The Impact of the Pension Protection Act of 2006 on Qualified Conservation Contributions: The Good, the Bad and the Ugly

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1 TAXES THE TAX MAGAZINE July 2007 The Impact of the Pension Protection Act of 2006 on Qualified Conservation Contributions: The Good, the Bad and the Ugly By Martha W. Jordan * Martha W. Jordan examines the impact of the Pension and Protection Act of 2006 on qualified conservation contributions. According to Martha, the PPA includes several provisions that speak directly to the efforts made by conservationists and preservationists to protect our natural and built environment. I. Introduction The Pension n and Protection Act of 2006 ( the PPA ), enacted da August 17, 2006, includes several provisions that t speak directly to the efforts made by conservationists and preservationists to protect our natural and built environment. nt. 1 Those changes offer some good od news, some ebad news, and some ugly news for the conservation and preservation movements. In addition, some provisions ion of the PPA applicable to charitable contributions ns generally erally will also impact conservationists and preservationists. First, the good news: The PPA encourages taxpayers to make sizeable qualified conservation contributions during their 2006 and 2007 tax years. The PPA temporarily increases the charitable contribution deduction limit for qualified conservation contributions made by individuals and certain corporate donors during those years. Additionally, for donors whose qualified conservation contributions during such years exceed even the increased charitable contribution deduction limit, the PPA extends the carryforward period for excess contributions and allows the taxpayer to take advantage of the increased limits during such extended carryforward period. These two changes, Martha W. Jordan is an Associate Professor at Duquesne Law School in Pittsburgh. combined, may increase a taxpayer s maximum permitted charitable contribution deduction by 400 percent or more. Second, the bad news: The PPA discourages taxpayers who rehabilitate historic buildings from making qualified conservation contributions until at least six years after the rehabilitated building is placed in service. Furthermore, the PPA fails to answer the nagging question that has surrounded donations made with respect to rehabilitated buildings in for the last several years. Specifically, the PPA fails to address whether the donation of a façade easement causes recapture of a portion of the rehabilitation credit. If anything, the PPA sets up taxpayers who make qualified conservation contributions too soon after rehabilitating a building for a double whammy a reduction of the charitable contribution deduction and recapture of a portion of the rehabilitation credit. Third, the ugly news: The PPA levels an all-out assault on façade easements granted with respect to contributing buildings in registered historic districts. The PPA narrows the definition of certified historic structure as it applies to registered historic districts. It mandates that any exterior easement granted with respect to a contributing building protect the building s entire exterior. And, finally, it increases the costs associated with donating such easements. The PPA stops short of prohibiting a charitable deduction for façade easements encumbering contributing build M.W. Jordan 43

2 Impact of the Pension Protection Act on Qualified Conservation Contributions ings, but the cumulative effect of the its provisions will probably be to curtail all façade easements on homes and other buildings of modest value located in registered historic districts. Lastly, a little bit extra: The PPA includes some anti-abuse provisions and tightens some of the existing rules regarding charitable donations. The PPA changes the definitions of qualified appraiser and qualified appraisal and modifies the penalties that may apply if a donor or appraiser abuses the system. These changes apply to charitable deductions in general, as well as to those made to encourage conservation or preservation. II. The Good: Increased Charitable Contribution Deduction Limit for Qualified Conservation Contributions Made During Tax Years Beginning in 2006 and 2007 A. Definition of Qualified Conservation Contribution As a general rule, Code Sec. 170 denies a charitable contribution nde deduction for a gift of a partial interest in property. 2 p Several exceptions to the partial interest rule exist, including ing one for qualified conservation contributions. 3 tib ti A taxpayer who makes a qualified conservation contribution is entitled to claim a charitable contribution deduction equal to the fair market value of the contribution. n. 4 The exception for qualified conservation contributions permits taxpayers to continue using their property, albeit in a limited fashion, while conserving the property s environmental, archeological or architectural features. A qualified conservation contribution is a gift of a qualified real property interest made exclusively for conservation purposes. 5 Code Sec. 170 recognizes the following three types of qualified real property interests: a taxpayer s entire property interest aside from any interest in subsurface minerals 6 ; a remainder interest 7 ; or a perpetual restriction, such as an easement, regarding the use of the property. 8 A qualified conservation contribution is made exclusively for conservation purposes only if it protects, in perpetuity, one of the following four conservation purposes: the preservation of land for use by the general public for outdoor recreation or for general education; the protection of 44 a relatively natural habitat for fish, wildlife, plants or a similar ecosystem; the preservation of open space for the scenic enjoyment of the general public or pursuant to a clearly delineated governmental conservation policy; and the preservation of a historically important land area or a certified historic structure. 9 B. Increased Contribution Limit for Individual Taxpayers The PPA substantially increases the maximum charitable contribution deduction available to individual taxpayers who make qualified conservation contributions during tax years beginning in 2006 or The increased deduction limit applies to any qualified conservation contribution made by an individual taxpayer during 2006 or 2007, including those made prior to enactment of the PPA. 11 Additionally, if the value of the qualified conservation contribution exceeds the increased deduction limit, the PPA increases the amount the individual may deduct under the rules permitting taxpayers to carry forward excess charitable contributions. An individual taxpayer s maximum aggregate charitable contribution deduction is limited to 50 percent of adjusted gross income (AGI). 12 Certain donations are subject to lower limits, depending on the type of property or the nature of the charitable recipient. In particular, cash donations to 50-percent charities, defined as those charities listed in Code Sec. 170(b)(1)(A), are deductible to the extent of 50 percent of AGI, but donations of long-term capital gain property to 50-percent charities are deductible only to the extent of 30 percent of AGI. 13 Long-term capital a gain property rty is any property that would generate elong-term capital al gain if sold dat fair market value. 14 The charitable deduction for a donation of long-term capital gain property equals the fair market value of the property; the charitable deduction for other property equals the lesser of the property s fair market value or the taxpayer s adjusted basis. 15 Qualified conservation contributions can only be made to 50-percent charities. 16 Furthermore, provided the underlying property is long-term capital gain property, qualified conservation contributions are considered donations of long-term capital gain property. 17 Consequently, most qualified conservation contributions are deductible to the extent of 30 percent of AGI. The PPA increases the annual limit from 30 percent to 50 percent of AGI for qualified conservation contributions made during 2006 and The 50-percent limit applies irrespective of the type of qualified real property interest given to the charity or the conservation

3 July 2007 purpose protected by the donation. 19 Qualified conservation contributions that qualify for the increased limit are taken into account after all other charitable contributions and, therefore, are deductible to the extent of 50 percent of AGI minus other allowable contributions. 20 Example. In 2006, Donor, who has AGI of $500,000, makes donations to two 50-percent charities: a cash contribution of $50,000 and a qualified conservation contribution worth $1 million. Donor s maximum charitable contribution deduction for 2006 is limited to $250,000. Both the cash and the qualified conservation contribution qualify for the 50 percent of AGI limit. Donor may deduct the $50,000 cash contribution and $200,000 of the $1 million qualified conservation contribution; the remaining $800,000 is carried forward. The PPA is even more generous to individuals who are farmers and ranchers. If a qualified farmer or rancher makes a qualified conservation contribution during 2006 or 2007 with respect to property used in farming or agricultural operations, the PPA increases the deduction limit to 100 percent of AGI. 21 A qualified farmer or rancher is an individual who derives more than 50 percent of gross income from the trade or business of farming or ranching. 22 As with contributions subject to the increased ed 50-percent ent limit, qualified conservation contributions ns subject to the 100-percent 0-p limit are taken into account coun after all other charitable contributions and are deductible dducti eto the eextent of 100 percent of AGI minus other allowable contributions. 23 Example. Donor, a qualified farmer, owns and farms Blackacre. In 2006, Donor gives Charity an open space easement with respect to Blackacre. The easement, which provides that the land will remain available for farming and agricultural use, has a fair market value of $1 million. Donor has AGI of $500,000 and makes cash contributions in 2006 totaling $50,000. Donor may deduct the entire $50,000 of cash contributions and $450,000 of the $1 million qualified conservation contribution; the remaining $550,000 of the qualified conservation contribution is carried forward. The increased 50-percent and 100-percent limits are retroactive; qualified conservation contributions made during 2006 but prior to the enactment of the PPA qualify for the increased limits. 24 Contributions made after August 17, 2006, qualify for the 100-percent limit only if the contribution is subject to a restriction that the underlying property will remain available for livestock production or agricultural use. 25 This requirement is satisfied as long as the land is available for such use; there is no requirement that the land actually be put to any particular use. 26 Contributions made after August 17, 2006, that omit this restriction are subject to the 50 percent of AGI limit. 27 A taxpayer, whose aggregate charitable contributions exceed the applicable limits, may carry the excess forward. As a general rule, taxpayers may carry the excess forward for five years, subject to the same limits applicable in the year of donation. 28 The PPA modifies this rule with respect to excess qualified conservation contributions made during 2006 and 2007 in two important ways. First, the PPA extends the carryforward period. If the value of a taxpayer s aggregate qualified conservation contributions made during 2006 or 2007 exceeds the applicable limit, generally 50 percent of the taxpayer s AGI, the excess may be carried forward for 15 years, instead of the normal five years. 29 Second, the PPA permits the taxpayer to continue taking advantage of the increased deduction limit during the carryforward period. 30 New Subsection 170(b)(1)(E)(ii) states that any excess qualified conservation contribution shall be treated as a charitable contribution to which clause (i) applies in each of the 15 succeeding years. 31 Since clause (i) establishes the increased deduction limit for qualified conservation contributions, that limit applies for the entire carryforward ard period. 32 Example. In 2007, Taxpayer, who has AGI of $100,000, makes a qualified conservation contribution worth $470,000. In 2007, Taxpayer may deduct $50,000 of the qualified conservation contribution, 50 percent of her AGI. The remaining $420,000 is carried forward. In 2008, Taxpayer has AGI of $100,000 and makes another qualified conservation contribution, this one worth $30,000. The qualified conservation contribution made in 2008 is deductible to the extent of 30 percent of Taxpayer s AGI. In addition, because the limit applicable to the excess qualified conservation contribution carried forward from 2007 is 50 percent of AGI, Taxpayer can deduct $20,000 of the $420,000 excess contribution. The remaining $400,000 excess contribution is carried forward and, assuming TAXES THE TAX MAGAZINE 45

4 Impact of the Pension Protection Act on Qualified Conservation Contributions 46 Taxpayer makes no other charitable contributions and continues to have AGI of $100,000, will be deducted over an eight-year period, 2009 to 2016, at the rate of $50,000 a year. Similarly, a qualified farmer or rancher who donates a qualified conservation contribution with respect to land available for agriculture or farming purposes may, if the value of the contribution exceeds 100 percent of the farmer s AGI, carry the excess forward for 15 years. 33 And, although the statutory language is not real clear, it appears that the 100 percent of AGI limit, rather than the 50-percent limit, applies to such excess contribution during the carryforward period. 34 Example. In 2007, Taxpayer, a qualified farmer, who has AGI of $100,000, makes a qualified conservation contribution with respect to land available for agricultural purposes. The qualified conservation contribution is worth $500,000. Taxpayer may deduct $100,000 in 2007, 100 percent of her AGI. The remaining $400,000 is carried forward for 15 years and will, during the carryforward period, be deductible to the extent of 100 percent of Taxpayer s AGI, less any other charitable contributions made during the carryforward period. Consequently, assuming Taxpayer makes no oot other charitable contributions, the $400,000 0 excess contribution will be deducted over a four-year r period, 2008 to 2012, 2, at the rate of $100, a year. The changes to the carryforward rules effectively ely extend the increased deduction limit for qualified conservation contributions through 2022, but only if the donation is made by the end of The continuing availability of the increased limits during the carryforward period exponentially increases the benefits from the charitable contribution deduction. Any taxpayer who is considering a qualified conservation contribution the value of which would exceed 30 percent of AGI should take advantage of the PPA s increased deduction limit. Furthermore, any taxpayer who has considered making a significant qualified conservation contribution but hesitated due to uncertainty about whether the taxpayer s future income would be sufficient to support the deduction should make that contribution before the end of The PPA s changes can increase a taxpayer s charitable contribution deduction by 400 percent or more. Example. Taxpayer has AGI of $100,000 in 2007 and in every year thereafter. In each of the following situations, assume the value of Taxpayer s donation is sufficient to permit the maximum allowable deduction. Also, assume Taxpayer makes no other charitable contributions during that year or at any time during the carryforward period. If Taxpayer donates Blackacre, long-term capital gain property, to charity in 2007, the 30 percent of AGI limit and five-year carryforward period limit Taxpayer s maximum charitable contribution deduction to $180,000; $30,000 (30 percent of AGI) in 2007 and $30,000 a year in each of the five years in the carryforward period. If, instead, Taxpayer donates a qualified conservation contribution with respect to Greenacre, the increased 50 percent deduction limit and 15-year carryforward period allow Taxpayer to deduct $50,000 in 2007 and $50,000 for the following 15 years, for a total deduction of $800,000. Taxpayer s total charitable contribution deduction is more than four times what it would be from an outright gift of Blackacre. And, if Taxpayer is a qualified farmer or rancher and the qualified conservation contribution is subject to the 100 percent of AGI limit, Taxpayer may claim a maximum deduction of $1.6 million. Even after factoring in the time value of money, the increased benefit to Taxpayer is substantial. The PPA includes ordering rules to determine how qualified conservation contributions o that qualify for the increased ed deduction nlimits integrate with other charitable donations made by the taxpayer. As mentioned previously, qualified conservation contributions subject to the increased deduction limits are taken into account after all other charitable contributions, which means that such qualified conservation contributions are deductible to the extent of the applicable increased limit reduced by any other charitable contribution deductions made during the year. 35 Additionally, such qualified conservation contributions are disregarded for purposes of determining the aggregate amount of contributions subject to the 30 percent of AGI limit. 36 In other words, a taxpayer who makes an outright donation of long-term capital gain property can make a qualified conservation contribution without worrying that it will impact the charitable deduction for the long-term capital gain property.

5 July 2007 These operating rules allow taxpayers to deduct any charitable contributions subject to lower limits and a shorter carryforward period first, which reduces the chances that making a sizeable qualified conservation contribution in 2006 or 2007 will make some of the taxpayer s other charitable contributions nondeductible. Presumably, these ordering rules will continue to apply during the carryforward period, but the PPA is not entirely clear on this point. Example. In 2006, Taxpayer has AGI of $100,000. Taxpayer gives Blackacre, long-term capital gain property, to her church, a 50-percent charity. The fair market value of Blackacre is $30,000. In addition, Taxpayer donates a qualified conservation contribution with respect to Greenacre. The fair market value of the qualified conservation contribution is $20,000. In any year other than 2006 or 2007, both gifts would be aggregated for purposes of calculating the taxpayer s charitable contribution deduction for long-term capital gain property, which is limited to the 30 percent of AGI. Such aggregation would mean that Taxpayer would have to carry some of the contribution forward. But, the PPA provides that the deduction subject to the 30-percent limit is calculated l without regard to the qualified conservation contribution. on. Consequently, Taxpayer may deduct the entire $30,000 for the gift of Blackacre. In addition, the qualified conservation contribution tib is deductible to the extent of the excess of 50 percent of Taxpayer s AGI over the deduction for the gift of Blackacre. c As a result, Taxpayer may deduct the entire $20,000 0 of the qualified conservation contribution. Taxpayer s total charitable contribution deduction is $50,000. C. Increased Deduction Limit Applicable to Corporate Taxpayers The limit for charitable contributions made by corporate taxpayers is 10 percent of taxable income. 37 A corporate taxpayer is permitted to carry excess contributions forward for five years, subject to the 10-percent limit. 38 The PPA extends the benefits of the increased 100- percent limit to privately held corporations engaged in the trade or business of farming or ranching. Qualified conservation contributions made during 2006 and 2007 with respect to land used for farming or agricultural use by such corporations are deductible to the extent of 100 percent of the corporation s net income. 39 The 100-percent limit is only available if the corporation meets the definition of a qualified farmer or rancher and its stock is not readily tradable on an established securities market at any time during the year. 40 If the corporation makes other charitable donations during 2006 or 2007, such donations are taken into account first for purposes of calculating the corporation s charitable contribution deduction. 41 If the value of the qualified conservation contribution exceeds 100 percent of the corporation s net income, the excess may be carried forward for 15 years. The 100-percent limit continues to apply during the carryforward period. 42 D. A Caution Clearly the increased deduction limits provide a tremendous incentive for making qualified conservation contributions in 2006 and A rather surprising incentive, given that much of the talk about qualified conservation contributions prior to the PPA concerned the government s suspicions that taxpayers were overstating their value. Taxpayers should not be deluded into thinking that the increased deduction limits constitute a moratorium on scrutinizing the valuation of qualified conservation contributions. That is far from the case; as discussed below, the PPA tightens both the rules for determining when a valuation overstatement has been made and the penalties imposed for such abuse. Consequently, ent taxpayers who take advantage of these eincentives should use diligence eto ensure that their donation is properly valued. III. The Bad: Reduction of Charitable Contribution Deduction for Qualified Conservation Contributions When Donor Has Claimed the Rehabilitation Credit Taxpayers may claim a tax credit for part of the cost of renovating a certified historic structure held for productive use in a trade or business or in an investment activity. 43 The rehabilitation credit, which is claimed in the year the rehabilitated building is placed in service, equals 20 percent of qualified rehabilitation TAXES THE TAX MAGAZINE 47

6 Impact of the Pension Protection Act on Qualified Conservation Contributions expenditures. 44 Qualified rehabilitation expenditures are limited to those rehabilitation expenditures that must be capitalized. 45 The rehabilitation credit is allowable only for substantial rehabilitations; generally speaking, this means aggregate qualified rehabilitation expenditures within a two-year measuring period must exceed the greater of the building s adjusted basis or $5, Furthermore, the rehabilitation must be done in accordance with the Secretary of the Interior s standards for rehabilitation and must meet the stringent requirements of the Code and Regulations, which are designed to ensure that the rehabilitated building s historic structure is substantially preserved. 47 If a rehabilitated building is disposed of within five years of being placed in service, the taxpayer must recapture a portion of the rehabilitation credit. 48 The percentage of the credit subject to recapture varies, depending on how long the rehabilitated building is used prior to the disposition. The percentage of the rehabilitation credit subject to recapture is 100 percent if disposition occurs during the first year of use; 80 percent for dispositions in the second year; 60 percent for dispositions in the third year; 40 percent for dispositions in fourth year; and 20 percent for dispositions in the fifth year of service. 49 There is no recapture if the disposition occurs more than nfiv five years sa after the rehabilitated building is placed in service. 50 If a portion on of the rehabilitated building is disposed of, then the rehabilitation credit allocable to that portion noft the ebuilding i is subject to recapture in accordance with the percentages set forth above Example. In July 2004, Taxpayer rehabilitates and places in service a certified historic structure, incurring qualified rehabilitation expenses of $10,000 and claiming a $2,000 rehabilitation credit. In January 2006, Taxpayer sells the building. Because the disposition occurs during the second post-rehabilitation year, Taxpayer must recapture 80 percent of the rehabilitation credit. Consequently, Taxpayer s tax liability for 2006 increases by $1,600. The IRS ruled in Rev. Rul , and the Tax Court has agreed, that the grant of a preservation easement is a partial disposition of the rehabilitated building, resulting in partial recapture of the rehabilitation credit. 52 The percentage of the building deemed to have been disposed of is determined by the ratio of the fair market value of the easement to the fair market value, undiminished by the easement, of the underlying property. 53 Example. In July 2004, Taxpayer rehabilitates and places in service a certified historic structure, incurs qualified rehabilitation expenses of $10,000, and claims a $2,000 rehabilitation credit. In January 2006, when the building has a fair market value of $40,000, Taxpayer gives Charity a façade easement with a fair market value of $5,000. The grant of the easement is treated as a disposition of 1/8 of the building, determined by the ratio of the value of the easement ($5,000) to the value of the building ($40,000), requiring recapture of 1/8 of the rehabilitation credit. Because the disposition occurs during the second post-rehabilitation year, the recapture percentage is 80 percent. Consequently, Taxpayer s recaptured credit is $200, 1/8 of the rehabilitation credit ($2,000) multiplied by 80 percent. Although Rev. Rul limits its discussion to partial dispositions resulting from grants of conservation easements, its conclusion is equally applicable to other qualified conservation contributions. Consequently, any qualified conservation contribution made with respect to a rehabilitated building should result in partial recapture of the rehabilitation credit if the contribution occurs within five years of the date the rehabilitated building is placed in service. Notwithstanding this, Rev. Rul will be triggered most frequently ent by donations ns of façade easements, ement since those are the most common on qualified conservation contribution made with respect to buildings. Qualified conservation contributions that only protect land should not trigger Rev. Rul For qualified conservation contributions made after August 17, 2006, the PPA adds new Code Sec. 170(f)(14), which reduces the charitable contribution deduction if the taxpayer has claimed the rehabilitation credit with respect to any building that is part of the contribution. 54 The amount of the reduction is based on the ratio of the total rehabilitation credits allowed with respect to the building during the five preceding tax years to the fair market value of the building on the date of the contribution. 55 Furthermore, the reduction is calculated by reference to the rehabilitation credit claimed with respect to the entire building and is not limited to the portion of the rehabilitation credit allocable to the qualified

7 July 2007 conservation contribution. Consequently, the PPA makes qualified conservation contributions less attractive during the six-year period following the time that a rehabilitated building is placed in service. Example. In 2006 Taxpayer makes a qualified conservation contribution with respect to a building. The unencumbered fair market value of the building at the time of the contribution is $1 million and the fair market value of the qualified conservation contribution is $50,000. In 2004, Taxpayer claimed a rehabilitation credit with respect to the building in the amount of $100,000. The ratio of the rehabilitation credits claimed in the preceding five years ($100,000) to the fair market value of the building ($1 million) is 10 percent. Taxpayer is required to reduce the charitable contribution deduction for the qualified conservation contribution by 10 percent, i.e., $5,000. Consequently, Taxpayer s ayer charitable contribution deduction is $45,000, rather than the fair market value of the qualified conservation contribution. io 56 Unfortunately, the PPA does not explicitly overrule the position taken by Rev. Rul Nor does the PPA address how to treat rehabilitation ita ion credits that t were claimed during the preceding five-year period and, then, recaptured in a subsequent year, either a subsequent year during the five-year period or in the year of the qualified conservation contribution. Since nothing in the PPA alters the IRS position that the grant of a qualified conservation contribution is a partial disposition of the rehabilitated building, Rev. Rul will continue to require recapture if the qualified conservation contribution is made during the recapture window a very unfair result, since including the recaptured portion of the rehabilitation credit in the calculation of the reduction of the charitable deduction is a double hit for the taxpayer. Example. In 2004, Taxpayer rehabilitates a building and places it in service, claiming a rehabilitation credit of $100,000. In 2006 Taxpayer makes a Although the PPA s temporary increase in the charitable deduction limits substantially encourages qualified conservation contributions in the short term, most of the permanent changes made by the PPA are bad news for preservationists. qualified conservation contribution with respect to the building. The unencumbered fair market value of the building at the time of the contribution is $1 million and the fair market value of the qualified conservation contribution is $50,000. The ratio of the rehabilitation credits claimed in the preceding five years ($100,000) to the fair market value of the building ($1 million) is 10 percent. Under the PPA, Taxpayer must reduce the charitable contribution deduction for the qualified conservation contribution by 10 percent, i.e., $5,000, which reduces Taxpayer s charitable contribution deduction to $45,000. Rev. Rul treats the contribution as a partial disposition of the rehabilitated building and requires Taxpayer to recapture a portion of the rehabilitation credit since the contribution occurred within five years after the date the rehabilitated building was placed in service. Taxpayer is deemed to have disposed of five percent of the building, determined by the ratio of the value of the qualified conservation contribution ($50,000) to the unencumbered fair market value of the building ($1 million). Consequently, since the deemed disposition occurred during the second post-rehabilitation tation year, Taxpayer a must recapture $4,000 of fthe rehabilitation ationcredit (five percent ent of the rehabilitation credit multiplied by the recapture percentage of 80 percent). The PPA combined with Rev. Rul results in both a $5,000 reduction to Taxpayer s charitable contribution deduction and a $4,000 increase in Taxpayer s tax liability from recapture of the credit. The Joint Committee Reports are no help with respect to this question. The example in the Joint Committee Reports does not mention recapture at all, but no definitive conclusion can be drawn from that omission. The Joint Committee may have omitted any reference to recapture because the donation causes recapture but such recapture has no effect on the calculation of the reduction of the charitable contribution deduction or because the Joint Committee was unaware of Rev. Rul and the entire problem. TAXES THE TAX MAGAZINE 49

8 Impact of the Pension Protection Act on Qualified Conservation Contributions Unless the IRS revokes Rev. Rul , it appears that taxpayers who donate qualified conservation contributions within five years of claiming the rehabilitation credit will be forced to recapture part of the rehabilitation credit, as well as reduce the charitable contribution deduction. If the IRS continues to follow Rev. Rul , it could, relying on the Tax Benefit Rule, alleviate some of the unfairness by ruling that to the extent the rehabilitation credit is recaptured, it is deemed not to have been claimed. This would prevent taxpayers from having to reduce their charitable contribution deduction for that portion of the rehabilitation credit from which they received no benefit. Not only does the PPA create, perhaps inadvertently, a double detriment, but new Code Sec. 170(f)(14) also adds to the controversy that surrounded Rev. Rul prior to the PPA. Based on the language of Section 50, which controls the recapture computation, pundits have speculated that recapture can be avoided by making the qualified conservation contribution before the rehabilitation begins. 57 The IRS indicated its agreement with this position but countered by asserting that all rehabilitation expenditures allocable to the qualified conservation contribution qualify for the rehabilitation credit only if the taxpayer qualifies as a lessee. 58 Rather than resolving this question, the language of the PPA raises the question of fw whether its required reduction of the charitable contribution n deduction can be circumvented by the same maneuver. er. New Code Sec. 170(f)(14) requires the amount of fthe echaritable able contribution deduction to be reduced if the taxpayer claimed the rehabilitation credit during the 5 preceding taxable ab years. By referring to the preceding taxable years, the provision implies there is no reduction provided the qualified conservation contribution is made before the rehabilitation credit is claimed. New Code Sec. 170(f)(4) raises the question of what abuse Congress is worried about when a taxpayer rehabilitates a building and then donates a qualified conservation contribution. Permitting a taxpayer to claim both the full rehabilitation credit and the full charitable contribution deduction provides the greatest incentive for taxpayers to preserve historic buildings. On the other hand, discouraging taxpayers from making the qualified conservation contribution until at least six years after the rehabilitation increases the odds that the contribution will never happen. Code Sec. 170(f)(14) appears to discourage preservation without curbing any abuse and without answering any of the questions raised by Rev. Rul IV. The Ugly: Changes Applicable to Contributing Buildings Contributing buildings are those buildings located within a registered historic district and certified by the Secretary of the Interior as being of significance to the district, in other words buildings that qualify as certified historic structures because they satisfy the definition of a contributing structure. 59 The PPA contains several provisions applicable to contributing buildings. First, the PPA narrows the definition of contributing structure. Then, it adds some new rules, which address substantive and compliance issues, applicable only to exterior façade easements granted with respect to contributing buildings located in registered historic districts. Façade easements granted with respect to buildings individually listed in the National Register are unaffected by the changes. A. Modification of Definition of Qualified Conservation Contribution The PPA modifies, slightly, the definition of qualified conservation contribution by narrowing the definition of a certified historic structure. A certified historic structure can be either a listed structure or a contributing structure. 60 A listed structure is individually listed in the National Register of Historic Places ( National Register ). 61 A contributing structure is not listed individually but rather located in a registered historic district and certified by the Secretary of the Interior as being of historic significance district. 62 etothe ict. Prior to the PPA, the definition of listed structure and that of contributing structure included buildings, structures and land areas. 63 Prior to the PPA, buildings, other structures and land areas located in a registered historic district and certified by the Secretary of the Interior as being of historic significance to the district satisfied the definition of contributing structures. 64 The PPA restricts the types of properties that can qualify as contributing structures by eliminating structures and land areas from the definition of contributing structure. Effective for qualified conservation contributions made after August 17, 2006, only buildings qualify as contributing structures; other structures and land areas qualify as certified historic structures only if they are individually listed on the National Register. 65

9 July 2007 B. Façade Easements Encumbering Contributing Buildings Must Protect Entire Exterior The PPA denies a charitable contribution deduction if a façade easement encumbering the exterior of a contributing building protects only a portion of the building. A façade easement granted on a contributing building must, if made after July 25, 2006, protect the entire exterior of the contributing building in order to be made exclusively for conservation purposes. 66 The PPA defines the entire exterior as including the front, sides, rear, and height of the contributing building 67 ; the Joint Committee Report interprets the height requirement to mean that the easement must protect the air space above the contributing building. 68 The PPA also requires that the easement prohibit changes to the exterior of the contributing building that are inconsistent with its historical character. 69 This provision of the PPA means that homeowners and other donors, who grant exterior façade easements with respect to contributing buildings, must inter alia relinquish any rights granted by the rules of the district to expand those buildings to the control of the charity holding the easement. After the donation, on, the terms of the easement, not the rules of ft the district, will control the extent t to which the taxpayer py may expand the building or build into the air space above. Further clarification atio is required with respect to the requirement that exterior façade easements must encumber all the exterior walls of a contributing ing building. What is an exterior wall for purposes s of this requirement? Is it the same as the definition of external wall used for purposes of the rehabilitation credit, which defines an external wall as one that has one face exposed to weather, earth or an abutting wall of an adjacent building or a shared wall that does not have windows or doors? 70 For example, some conservationists are wondering whether the wall between two contiguous row houses is considered an exterior wall. If the definition adopted for purposes of the rehabilitation credit applies, the answer to this question is yes. 71 The requirement that a façade easement on a contributing building must protect all exterior walls also raises questions with respect to public access. The Regulations state that the public must have access to the architectural features protected by a façade easement. 72 If a façade easement on a contributing building protects all the exterior walls, must the public have access to the entire exterior or only to the frontage? If access to the entire exterior is required, homeowners, and other donors, will be forced to provide the public sufficient access to their backyards and other private areas to satisfy the Regulations public access requirement. C. Increased Compliance Costs for Façade Easements Encumbering Contributing Buildings The PPA also increases the compliance costs of donating a façade easement on a contributing building. First, the PPA requires the donor and the charity to enter into a written agreement addressing the charity s authority to accept and manage the easement. 73 The agreement, which must be signed under penalty of perjury, must certify that the donee is a qualified organization and that one of its purposes is environmental protection, open space preservation, land conservation or historic preservation. 74 The statement must also certify that the donee has both the necessary resources and the commitment to manage and enforce the easement. 75 The requirement of a written agreement applies to façade easements granted with respect to contributing buildings after July 25, Another added compliance requirement increases the supporting documentation that a taxpayer who grants an exterior façade easement on contributing building must include with the tax return on which h the charitable deduction is claimed. The PPA requires es the etaxpayer to oinclude the efollowing low three things with the tax return for the year of the contribution: (1) a qualified appraisal; (2) photographs of the building s entire exterior; and (3) a description of all restrictions on the development of the building. 77 The requirement that the qualified appraisal must be attached to all returns on which the taxpayer claims a gift of a façade easement with respect to a contributing building is a substantial departure from the rule applicable to other donations. As a general rule, donors are required to obtain a qualified appraisal whenever the value of the donation exceeds $5,000; however, the qualified appraisal need not be attached to the return unless the value of the charitable donation exceeds $500, For donations valued at $500,000 or less, only a summary of the appraisal must be attached. 79 The TAXES THE TAX MAGAZINE 51

10 Impact of the Pension Protection Act on Qualified Conservation Contributions new rules require the donor of a façade easement encumbering a contributing building to obtain a qualified appraisal and to attach such appraisal to the donor s tax return, regardless of the value of the easement. Although Code Sec. 212(3) authorizes the donor to deduct the cost of the appraisal as an expense paid in connection with the determination of the donor s income tax, 80 the additional cost associated with getting an appraisal may make it cost prohibitive to grant an easement that is valued at less than $5,000. Exterior photographs, as long as they are sufficient to establish the existing exterior, are only required to the extent practical. 81 An example in the Joint Committee Report mentions a façade easement encumbering a skyscraper as an example of a situation in which it might be impractical to photograph the entire exterior. 82 The Joint Committee Report says that aerial photographs of the roof are unnecessary. 83 The PPA requires the donor to describe current restrictions applicable to the contributing building. The types of current restrictions that must be disclosed on the tax return include zoning laws, ordinances, neighborhood association rules, restrictive covenants and other similar restrictions. 84 Consequently, any restrictions imposed as a result of the contributing building s location in a registered historic district will have to obe ed disclosed. sed. This requirement em and the mandatory requirement that all appraisals aisals must be attached to the return appear to be a response to the concern that teasements granted in registered historic districts were being valued without taking into account the pre-existing impact of the district s 52 fee on all qualified conservation contributions would seem to make more sense. Furthermore, if all qualified conservation contributions were subject to the fee, the amount of the fee could be decreased without reducing the revenue available for enforcement. Limiting the fee to façade easements granted with respect to contributing buildings is justifiable only if the government thinks that such qualified conservation contributions are the primary source of abuse and the principal use of the fund will be to monitor such easements. D. Summary These changes may have been prompted by a report issued in January 2005 by the Joint Committee on Taxation, which recommended modifying the definition of qualified conservation contribution to eliminate façade easements granted with respect to private residences. 89 Although the PPA does not adopt this recommendation, practically speaking, these changes will most probably curtail grants of façade easements on contributing buildings except in those instances where the value of the easement is substantial. By considerably increasing the compliance costs associated with façade easements granted with respect to contributing buildings, the PPA probably makes façade easements uneconomical for owners of contributing buildings of modest value. At a minimum, the PPA makes façade easements on contributing buildings much less attractive than those granted with respect to buildings listed individually on the National Register. And, because of he d strict s the increased compliance ce costs are limited to con- restrictions on the building s value. 85 tributing tingbuildings in registered ereddistricts, s, they are In addition to the above reporting requirements, more likely to apply to residential buildings than taxpayers who donate exterior façade easements with to commercial buildings. Consequently, the PPA respect to contributing buildings must pay a filing fee represents an even further retreat from Congress of $500 if the value of the façade easement exceeds unsuccessful attempt in 2001 to provide tax relief $10, Revenue generated by the filing fees will to historic homeowners. 90 be used to enforce compliance with the rules regarding qualified conservation contributions. 87 The filing V. A Little Bit Extra: fee requirement applies to façade easements granted with respect to contributing buildings after February Changes Applicable to 17, 2007, 180 days after the PPA was enacted. All Charitable Contributions 88 Neither the PPA nor the Joint Committee Report explains why the filing fee is imposed only on façade easements granted with respect to contributing Qualified Appraiser and A. Codification of the Definition of buildings. Given that the revenue generated by the Qualified Appraisal fee will be used to monitor all qualified conservation contributions, and not just façade easements The PPA adds new Code Sec. 170(f)(11)(E), which encumbering contributing buildings, levying the codifies the definitions of qualified appraiser and

11 July 2007 qualified appraisal. 91 The codified definitions apply to all tax returns filed after August 17, Until Regulations can be promulgated explaining the new definitions, taxpayers and their advisors must look to Notice for guidance. In addition, the requirements of Reg A-13(c) continue to apply, except to the extent that such Regulation is inconsistent with new Code Sec. 170(f)(11)(E). 93 In particular the requirements of Reg A- 13(c)(3), which inter alia addresses the requirements for a qualified appraisal, Reg A-13(c)(5), which inter alia disqualifies certain persons from acting as a qualified appraiser, Reg A- 13A(c)(6), which inter alia prohibits contingent fees, and Reg A-13(c)(7), which includes various definitions, continue to apply Qualified Appraiser The PPA defines a qualified appraiser as one who has both general expertise, which is satisfied if the appraiser meets certain general professional requirements, and specific expertise, which requires the appraiser to be qualified to appraise the specific type of property that is the subject of the appraisal. 95 The determination of whether a person is a qualified appraiser is made as of the date the appraisal. 96 A qualified appraiser ais must regularly perform appraisals for compensation on and must satisfy any other requirements to be prescribed in future ur Regulations. 97 The appraiser must have been designated as such hby a recognized professional siona organization or otherwise meet the minimum educational and experience requirements to be prescribed e in future ure Regulations. 98 Notice provides that, t, until such Regulations are issued, this requirement is satisfied by an appraisal designation awarded on the basis of demonstrated competency in valuing the type of property that is the subject of the appraisal. 99 For appraisals of real property made for returns filed on or before October 19, 2006, an appraiser will be treated as having the minimum required education and experience if the appraiser is a qualified appraiser within the meaning of Reg A-13(c)(5) with respect to appraisals of the type of property being valued. 100 For returns filed after that date, the appraiser must be licensed or certified with respect to the type of property by the state where the property is located. 101 Furthermore, the appraiser must demonstrate verifiable education and experience with respect to valuing the type of property that is the subject of the particular appraisal. 102 Until Regulations are issued, this requirement is satisfied if the appraiser makes a declaration in the appraisal that, due to the appraiser s background, experience, education, and membership in professional associations, the appraiser is qualified to appraise the type of property that is the subject of the appraisal. 103 Lastly, an appraiser is disqualified if at any time during the prior three years the appraiser has been prohibited from practicing before the IRS. 104 The IRS may disqualify appraisers in certain circumstances, including the assessment of a penalty against the appraiser Qualified Appraisal The PPA provides two requirements for a qualified appraisal. First, it must be treated as a qualified appraisal under the Regulations or other guidance prescribed by the Secretary of the Treasury. 106 Under Notice , an appraisal conducted by a qualified appraiser in accordance with generally accepted appraisal standards will be treated as a qualified appraisal if it complies with the requirements of Reg A-13(c), except to the extent such regulation is inconsistent with new Code Sec. 170(f)(11). 107 Second, a qualified appraisal must be conducted by a qualified appraiser in accordance with generallyaccepted appraisal standards and any Regulations or other guidance prescribed by the Secretary. 108 Until Regulations can be promulgated, this requirement is satisfied if the appraisal is consistent with the substance and principles of the Uniform Standards of Professional Appraisal praisal Practice. ce. 109 B. Penalties 1. Penalties Applicable to Donors Taxpayers who overstate the value of donated property by more than a certain percentage are subject to the Code s penalties for underpayments of income tax resulting from substantial or gross valuation misstatements. 110 The penalties apply only if the valuation misstatement causes the tax liability to be understated by at least 10 percent. 111 Additionally, the understatement must exceed $5,000 ($10,000 for corporations other than S corporations and personal holding companies) before the penalty applies. 112 The PPA increases the chances that a donor may be subject to one of these penalties. The PPA reduces the percentage by which the value of the donated property must be overstated before the TAXES THE TAX MAGAZINE 53