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Real Estate Partnership Loses Huge Charitable Deduction

Serious missteps by a real estate partnership caused it to lose a huge charitable deduction claimed for donation of property to the University of Michigan. The facts in the Tax Court case, Reri Holdings I, LLC, Jeff Blau, Tax Matters Partner, v. Commissioner, speak for themselves. Read on.

Facts Show $30 Million Overvaluation

RERI Holdings I, LLC, paid $2.95 million in March 2002 to acquire a remainder interest in a property. Seventeen months later, in August 2003, RERI donated the remainder interest to the University of Michigan. On its 2003 partnership return, RERI claimed a $33,019,000 charitable deduction for the donation. On the required form for reporting noncash contributions attached to RERI’s tax return, the partnership left the space blank for “Donor’s cost or other adjusted basis.” Now keep in mind that the amount of the deduction claimed should reflect the fair market value of the remainder interest. So, RERI had a problem. Had the property’s value increased by $30 million in 17 months? The Court gave a resounding “no”, finding the fair market value in August 2003 was $3,462,886.

Interestingly, the Tax Court decided the case on different grounds than valuation. It ruled that because RERI failed to include what it paid for the property on Form 8283, Noncash Charitable Contributions, the partnership did not comply with the strict substantiation requirements for donations of property. Not only was RERI unable to take a $33 million deduction, it could not take any deduction at all, even the $2.95 million it paid for the interest. The failure to correctly fill out the form killed the deduction before even reaching the issue of valuation.

RERI argued it had “substantially complied” with the substantiation rules, but the Court found that neglecting to provide the cost/adjusted basis was a serious omission. RERI had not provided sufficient information to allow the IRS to evaluate the reported contribution, so it was disallowed in full.

Partnership Gets Penalized

Although valuation was not the basis of the decision, the inflated value factored in to whether RERI’s deduction resulted in a “gross valuation misstatement.” The Court found that it did, triggering higher penalties for RERI of 40% of the understatement of tax. (The usual penalty is 20%.) A gross valuation misstatement exists if the value of any property claimed on a tax return is 200% higher than the correct amount. At the time of the RERI case, the rule for gross valuation misstatement was 400% higher than the correct amount. The $33 million valuation more than met this standard.

Valuing Remainder Interests

The donated property was in California and was subject to a 15-year lease held by AT&T for a web hosting facility. The property also was encumbered by a $43 million bank loan. The Court noted that there were significant restrictions on the property that were not factored into the valuation when RERI claimed the donation. Valuation of remainder interests is very technical and the Court spent much of the opinion discussing the process. In the end, the Court held that RERI had made “no good faith investigation” of the value of the property.

The take-away is this: charitable contributions of property are all about valuation and substantiation. The IRS most commonly uses these two factors to challenge property donations. While lack of proper substantiation will prevent any deduction, overvaluation of property interests can result in a 40% penalty if the taxpayer significantly overstates the value of donated property.

Serious missteps by a real estate partnership caused it to lose a huge charitable deduction claimed for donation of property to the University of Michigan. The facts in the Tax Court case, Reri Holdings I, LLC, Jeff Blau, Tax Matters Partner, v. Commissioner, speak for themselves. Read on.

Facts Show $30 Million Overvaluation

RERI Holdings I, LLC, paid $2.95 million in March 2002 to acquire a remainder interest in a property. Seventeen months later, in August 2003, RERI donated the remainder interest to the University of Michigan. On its 2003 partnership return, RERI claimed a $33,019,000 charitable deduction for the donation. On the required form for reporting noncash contributions attached to RERI’s tax return, the partnership left the space blank for “Donor’s cost or other adjusted basis.” Now keep in mind that the amount of the deduction claimed should reflect the fair market value of the remainder interest. So, RERI had a problem. Had the property’s value increased by $30 million in 17 months? The Court gave a resounding “no”, finding the fair market value in August 2003 was $3,462,886.

Interestingly, the Tax Court decided the case on different grounds than valuation. It ruled that because RERI failed to include what it paid for the property on Form 8283, Noncash Charitable Contributions, the partnership did not comply with the strict substantiation requirements for donations of property. Not only was RERI unable to take a $33 million deduction, it could not take any deduction at all, even the $2.95 million it paid for the interest. The failure to correctly fill out the form killed the deduction before even reaching the issue of valuation.

RERI argued it had “substantially complied” with the substantiation rules, but the Court found that neglecting to provide the cost/adjusted basis was a serious omission. RERI had not provided sufficient information to allow the IRS to evaluate the reported contribution, so it was disallowed in full.

Partnership Gets Penalized

Although valuation was not the basis of the decision, the inflated value factored in to whether RERI’s deduction resulted in a “gross valuation misstatement.” The Court found that it did, triggering higher penalties for RERI of 40% of the understatement of tax. (The usual penalty is 20%.) A gross valuation misstatement exists if the value of any property claimed on a tax return is 200% higher than the correct amount. At the time of the RERI case, the rule for gross valuation misstatement was 400% higher than the correct amount. The $33 million valuation more than met this standard.

Valuing Remainder Interests

The donated property was in California and was subject to a 15-year lease held by AT&T for a web hosting facility. The property also was encumbered by a $43 million bank loan. The Court noted that there were significant restrictions on the property that were not factored into the valuation when RERI claimed the donation. Valuation of remainder interests is very technical and the Court spent much of the opinion discussing the process. In the end, the Court held that RERI had made “no good faith investigation” of the value of the property.

The take-away is this: charitable contributions of property are all about valuation and substantiation. The IRS most commonly uses these two factors to challenge property donations. While lack of proper substantiation will prevent any deduction, overvaluation of property interests can result in a 40% penalty if the taxpayer significantly overstates the value of donated property.

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