The Palmolive Building in Chicago is one of the country’s premier Art Deco skyscrapers. Built in 1929 as headquarters for the famous soap manufacturers, the building was later occupied by Playboy Enterprises for about 30 years, then housed retail, offices and high-end condominiums beginning in the 2000s. The famous façade of this building is the subject of a multimillion dollar conservation easement case recently handed down by the U.S. Tax Court. In the case of Palmolive Building Investors, LLC v. Commissioner, a technical error relating to the mortgages on the property cost the taxpayers a $33.41 million conservation easement deduction.
Facts of the Case
The building was designated as a Chicago Landmark and put on the National Historic Register in 2003, setting it up as appropriate property for a façade easement. Palmolive Building Investors, LLC, acquired the building in 2001 and, in 2004, transferred a façade easement by executing a deed in favor of the Landmarks Preservation Council of Illinois, a qualified organization. The easement required that the exterior perimeter walls of the building’s façade be preserved in perpetuity. At the time the deed was executed, the building was encumbered by two mortgages. Although the mortgagees agreed to subordinate their mortgages to the Preservation Council’s rights, the deed gave the mortgagees a right to any insurance and condemnation proceeds until the mortgage was paid off in the event that the easement was later extinguished through a judicial proceeding.
A façade easement is a voluntary legal agreement with a qualified nonprofit organization that permanently protects the historic character of a building’s façade.
Problem with Mortgage Subordination
The partnership claimed a charitable contribution deduction for the easement contribution which was disallowed by the IRS. The IRS also slapped on valuation penalties. The IRS took the position that the easement deed did not satisfy the perpetuity requirement because it gave the mortgagees the superior right to extinguishment proceeds and because the Preservation Council was not guaranteed to receive share of any proceeds resulting from a possible extinguishment of the easement. The partnership argued that the easement deed contained a saving clause that would apply to retroactively reform the deed to comply with IRS regulations if the mortgagee consented, so they should be allowed to correct the error. The partnership also noted that the possibility of the mortgagees getting any proceeds was “so-remote-as-to-be-negligible” and should not affect the validity of the easement.
Tax Court Finds Violation of Perpetuity Rule
The Tax Court took a hard line in denying the conservation easement deduction, concentrating on the technical requirements of the IRS regulations. First, the Court said the easement deed failed to satisfy the “in perpetuity” requirement because the mortgages on the building were not fully subordinated to the easement. The Court also held that the defects in the easement deed were not cured by the provision that “purports to retroactively amend the deed” because the requirements for the charitable contribution must be satisfied “at the time of the gift.” Finally, the Court explained that a provision in the rules that says contributions will not be defeated by a remote possibility of a perpetuity problem cannot save the Palmolive easement. This is because mortgage subordination problems are listed in the regulations as specifically foreseeable events so are “by their nature not remote.”
This technical reading of the regulations is contrary to the holding by the First Circuit Court of Appeals in an earlier façade conservation easement case, Kaufman v. Commissioner. In that case, the Appeals Court rejected the Tax Court’s holding that the deed did not make a mortgage subordinate enough, finding the Tax Court’s reading was too extreme. The taxpayer eventually lost that case for other reasons, but interestingly, the Tax Court in Palmolive, said it would not follow the First Circuit’s reasoning in Kaufman. How can the Tax Court do this? Because the rules of precedent in the U.S. judicial system give independence to the different circuit courts. Palmolive is in another Circuit, the 7th Circuit, so decisions from the First Circuit are not binding.
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.”
Remote future event. A deduction shall not be disallowed under section 170(f)(3)(B)(iii) and this section merely because the interest which passes to, or is vested in, the donee organization may be defeated by the performance of some act or the happening of some event, if on the date of the gift it appears that the possibility that such act or event will occur is so remote as to be negligible.”
Despite the popularity of conservation easements and Congress’s vocal and continued support for these tax breaks, the IRS and the Tax Court continue to take a hard line when evaluating the deduction. Taxpayers must make sure that all requirements of Section 170 are satisfied at the time the conservation easement is granted and cannot count on the possibility of fixing problems later.