Palmer Ranch v. Comm’r—11th Circuit Remands Conservation Easement Valuation to Tax Court
Valuation Concepts
As background, the 11th Circuit explained that:
- the value of a conservation easement for deduction purposes is generally equal to the difference between the fair market value of the subject property before the easement donation (the before-value) and the fair market value of the subject property after the easement donation (the after-value);
- a parcel’s before-value is based on the parcel’s highest and best use (HBU) before the easement’s conveyance, which is the “reasonable and probable use that supports the highest present value” or “the highest and most profitable use for which the property is adaptable and needed or likely to be needed in the reasonably near future”; and
- one method of valuing a parcel once its before-easement HBU is determined is through the use of the “comparable-sales method,” which entails considering sales of similarly situated parcels.
The Dispute
In 2006, Palmer Ranch Holdings (a partnership) donated to Sarasota County, Florida, a conservation easement with regard to an 82.19-acre parcel of land located in the county (the B-10 parcel). Palmer Ranch made this “altruistic” donation after having failed in its attempt to rezone the B-10 parcel and the adjacent B-9 parcel for multifamily residential development. Palmer Ranch claimed a federal charitable income deduction of $23.9 million for the donation under IRC § 170(h) and the IRS objected, claiming that the easement had a value of only $6.9 million.
In Palmer Ranch v. Comm’r, T.C. Memo 2014-79, the Tax Court held that Palmer Ranch was entitled to a deduction of $19.9 million for the easement donation. While the Tax Court agreed with Palmer Ranch that the HBU of the B–10 parcel before the donation was a 360-mutlifamily unit development configured to protect the eagle’s nest and other environmentally sensitive areas on the parcel, it determined that the before-value of the B-10 parcel was just over $21 million, not just over $25 million as had been posited by Palmer Ranch.
Unhappy with the Tax Court’s reduction of its claimed deduction by almost $4 million, Palmer Ranch appealed to the 11th Circuit.
IRS’s Arguments on Appeal
On appeal, the IRS argued that the Tax Court had erred because (i) contrary to the Tax Court’s finding, rezoning of the B-10 parcel to permit the hypothesized 360-unit development was not “reasonably probable,” (ii) the Tax Court failed to address whether the 360-unit development was “needed or likely to be needed in the reasonably near future,” and (ii) the Tax Court failed to consider that a willing buyer of the B-10 parcel would discount the price because of the failed rezoning history. The 11th Circuit disagreed.
(i) “Reasonably Probable” Rezoning
The 11th Circuit agreed with the Tax Court that, despite two failed rezoning attempts in the past, rezoning of the B-10 parcel to permit the hypothesized 360-unit development was “reasonably probable.” The 11th Circuit explained that, because the 360-unit development was configured to address the Board of County Commissioner’s previously expressed environmental concerns, the rezoning history suggested that the rezoning would be approved.
(ii) Development “Needed or Likely to be Needed in the Reasonably Near Future”
While the 11th Circuit agreed that the Tax Court had failed to address whether the hypothetical 360–unit development was “needed or likely to be needed in the reasonably near future,” it found that failure to be a harmless error under the circumstances.
The 11th Circuit first explained that the Tax Court had inappropriately confined its HBU analysis to consideration of whether the Board of County Commissioners would approve the rezoning; the Tax Court should have gone a step further and considered whether, assuming rezoning, a developer would perceive enough demand for the proposed 360 housing units to actually break ground. The 11th Circuit pointed to Esgar Corp. v. Comm’r, 744 F.3d 648 (10th Cir. 2014), in which the 10th Circuit held that, just because the properties at issue could be rezoned for gravel mining did not mean that gravel mining was the properties’ HBU. Determining a properties’ HBU also necessitates a look at market demand, and, at the time of the easement donations in Esgar, there was no demand for gravel from the properties and no evidence that this was likely to change in the reasonably foreseeable future.
The 11th Circuit then determined that the Tax Court’s failure to undertake a “market-demand inquiry” in Palmer Ranch was harmless because, at the time of the easement’s donation, the market for development of the type proposed for the B-10 parcel was “bullish.”
(iii) Discounting for the Costs, Time, and Risks Associated with Rezoning
The IRS argued that hypothetical buyers of the B-10 parcel would glean from the failed rezoning history a risk that the parcel could not be developed as proposed and would discount the purchase price accordingly. The 11th Circuit rejected this argument, explaining that “the test for highest and best use already bakes in some adjustment for development risk” and “from the vantage of 2006, there was substantially no risk that B–10 would not be developed [as proposed] in the near future.” “No risk,” said the court, “means no reason for a risk-based discount.”
The 11th Circuit’s analysis of this point was incomplete. As explained in my forthcoming article, Conservation Easements and the Valuation Conundrum, even if it is determined that rezoning of a property is “reasonably probable,” appraisal sources indicate that under no circumstances should the property be valued as if it were already rezoned. The risk of being denied rezoning, or that an exaction or other condition may be placed on the rezoning, always exists and must be taken into account. In addition, the time delay and costs associated with the rezoning process must also be considered. Rezoning of the B-10 parcel would have involved a multi-step process: (i) a preapplication meeting with County staff, (ii) a neighborhood workshop, (iii) submitting of applications to the County for staff review, (iv) public hearings by the planning commission, (v) a public hearing by the Board of County Commissioners, and (vi) possible judicial review. Accordingly, even though the 11th Circuit concluded that the risk of being denied rezoning of the B-10 parcel was negligible (that such risk was “baked into” the test for HBU), the possibility that an exaction or other condition might have been placed on the rezoning, as well as the time delay and costs associated with the rezoning process should also have been considered. A willing buyer considering purchase of the B-10 parcel in its not-yet-rezoned state would have taken those factors into account and likely discounted the purchase price of the B-10 parcel as a result.
In addition, appraisal sources further instruct that finding true comparable sales in the reasonable-probability-of-rezoning context is difficult. Developers interested in purchasing property for development typically condition their purchases on procurement of the necessary rezoning approvals. If the approvals are not obtained, the sales generally do not take place. Accordingly, sales of properties that have sold for development generally do not represent the price at which the property would have sold if the purchaser had to procure rezoning after the date of closing. Instead, such sales represent the price of a property with the rezoning approval already in place. Although appraisers must often resort to using such sales as comparables, it is essential that they make appropriate adjustments to account for the risks, time delays, and costs inherent in the rezoning procurement process. That neither the Tax Court nor the 11th Circuit discussed this issue with regard to the comparables gives the reader less confidence in their conclusions regarding the before-value of the not-yet-rezoned B-10 parcel.
Palmer Ranch’s Arguments on Appeal
On appeal, Palmer Ranch argued that the Tax Court erred in reducing the B-10 parcel’s before-value from just over $25 million to just over $21 million. In particular, Palmer Ranch argued that (i) once the Tax Court had rejected the “lowball” HBU asserted by the IRS’s valuation expert in his appraisal, the court was bound to adopt Palmer Ranch’s expert’s valuation without entertaining any reduction, (ii) the Tax Court erred by “concoct[ing] sua sponte” a valuation method that was advanced by neither party and contrary to established comparable-sales appraisal principles, (iii) the Tax Court impermissibly ventured beyond the evidentiary record in its discussion of monthly appreciation rates, and (iv) the Tax Court erred “in finding that there was no appreciation throughout 2006” and, in any case, incorrectly calculated the amount of pre-2006 appreciation.
The 11th Circuit rejected Palmer Ranch’s first contention—that the Tax Court was bound to adopt Palmer Ranch’s expert’s valuation once it had rejected the IRS expert’s lowball HBU. The 11th Circuit explained that, in deduction cases, the Tax Court is not bound to accept the taxpayer’s valuation in full merely because the IRS’s valuation is unsatisfactory. Rather, the Tax Court may determine its own valuation based on the whole of the evidentiary record and it is free to treat the work of the taxpayer’s expert as a starting point. The 11th Circuit further explained in a footnote:
To be as clear as the Sarasota sky, we do not hold that the tax court is obligated to use the comparable-sales method to value B–10 … we recognize the tax court’s expertise in adjudicating tax disputes, and therefore will not lay down a hardline rule confining the tax court to the parties’ preferred appraisal method(s) in every case. The tax court has discretion to adopt a valuation method befitting the matter before it—even if the parties have not proposed that method.
The 11th Circuit, however, agreed with Palmer Ranch’s other contentions regarding errors made by the Tax Court. First, the 11th Circuit explained that the Tax Court’s $21 million before-value for the B-10 parcel
was premised on an old appraisal as modified by monthly appreciation rates, instead of on comparable sales.… Because the parties’ appraisers both used the comparable-sales method, and because the tax court neither voiced disapproval nor acknowledged (much less explained) its departure from the method, that departure was error. The tax court must at minimum explain why it departed from the comparable-sales method in valuing B–10.
The 11th Circuit then explained that, even if the Tax Court’s unexplained departure from the comparable-sales method was proper, the Tax Court still erred by relying on evidence outside the record to value B–10. In particular, in choosing a monthly appreciation rate the Tax Court relied upon an old appraisal report that was not in the evidentiary record. The 11th Circuit explained that a “trial judge may not … undertake an independent mission of finding facts ‘outside the record of a bench trial over which he [presides].’” Lastly, the 11th Circuit found that the Tax Court seems to have erred in how it applied its chosen monthly appreciation rate (it may have made a mathematical error).
The 11th Circuit ultimately concluded that,
[o]n remand, …the tax court must either stick with the comparable-sales analysis or explain its departure. Whatever the tax court chooses to do, the court must keep its sights set strictly on the evidentiary record for purposes of selecting an appreciation rate, and ensure that it crunches the numbers correctly.
Contrary to some of the commentary on the case, the 11th Circuit did not find that Palmer Ranch’s asserted $25 million before-value for the B-10 parcel was correct. Rather, the court specifically noted that “[o]ur holding in no way precludes the tax court from valuing B-10 below” that amount, provided the valuation is based on the evidence.
A Final Issue—Enhancement
In addition to not addressing all of the factors that might have impacted the before-value of the B-10 parcel, another troubling aspect of Palmer Ranch is the seeming lack of analysis regarding whether the easement donation increased the value of Palmer Ranch’s other property. At the time of the donation of the easement, Palmer Ranch reportedly owned a 39-acre parcel “immediately to the north of” the B-10 parcel (the B-9 parcel). If the B-9 parcel was contiguous to the B-10 parcel, the deduction should have been equal to the difference between the fair market value of the entire contiguous parcel (B-9 and B-10) before and after the donation of the easement. See Treas. Reg. § 1.170A-14((h)(3)(i). If the B-9 parcel was not contiguous to the B-10 parcel, the deduction should have been reduced by the amount (if any) by which the donation of the easement increased the value of the B-9 parcel. See id. It is impossible to tell from the court opinions whether donating the easement on the B-10 parcel increased the value of the B-9 parcel. It certainly might have, since people are often willing to pay more to live adjacent to or near permanently protected open space. And if it did, the deduction should have been reduced accordingly.
In a February 22, 2016, Daily Business Review article discussing the case, the reporter notes that Hugh Culverhouse, Jr., who owns Palmer Ranch, is “finalizing a deal to sell the adjoining 38-acre parcel. Coming soon: 36 single-family homes with a view.” This suggests that donating the easement on the B-10 parcel may indeed have increased the value of the B-9 parcel.
Nancy A. McLaughlin, Robert W. Swenson Professor of Law, University of Utah S.J. Quinney College of Law