Mitchell v. Commissioner—10th Circuit Affirms Tax Court, Mortgages Must Be Subordinated When Conservation Easement is Donated
In 2003, a partnership of which Ms. Mitchell was a partner donated a conservation easement with a claimed value of $504,000 to a land trust. The terms of the deed purported to transfer the easement to the land trust in perpetuity and in a manner necessary to satisfy the requirements of § 170(h). However, the partnership did not obtain a subordination agreement from the lender holding an outstanding mortgage on the subject property until almost two years following the date of the donation.
The IRS argued that the mortgage subordination requirement is a bright-line requirement that requires any existing mortgage to be subordinated to the rights of the holder of the easement, irrespective of the risk of foreclosure or any alternate safeguards. The IRS also asserted that subordination must occur at the time of the donation because, without subordination, the easement would be vulnerable to extinction upon foreclosure and, thus, the conservation purpose would not be protected in perpetuity as required under § 170(h). The 10th Circuit agreed with the IRS.
Delegation of Rulemaking and Deference to Commissioner
The 10th Circuit first explained that, although taxpayers are generally not permitted to deduct charitable contributions of partial interests in property, Congress made an exception to this rule for contributions of conservation easements—provided the contributions meet certain statutory requirements. One such requirement is that the conservation purpose of an easement must be “protected in perpetuity.” The 10th Circuit explained that, because the Code does not define the phrase “protected in perpetuity” or otherwise describe how a taxpayer may accomplish this statutory mandate, “Congress has tasked the Commissioner with promulgating rules to ensure that a conservation purpose be protected in perpetuity.” Acting pursuant to that authority, the Commissioner promulgated Treasury Regulation § 1.170A-14(g), which includes the mortgage subordination requirement.
Citing to the Supreme Court’s holding in Mayo Found. for Med. Educ. & Research v. United States, 131 S.Ct. 704, 711 (2011), the 10th Circuit noted that, because the Commissioner promulgated the regulations under § 170(h) pursuant to the authority granted to him by Congress, the regulations are binding on taxpayers unless they are “arbitrary and capricious in substance, or manifestly contrary to the statute.” In addition, “where Congress has delegated to the Commissioner the power to promulgate regulations for the enforcement of the Code, ‘[the court] must defer to his regulatory interpretations of the Code so long as they are reasonable.’”
The 10th Circuit explained that requiring existing mortgages to be subordinated to conservation easements prevents extinguishment of the easements in the event the landowners default on the mortgages. In this way, said the court, the mortgage subordination requirement is “reasonably related” to Congress’s mandate that the conservation purpose be protected in perpetuity. The 10th Circuit also rejected Ms. Mitchell’s claim that the mortgage subordination provision is arbitrary and capricious, and therefore unenforceable. Although declining to consider this argument because it was raised for the first time on appeal, the 10th Circuit noted that the argument would fail because the mortgage subordination provision is a reasonable exercise of the Commissioner’s authority to implement the statute.
The 10th Circuit then proceeded to reject each of Ms. Mitchell’s arguments as to why she should be entitled to a deduction despite her failure to obtain a subordination agreement at the time of the donation.
Subordination Must Be Timely
Ms. Mitchell argued that, since the mortgage subordination regulation contains no explicit timeframe for compliance, it should be interpreted to allow for subordination to occur at any time. The 10th Circuit rejected this argument as “foreclosed by the plain language of the regulations.” The court noted that the regulation “expressly provides that subordination is a prerequisite to allowing a deduction.” The regulation, explained the court, states that “no deduction will be permitted … unless the mortgagee subordinates its rights in the property” (emphasis added by the court). Since in 2003, when the Mitchells requested a charitable deduction for the donation of the easement, the property was subject to an unsubordinated mortgage, Ms. Mitchell was not entitled to a deduction under the plain language of the regulation.
The 10th Circuit further noted that, even if it were to view the regulation as ambiguous with respect to timing, the result would be no different because the court must defer to the Commissioner’s reasonable interpretation on this point. The court explained that the Commissioner’s interpretation was not plainly erroneous or inconsistent with the mortgage subordination provision’s plain language. Moreover, there was no reason to suspect the Commissioner’s interpretation did not reflect the agency’s fair and considered judgment on the matter. Because a conservation easement subject to a prior mortgage obligation is at risk of extinguishment upon foreclosure, requiring subordination at the time of the donation is consistent with the requirement that the conservation purpose be protected in perpetuity.
Functional Subordination Not Sufficient
Ms. Mitchell argued that strict compliance with the mortgage subordination requirement was unnecessary because the easement deed allegedly contained sufficient safeguards to protect the conservation purpose in perpetuity. The 10th Circuit rejected this argument as inconsistent with the plain language of the mortgage subordination provision. The court pointed out that the regulation contains one narrow exception to the “unambiguous” subordination requirement—for donations occurring prior to 1986. In the case of a pre-1986 donation, a taxpayer may be entitled to a deduction without subordination if the taxpayer can demonstrate that the conservation purpose is otherwise protected in perpetuity. The negative implication of this express, time-limited exception, said the court, is that no alternative to subordination will suffice for post–1986 donations. The court thus declined to adopt a “functional” subordination rule for donations occurring after 1986.
Likelihood of Foreclosure Irrelevant
Ms. Mitchell further argued that strict compliance with the mortgage subordination requirement was unnecessary in her case because the risk of foreclosure was so remote as to be negligible (the partnership apparently paid its debts on time and had sufficient assets to satisfy in full the amounts due). She pointed to Treasury Regulation § 1.170A-14(g)(3), which provides that a deduction will not be disallowed merely because the interest that passes to the donee organization may be defeated by the happening of some future event, “if on the date of the gift it appears that the possibility that such . . . event will occur is so remote as to be negligible.” She argued that this provision acts as an exception to the mortgage subordination provision—i.e., that because the risk of foreclosure in her case was arguably so remote as to be negligible, failure to satisfy the mortgage subordination requirement should be forgiven.
The 10th Circuit rejected this argument, holding that the remote future event provision does not modify the mortgage subordination requirement. The court explained, among other things, that the remote future event provision cannot reasonably be interpreted to include the relatively unexceptional risk of foreclosure, which exists any time a taxpayer donates a conservation easement with respect to property subject to a mortgage. The court noted that the remote future event provision (i) contains a discrete example of what qualifies as a remote future event—a state statutory requirement that a use restriction must be rerecorded every 30 years to remain enforceable—and (ii) identifies the risk that sometime in the future the donee will neglect to rerecord as an example of the type of event that should not prevent a deduction. This example, said the court, is easily distinguishable from the risk of foreclosure. “The possibility that sometime in perpetuity—30, 60, 90, 120, or more years after the donation—the donee may neglect to renew the easement is considerably more remote than the risk of foreclosure under a mortgage obligation limited to a finite repayment period.” The risk of foreclosure, said the court, is simply too unlike the provision’s listed example for us to believe that the Commissioner intended the provision to cover it.
The 10th Circuit also explained that, even if it were to assume the remote future event provision could reasonably be interpreted to have general applicability to the mortgage subordination provision, the court would be required to enforce the terms of the specific subordination requirement to prevent that requirement from becoming meaningless. In promulgating the rules, explained the court, the Commissioner specifically considered the risk of mortgage foreclosure to be neither remote nor negligible, and therefore chose to target the accompanying risk of extinguishment of the conservation easement by strictly requiring mortgage subordination.
Finally, the 10th Circuit noted that, even if the regulations were unclear with respect to the interplay between the mortgage subordination and remote future event provisions, Ms. Mitchell would not prevail because the court is required to defer to the Commissioner’s interpretation to resolve any ambiguity unless it is “plainly erroneous or inconsistent with the regulations” or there is any other “reason to suspect the interpretation does not reflect the agency’s fair and considered judgment on the matter.” Rather than being plainly erroneous or inconsistent with the regulations, the 10th Circuit found the Commissioner’s interpretation—that the mortgage subordination provision is unmodified by the remote future event provision—to be consistent with the regulation’s plain meaning. In addition, the court found no reason to suspect that the Commissioner’s interpretation did not reflect the agency’s fair and considered judgment on the matter in question. “[I]t is reasonable,” said the court, “for the Commissioner to adopt an easily-applied subordination requirement over a case-by-case, fact-specific inquiry into the financial strength or credit history of each taxpayer.” In support of this holding, the court quoted the following passage from an article published by the author of this blog post:
The specific requirements in the Code and Treasury Regulations establish bright-line rules that promote efficient and equitable administration of the federal tax incentive program. If individual taxpayers could fail to comply with such requirements and claim that their donations are nonetheless deductible because the possibility of defeasance of the gift is so remote as to be negligible, the Service and the courts would be required to engage in an almost endless series of factual inquiries with regard to each individual conservation easement donation.
The 10th Circuit concluded that the mortgage subordination provision does not permit a charitable contribution deduction unless any existing mortgage has been subordinated, irrespective of the likelihood of foreclosure, and the subordination agreement must be in place at the time of the gift.
Nancy A. McLaughlin, Robert W. Swenson Professor of Law, University of Utah S.J. Quinney College of Law