In a recent case from the Fourth Circuit Court of Appeals, Mann v. U.S., 127 AFTR 2d 2021-XXXX (4th Cir. Jan. 6, 2021), the Court determined that the donation of a house which was subject to demolition failed to satisfy two requirements under Section 170 of the Code. First, the taxpayer failed to donate the taxpayer’s entire interest in the property as required under Section 170(f)(3).[1] Secondly, the appraisal failed to meet the requirements of a “qualified appraisal” under Section 170(f)(11)(C).[2]
Procedural Posture
This case arrived at the Fourth Circuit on appeal from refund suit from District Court, being that the taxpayers, in lieu of petitioning the Tax Court, opted to instead pay the tax, sue for refund, and argue with the Dept. of Justice in District Court instead of Chief Counsel in Tax Court. At appeal, the Manns challenged the District Court’s ruling affirming disallowance of a charitable deduction by the IRS following the filing of an amended return by the Manns.
Factual Background
Following the intended sale of their 20-year home, the Manns, in an effort to downsize, purchased a new home for a purchase price of $2.25 million. After discovering issues with the house, the Manns decided to wipe the slate clean, demolish the home, and rebuild their new home on the same site. In the process of coming to the decision to demolish the home, builders recommended that the Manns consider working with Second Chance, a charitable organization offering “deconstruction” services. Second Chance is a 501(c)(3) charitable organization out of Baltimore, Maryland, that offers deconstruction services to (1) provide workforce development and job training, and (2) prevent salvageable building materials and fixtures from ending up in landfills.
The Manns engaged Second Chance and, as part of the project, Second Chance requested a $20,000 cash contribution to help defray the costs of Second Chance’s training program. The Manns entered into a two-page “Agreement for Charitable Contribution” with Second Chance, dated December 1, 2011.
The Court quoted how a Second Chance Deconstruction Sales Manager explained to Lawrence Mann how the tax deduction for the donation would work. Specifically “You should of course discuss this with your CPA, but I can confidently say that a ‘contents’ donation is as solid as it gets.[…] The approach that we are discussing only considered the value of what crosses the threshold of our warehouse, based on a manifest that we sign to verify receipt.”
Lawrence Mann initially wanted the $20,000 cash contribution to be contingent upon the IRS’ acceptance of the deduction, but eventually he wrote a $10,000 check on December 31, 2011 and a $1,500 check written in 2012 (not the remaining $10,000 due per the donation agreement).
The Manns engaged NoVaStar Appraisals, Inc. (“NoVaStar”) to provide an appraisal establishing the value of the donation. In mid-October, NoVaStar appraised both the house and accompanying personal property in the house being donated concluding that the “highest and best use” of the house was “not disassembly, but rather physically moving the structure to another lot” to function as a residence. The appraiser further added that “disassembly destroys part of the structure during the process […]” The appraiser concluded that the fair market value of the home was $1.875 million and concluded the land-only valuation to be $1.2 million. Subtracting the land value from the home’s aggregate value, the appraiser determined the structure was worth $675,000, such being the value the Manns used in preparing their income tax return and in turn, claiming their charitable deduction for the donation of the home.
Second Chance commenced the first phase deconstruction, removing non-structural interior elements, on December 22, 2011. The second phase required a demolition permit. Second Chance needed to wait until the Manns’ contractor obtained the permit before commencing the second phase of deconstruction and removing the exterior and structural elements. While Second Chance maintained a complete inventory of the items it removed from the home during the first phase, it did not do so during the second phase of the project. Further, the Manns prepared a list of 40 items of personal property, including furniture and home decorations that were donated to Second Chance, valued at $24,206 per the NoVaStar appraisal.
At this point, it is worth noting that this is not the first case involving Second Chance.[3] Some, some aggrieved donors have gone so far as filing a class action lawsuit against Second Chance.[4] While the lawsuit was dismissed, the articles indicate the effect of lawsuits on the number of donations to Second Chance, noting Second Chance stated that after the filing of the class action, building donations fell as much as 25%.[5]
The Audit
Following submission of their 2011 and 2012 tax returns, claiming $675,000 in in-kind contribution and $10,000 in cash contributions for 2011 and $1,500 in cash contributions for 2012, the IRS selected the Manns’ returns for audit. The initial audit report determined the deductions should be disallowed. Appeals provided no relief. Following Appeals, the IRS calculated the tax liability of the Manns to be $191,638 for 2011 and $2,464 for 2012 before assessment of any applicable penalties and interest. The Manns, in lieu of going to Tax Court, opted to pay the tax in full and in November 2015 filed a claim for refund and request for abatement. The Manns also filed an amended return in August 2016 for the year 2011 that “for settlement purposes only” adjusted the claimed deduction from $675,000 to $313,353, based on an alternative appraisal by NoVaStar. This appraisal (“Second Appraisal”) utilized a cost approach instead of “highest and best use” approach. The IRS again disallowed the deduction.
The Arguments: Severance from the Land, Entire Interest, and Appraisal
While the initial appraisal looked at the house as a whole, the Second Appraisal represented the aggregate value of the house’s components. The Manns argued that (1) they severed the house from the real property by virtue of the written donation agreement, (2) such interest was their entire interest in the donated property, and (3) the property was properly appraised under the Second Appraisal.
With respect to (1) and (2), which go hand in hand, one must first take note that this donation involves a donation related to real property, a house. In many states, one must record a public filing to convey real property. If the Manns were able to successfully argue that the donation agreement converted the improvements on the real property (house) into personal property, severing such property from the land, then the gift would likely be a gift of personal property as argued. Without severing the house from the land, and absent recordation of an instrument of conveyance or some other instrument separating the house from the land, if even possible, then such a gift was a gift of a partial interest in the real property held by the taxpayer, generally disallowed under the Code.
The government argued that an instrument of conveyance did not exist. Thus, the house was never severed from the land and therefore remained part of the real property. Further, the government argued that the donation agreement was not for the donation of the house, but instead for a donation of the right to use the house for a specific purpose, to conduct demolition training and salvage. Lastly, the government argued the Second Appraisal being “of all the building materials in the house, including those that were not salvaged, was improper,” and that Second Chance failed to keep records of the items salvaged. Therefore, the Manns “failed to support their donation with a qualified appraisal, as IRC 170(f)(11)(C) requires.”
The Court’s Analysis
Separation from the Land
With respect to severance from the land, the Court cited Maryland state law and Maryland cases regarding the issue, eventually concluding that Linda Mann never conveyed the entire interest in the house as a result of her failure to deliver a recorded deed or other instrument of record showing transfer of title to the improvements. As a result, Linda Mann remained the record titleholder in the eyes of Maryland and therefore also remained on the hook for property taxes. The Court concluded that Linda Mann maintained some aspect of ownership. As a result of the retained ownership, the gift was not of the Manns’ entire interest in the donated property. While it appears that the Court reached its conclusion based on the government’s property tax argument, being responsible for the property taxes does not seem to be the dispositive factor. Rather, it was the mere existence of a right, significant enough to result in an assessment of taxes upon the donor, (in this case, emanating from the lack of a recorded instrument of conveyance) that resulted in Linda Mann not giving away her entire interest in the house.
The Donation Agreement
Turning then to the donation agreement, the Court determined that the agreement contemplated Second Chance would not take all of the house, instead, it would deconstruct as needed for training and salvage purposes. Again, the Manns seem to not have given away the entirety of the house. The Court, relying on substance-over-form with respect to the donation agreement, held that the substance of the donation agreement was a gift of less than the taxpayer’s entire interest in the property.
The Appraisal
Lastly, the Court held the Manns failed to substantiate the value of the purported charitable contribution. The Second Appraisal assumed that every component of the house would be severed and donated to Second Chance. This was not the case. The Second Appraisal used a “cost approach to value” using a 60-year economic life and effective age of 10 years and concluded that the assets should be discounted in value by 17% from their new/uninstalled values. In supporting the District Court’s ruling that the appraisal was flawed due to not every component being donated to Second Chance, the Court cited Rolfs v. Comm’r, 668 F.3d 888, 895 (7th Cir. 2012). Rolfs presented a similar situation where a taxpayer made a donation of a house to a local fire department for deconstruction in a training exercise. In Rolfs, the Seventh Circuit Court of Appeals held that none of the value of the house, as a house, was actually given away. The Fourth Circuit also noted that the Seventh Circuit, in Rolfs, as discussed in the District Court’s opinion, offered a means to properly value the donation. Specifically, the District Court advised that “a ‘proper way’ to value the donation would have been ‘based on the resale value of the specific building materials and contents’ that Second Chance removed from the premises.[6] The Court held that the appraisal never provided the IRS with an estimate of the value of the specific materials used or removed. Therefore, the appraisal failed to meet the requirements under Section 170(f)(11)(C) of the Code.
Closing
In affirming the lower court’s decision, the Fourth Circuit noted the District Court’s opinion which offered helpful analysis and insight as to how to properly handle such gifts, citing to the discussion Rolfs in the District Court’s opinion, giving guidance to others who may entertain such transactions. While such may seem unfair, Section 170 and the regulations issued under Section 170 provide some very specific rules for deductibility of donations. Primary among these rules are qualification and substantiation. On both grounds the Manns lost on their appeal.
[1] It is worth noting that an exception to the “entire interest” rule exists under Section 170(h) of the Code with respect to qualified conservation contribution (conservation easements).
[2] Also see Treas. Reg. § 1.170A-13(c)(3)(ii)(I).
[3]See https://www.baltimoresun.com/business/bs-bz-second-chance-recovers-dismissal-lawsuit-20201023-smirvwu3djed7og3z2cw4vt7qi-story.html
[4] Id.
[5] See https://www.secondchanceinc.org/gogtay-dixit-v-second-chance-inc-lawsuit-dismissed-with-prejudice/
[6] See Mann v. U.S., 364 F. Supp. 3d 553, 564 (D. Md. 2019).
