easement. Under IRC Section 6662(a), the IRS can assess a taxpayer an accuracy related penalty equal to 20% of the understatement of tax required to be shown on the return. This applies to, among other things, a substantial valuation misstatement. If that error is considered a gross valuation misstatement, the penalty can be increased to 40%.

Penalties can be avoided if a taxpayer can demonstrate reasonable cause. (SeeIRS Penalties – Late Filing and Late Payment) That option also applies to valuation misstatements if the taxpayer can demonstrate that: 1) the claimed value was based on a qualified appraisal made by a qualified appraiser; and, 2) the taxpayer made a good faith investigation of the value of the contributed property. This second element is where it is easy for a taxpayer to fail and lose the benefit of the reasonable cause exception.

In Whitehouse, the taxpayer possessed the qualified appraisal made by a qualified appraiser, but the taxpayer did not prove that it made a good faith investigation of the value of the restrictive easement. The taxpayer argued that it had “retained eminently qualified professionals” on whom it relied and “without any further showing” that should be enough. Whitehouse, 139 T.C. No 13, 96. The Court did not accept this argument.

Relying on an expert, like an attorney or a CPA qualified in the area, can be acceptable as reasonable cause in many cases, (See IRS Penalties – Late Filing and Late Payment) but the taxpayer needs to do more for penalty relief involving valuation misstatements. The Court in Whitehouse found that for the statute to having any meaning, the taxpayer has to show it made a good faith investigation of the value of the restrictive easement. The court had no evidence that anyone made such an investigation. No one told the court that they, in good faith, investigated the claim that the property had appreciated 970% in three years and that the easement was worth 83% of what the partnership paid for the property.

The court found that the easement had a value, but much less than the taxpayer had claimed. It also found that because no one presented any evidence that the partnership conducted a good faith investigation of the value of the easement, the partnership was subject to the 40% accuracy penalty.