For anyone doing work related to the valuation industry, this is an interesting opinion that is worth reading in its entirety.
In the early '90s, Mr. Drummond (not the father of Kimberly, Willis and Arnold), purchased 251 acres from the Resolution Trust Company for $1,050,000. The land is located on the Gulf of Mexico in Alabama. Soon after the purchase, he conveyed his interest in the property to an LLC he created (D&E Investments, LLC). With the property, D&E developed a residential resort community called Kiva Dunes, complete with golf course, swimming pools, etc. The golf course, Kiva Dunes Golf Course, was conveyed to Kiva Dunes LLC (also formed by Mr. Drummond).
At issue for the Tax Court is the value of a conservation easement donated by Kiva Dunes to the North American Land Trust.
It is not clear from the opinion, but it seems the easement was placed
on property adjacent to the golf course. Kiva Dunes LLC claimed a
$30,588,235 charitable deduction for the easement on its 2002 tax
return. The IRS's expert valued the easement at $10,018,000 while Kiva's expert valued the easement at $31,938,985.
The general rule is that charitable contributions of partial interests in property are not deductible. An easement, by definition, is a partial interest in property. But there is an exception for qualified conservation contributions under section 170(f)(3)(B)(iii). Section 170(h) defines "qualified conservation contribution for purposes of (f)(3)(B)(iii). Initially, the IRS challenged whether the contribution here even qualified, but later conceded this point.
The value of a charitable contribution deduction of property is its
fair market value at the date of the donation. Regulation 1.170A-1(c)
defines fair market value as: the price at which property would change
hands between a willing buyer and willing seller, neither being under
any compulsion to buy or sell and both having reasonable knowledge of
The Tax Court points out that, in the case of real property, the "highest and best use" is considered fair market value. And in the case of easements, the common approach is the "before and after" method; that is, the value of the property before the easement minus the value of the property after the easement equals the value of the easement.
These cases generally come down to a battle of experts. The value of property is a question of fact. The Tax Court being the trier-of-fact, is free to pick one expert over the other, or to reject both.
experts agreed that the highest and best use of the easement would have
been a residential subdivision.In assessing the "before value,"
the Tax Court looked at three key variables the two experts disagreed
on. First, how many lots could be sold on the easement if it were a
residential subdivsion, the average selling price of each lot, and how
fast the lots would be sold. Kiva Dunes's expert offered very
impressive analysis on the issue, and the Tax Court accepted their
expert's opinion without change - $31,938,985. This figured assumed 370 lots could be sold at an average selling price of $170,000 over a ten-year period (multiplying 370 by $170,000 equals $62.9 million, thus the ten-year period cuts the value in half).
The experts used different methods for the "after value" analysis.
Kiva's expert used the market approach (comparable sales). The IRS's
expert used an income approach; he capitalized the earnings of the golf
course. The problem for the IRS's expert was that the income stream he
capitalized was incorrect.
Here again, Kiva's expert held the day. He presented five comparable sales of similar pieces of property in Alabama, and then made adjustments to each comparable sale based on seven variables. Some of the variables included, market conditions, location, and size. The Tax Court increased Kiva's "after value" for improvements made to the golf course by Kiva and enhancements. After adjustments, the Tax Court concluded the "after value" plus enhancements equaled $3,282,981.
Subtracting the after value ($3,282,981) from the before value ($31,938,985), the value of the easement equals $28,656,004.
First, the IRS picked the wrong caddy to play golf with. Their
expert had very little experience in the state of Alabama, and made
critical errors applying valuation methodology. Kiva obviously had a
little more at stake, and no doubt went after a more qualified appraiser.
Second, let's put the value of this deduction in perspective; at a marginal tax rate of 28%, U.S. taxpayer's paid approximately $8 million for the easement. Two questions arise: should we buy it, and did we overpay?
The second question is probably easier to answer than the first. Kiva Dunes is still selling home lots and the average price appears to be north of $170,000. Given the real-estate bust, the ten-year sellout assumption is most likely at risk. Like everyone else over the past five years, we probably over paid for real estate. Hurrican Katrina hit Baldwin County very hard in 2005, but I won't try to factor this into the analysis.
Should we buy conservation easements in the first place? This requires an entire post by iteslf. But, it's a question worth considering, particularly now when we need to increase tax revenue. Perhaps a suspension until the country can get further out of debt would be prudent.