Tenth Circuit Affirms Tax Court on Easement Valuation, Capital Gains Treatment of State Tax Credits

Jennifer Rubin (Kenneth L. Greene, Tax Division of Department of Justice, and Kathryn Keneally, Assistant Attorney General, on the brief), Washington, D.C., for Respondent-Appellee.

Before KELLY, GORSUCH, and HOLMES, Circuit Judges.

KELLY, Circuit Judge.

Petitioners-Appellants Esgar Corporation, George and Georgetta Tempel, and Delmar and Patricia Holmes (collectively, the "Taxpayers") appeal from two decisions of the United States Tax Court. Esgar Corp. v. Comm'r, 103 T.C.M. (CCH) 1185, 2012 WL 371809 (T.C. 2012); Tempel v. Comm'r, 136 T.C. 341 (T.C. 2011). They argue that the Tax Court erred in valuing conservation easements they claimed as charitable deductions and in determining the holding period of state tax credits they sold. Our jurisdiction arises under I.R.C. § 7482,¹ and we affirm.

In December 2004, the partnership transferred approximately 163 of the non-leased acres to the Taxpayers individually. Id. at *4. When all was said and done, Esgar and the Tempels each owned 54.34 acres, and the Holmeses owned 54.35 acres of land adjacent to the Midwestern Farms Pit. Id. On December 17, 2004, the Taxpayers each donated a conservation easement over their respective property to the Greenlands Reserve. Id. at *5. The donations granted a perpetual easement over the properties, giving Greenlands the right to preserve the natural condition of the land and protect its biological, ecological, and environmental characteristics. Id. The grant specifically prohibited the mining of sand, gravel, rock, or any other minerals on the properties. Id.

The Taxpayers claimed charitable deductions on their 2004, 2005, and 2006 tax returns for "qualified conservation contributions" under I.R.C. § 170(f)(3)(B)(iii). Id. The Taxpayers engaged William Milenski to appraise their contributions. Mr. Milenski concluded that, had the conservation easements not been granted, the properties would have realized their greatest potential as a gravel mining operation. Id. Based on the value of that relinquished use, Mr. Milenski valued Esgar's donated conservation easement at $570,500, the Holmeses' at $867,500, and the Tempels' at $836,500. Id. The Taxpayers claimed these amounts as charitable contributions on their respective 2004 tax returns, deducting what they could and carrying the remainder forward onto their 2005 and 2006 returns. Id.

Also as a result of their donations, the Taxpayers received transferable tax credits from the State of Colorado. Tempel, 136 T.C. at 342. Between December 22 and 31, 2004 -- within two weeks of receiving the credits -- the Taxpayers sold portions of their credits to third parties. Id. at 343. From these sales, Esgar received net proceeds of $18,000, the Tempels received net proceeds of $82,500, and the Holmeses received net proceeds of $164,625. Id.; Stip. of Facts at 11 ¶¶ 47-49. On their respective 2004 tax returns, the Taxpayers reported these proceeds as income, albeit each differently: Esgar reported the income as a long-term capital gain; the Tempels reported it as a short-term capital gain; and the Holmeses reported it as ordinary income. Tempel, 136 T.C. at 343; Stip. of Facts at 12 ¶ 54, 15 ¶ 67, 16 ¶ 75.

After an audit of the Taxpayers' 2004, 2005, and 2006 returns, the Commissioner determined that the Taxpayers' conservation easements were in fact valueless and that the sales proceeds from their state tax credits should be reported as ordinary income. The Commissioner issued notices of deficiency for the 2004, 2005, and 2006 tax years. The notices indicated that Esgar, the Holmeses, and the Tempels had understated their tax liability for those years by $32,357, $82,296, and $93,681, respectively. Esgar Corp., 2012 WL 371809, at *1. The Taxpayers challenged these notices in the United States Tax Court, and a three-day trial was held in Denver, Colorado, in November 2009.

In the Tax Court, the Commissioner did not challenge whether the conservation easements were deductible "qualified conservation contributions" under I.R.C. § 170(h). Rather, the only issue was the easements' value. Concerning valuation methodology, the parties agreed that there were no comparable sales of easements with which to compare the Taxpayers' donations. Thus, the parties agreed on "before and after" valuation.³ The Taxpayers and the Commissioner agreed that the after value of the Esgar and Tempel properties was $24,000, and the after value of the Holmes property was $27,000. Id. at *7. Their disagreement, and thus the trial, centered around the properties' before value.

The Tax Court noted that a property's "highest and best use" determines its before value. Id. The Taxpayers argued that their properties' highest and best use before granting the easements was gravel mining; the Commissioner argued that it was agriculture.⁴Id. To this end, both sides introduced reports and testimony from various experts. Id. at *8-14. Taking into account these experts, the Tax Court sided with the Commissioner's conclusion that agriculture was the properties' highest and best use. Id. at *15. This conclusion was based in part on a finding that, although "it would have been physically possible to mine the properties in 2004 (or in the future)," there was no demand for such use "in the reasonably foreseeable future." Id. at *19. The Tax Court then decided the properties' before value based on comparable sales of agricultural lots. It concluded that the before value of the Esgar and Tempel properties was $73,774, and the before value of the Holmes property was $76,502.50. Id. at *22. After subtracting the properties' after values, the Tax Court valued the Esgar and Tempel conservation easements at $49,774, and the Holmes conservation easement at $49,502.50. Id.

In a separate decision, the Tax Court held that the Taxpayers' state tax credits were capital assets and that their holding periods were insufficient to qualify for long-term capital gain treatment. Tempel, 136 T.C. at 355. The resulting income was thus properly reported as short-term capital gains.

This appeal followed.

On the other hand, we review the Tax Court's findings of fact for clear error. Cox, 514 F.3d at 1123. The Supreme Court has delineated the nature of our review:

The Taxpayers point to three errors by the Tax Court, each of which they frame as a "misapplication of legal standards and methodologies mandated by the Internal Revenue Code and Treasury Regulations." Aplt. Br. 17. They argue that: (1) the Tax Court erroneously placed on them the burden of proving the before value of their properties; (2) the Tax Court applied incorrect legal standards in valuing their conservation easements; and (3) the Tax Court erred in determining the holding period of their state tax credits. Aplt. Br. 2-3. We consider each in turn.

A. Burden of Proof Allocation and Factual Inferences

The Taxpayers argue that the Tax Court erred by placing on them the burden of proving the before value of their properties. They contend that they satisfied I.R.C. § 7491(a)'s requirement of producing credible evidence on that issue, thus shifting the burden to the Commissioner. Aplt. Br. 20-30. Because the burden was not properly allocated, they argue, the Commissioner was allowed to prevail without presenting any "objective evidence" that agriculture was the properties' highest and best use. Id. at 31. They assert that the Tax Court's decision is devoid of "factual evidence presented by the Commissioner" but is instead supported "through negative presumptions of fact improperly inferred" against them. Id. at 34.

The Taxpayers argue that they introduced credible evidence that gravel mining was their properties' highest and best use, thus shifting the burden to the Commissioner to disprove that matter. Aplt. Br. 20-30. For the purpose of their appeal we will assume -- without deciding -- that they were entitled to § 7491's burden shift. However, like the Tax Court, we conclude that the application of § 7491 is immaterial to the outcome of this case because, on this record, the Tax Court could hold that the preponderance of the evidence favored the Commissioner.

Congress enacted § 7491 to remove a perceived disadvantage experienced by taxpayers who litigate with the IRS. See S. Rep. No. 105-174, at 44 (1998). It did so by requiring that if both sides produce evidence and "the court believes that the evidence is equally balanced, [then] the court shall find that the Secretary has not sustained his burden of proof." Id. at 46. In applying § 7491, however, courts have concluded that if the evidence is not "equally balanced," then there is no need to rule on whether the burden shifts to the IRS. Trout Ranch, LLC v. Comm'r, 493 F. App'x 944, 955 (10th Cir. 2012) (unpublished);⁶Whitehouse Hotel Ltd. P'ship v. Comm'r, 615 F.3d 321, 332-33 (5th Cir. 2010); Keating v. Comm'r, 544 F.3d 900, 906 (8th Cir. 2008); Geiger v. Comm'r, 279 F. App'x 834, 835 (11th Cir. 2008) (unpublished); Blodgett v. Comm'r, 394 F.3d 1030, 1039 (8th Cir. 2005); FRCG Inv., LLC v. Comm'r, 89 F. App'x 656, 656 (9th Cir. 2004) (unpublished); Knudsen v. Comm'r, 131 T.C. 185, 189 (T.C. 2008).

Importantly, the Eighth Circuit has held that:

We will, however, briefly address the Taxpayers' contention that the Commissioner produced no "credible," "reliable," or "objective" evidence regarding the highest and best use of the properties. Aplt. Br. 22-24, 31, 34, 35. We start by noting that the Commissioner need not produce any evidence if other evidence in the record satisfies his burden for him: "The case law is clear that the determination whether [the Commissioner's burden of proof] has been satisfied is not limited to [the Commissioner's] affirmative evidence but can be made on the basis of the whole record." Anclote Psychiatric Ctr., Inc. v. Comm'r, 76 T.C.M. (CCH) 175, 1998 WL 421954, at *13 (T.C. 1998), aff'd, 190 F.3d 541 (11th Cir. 1999). See also Silverman v. Comm'r, 538 F.2d 927, 933 (2d Cir. 1976); Clark v. Comm'r, 266 F.2d 698, 717 (9th Cir. 1959); cf. Salehpoor v. Shahinpoor, 358 F.3d 782, 786 (10th Cir. 2004) (court reviews "record as a whole" to determine whether moving party is entitled to judgment as a matter of law). In this case, the Tax Court determined that much of the Taxpayers' own evidence undermined their position that gravel mining was their properties' highest and best use. Esgar Corp., 2012 WL 371809, at *9, *10, *11, *15 n.22, *16-17, *17 n.24, *17-18, *18, *19. The conclusion that this evidence weighed in the Commissioner's favor was not clearly erroneous.

Additionally, the Taxpayers' assertion that the Commissioner's case was devoid of "factual evidence" is incorrect. Aplt. Br. 34. The Commissioner offered the expert testimony of Kevin McCarty, a certified general appraiser who had appraised some 150 conservation easements. Esgar Corp., 2012 WL 371809, at *12-13; Tr. Trans. at 595-706, Esgar Corp., 103 T.C.M (CCH) 1185 (No. 2012-35). Mr. McCarty opined that the properties' highest and best use was agriculture. Esgar Corp., 2012 WL 371809, at *12. Whether to accept Mr. McCarty's expert opinion was for the Tax Court to decide "in the exercise of [its] sound judgment." Hughes v. Comm'r, 97 T.C.M. (CCH) 1488, 2009 WL 1227938, at *5 (T.C. 2009); see also Helvering v. Nat'l Grocery Co., 304 U.S. 282, 295 (1938). Mr. McCarty's opinion was certainly one way of viewing the evidence. "Where there are two permissible views of the evidence, the factfinder's choice between them cannot be clearly erroneous." Anderson v. City of Bessemer, 470 U.S. 564, 574 (1985). Moreover, Mr. McCarty's expert opinion constitutes substantial evidence on which the Tax Court could base its conclusion that agriculture was the properties' highest and best use.

We disagree. It is the function of the Tax Court to "draw appropriate inferences, and choose between conflicting inferences in finding the facts of a case." Powers v. Comm'r, 105 T.C.M. (CCH) 1798, 2013 WL 2338502, at *7 (T.C. 2013); see Scottish Am. Inv. Co., 323 U.S. at 124; Nat'l Grocery Co., 304 U.S. at 294; Home Co., 212 F.2d at 639. The Tax Court may draw these inferences from the whole record, including the Commissioner's evidence on a given fact and the taxpayer's lack thereof. See Anclote Psychiatric Ctr., Inc., 1998 WL 421954, at *13.

Inference drawing does not constitute a shift in the burden of proof. The Seventh Circuit rejected such an argument in Steiner v. Comm'r, 350 F.2d 217 (7th Cir. 1965). In that case -- where the Commissioner held the burden of proving the taxpayer's fraud -- the court noted that:

As discussed above, the Tax Court's decision is supported by a record of evidence from both sides. Presented with Mr. McCarty's estimate, the Tax Court did not rely solely on the missing-evidence inference to find that existing supply in Prowers County was sufficient to satisfy future increases in demand. That inference was just one more factor indicating that gravel mining was not the properties' highest and best use.

B. Conservation Easement Valuation

Next, the Taxpayers argue that the Tax Court applied erroneous legal standards to value their conservation easements. They make two arguments: (1) that the Tax Court erred by adopting the properties' current use as its highest and best use rather than taking a "development-based approach," Aplt. Br. 38; and (2) that the Tax Court erred by citing eminent domain principles in reaching its valuation determination. We address both issues.

Although taxpayers are generally not permitted to deduct contributions of an interest in property less than their entire interest, Congress has permitted such partial interest contributions where the interest donated is a "qualified conservation contribution." I.R.C. § 170(f)(3)(B)(iii). Commonly called "conservation easements," the contribution must meet certain statutory requirements, id. at § 170(h), none of which are at issue here. Often value is the only contested issue concerning the tax treatment of conservation easements.

Valuation can prove difficult because "most open-space easements are granted by deed of gift [so that] there is rarely an established market from which to derive the fair market value." Symington v. Comm'r, 87 T.C. 892, 895 (T.C. 1986). The IRS addressed this problem through regulations. See Treas. Reg. § 1.170A-14 (as amended in 2009). Treasury Regulation § 1.170A-14 provides that the value of a conservation easement is "the fair market value of the perpetual conservation restriction at the time of the contribution." Id. at § 1.170A-14(h)(3)(i). There are two alternative methods of calculating this value: the "comparable sales" method and the "before and after" method. Id.

Under the comparable sales method, the donated easement's fair market value may be extrapolated from sales of other easements, "[i]f there is a substantial record of sales of easements comparable to the donated easement." Id. Because it is often the case that such sales are few and far between, the regulations provide for an alternative measure -- the before and after method:

The highest and best use inquiry is one of objective probabilities. The "realistic, objective potential uses for property control" its valuation. Symington, 87 T.C. at 896 (citing Stanley Works & Subsidiaries v. Comm'r, 87 T.C. 389, 400 (T.C. 1986)). Valuation does not depend on "whether the owner actually has put the property to its highest and best use." Id. at 897. Rather, courts must "focus on 'the highest and most profitable use for which the property is adaptable and needed or likely to be needed in the reasonably near future.'" Id. (quoting Olson v. United States, 292 U.S. 246, 255 (1934));⁸see also Whitehouse Hotel Ltd. P'ship, 615 F.3d at 335. A suggested higher use other than current use "requires both 'closeness in time' and 'reasonable probability.'" Hilborn, 85 T.C. at 689.

The IRS has adopted this objective approach to highest and best use. Treasury Regulation § 1.170A-14 calls for the court to objectively assess "how immediate or remote the likelihood is that the property . . . would in fact be developed." Treas. Reg. § 1.170A-14(h)(3)(ii). This is the same as asking a court to determine the reasonable probability that development is "likely to be needed in the reasonably near future." Symington, 87 T.C. at 897.

We have some difficulty accepting the Taxpayers' position. First, the record belies their contention that the Tax Court "failed to identify" the proper valuation standard. Aplt. Br. 18. The Tax Court stated that the fair market value of property "must be evaluated considering the property's highest and best use." Esgar Corp., 2012 WL 371809, at *7. To that end, it cited § 1.170A-14(h)(3)(ii), Symington, and other highest and best use cases. Id. Its opinion centered on an assessment of gravel mining as the highest and best use of the properties. Id. at *15-19.

The Taxpayers also argue that the Tax Court erred in its application of the highest and best use standard. Aplt. Br. 18, 35-41. They do not argue that the Tax Court erred in its finding that gravel mining was not the properties' most reasonably probable use. That conclusion, of course, would be subject to review for clear error. Cox, 514 F.3d at 1123; Home Co., 212 F.2d at 639. Rather, they ask us to review de novo whether the Tax Court failed to apply the proper highest and best use analysis altogether. Aplt. Br. 39. As mentioned above, it clearly did not.

The Tax Court was not bound to accept gravel mining as the properties' highest and best use if that use was not reasonably probable to manifest in the reasonably near future. See Symington, 87 T.C. at 897. In other words, after taking into account the properties' current use and the fact that the likelihood of development was remote, the Tax Court certainly could find that the properties' current use, agriculture, was its highest and best use. See Treas. Reg. § 1.170A-14(h)(3)(ii). In its objective assessment of the likelihood that the properties would be developed into a gravel mine, the Tax Court found: (1) as of 2004, there was no unfulfilled demand for gravel in Prowers County, Esgar Corp., 2012 WL 371809, at *16; (2) demand from the Front Range for Prowers County gravel was not poised to increase in the "reasonably foreseeable future," id. at *17; (3) supply produced by the four existing Prowers County gravel pits was sufficient to satisfy any increases in demand, id. at *17-18; and (4) transporting gravel via rail from Prowers County to the Front Range was not a "reasonably foreseeable possibility" in 2004, id. at *18.⁹

The Tax Court applied the correct highest and best use standard, looking for the use that was most reasonably probable in the reasonably near future, and it did not clearly err by concluding that use was agriculture.

The Taxpayers have not satisfied us that we are comparing apples and oranges when it comes to evaluating highest and best use. Conservation easement valuation requires a finding of "highest and best use." See Treas. Reg. § 1.170A-14(h)(3)(ii). Just compensation valuation requires an identical finding, i.e., the "highest and most profitable use" for which the property was suited before the taking. Olson, 292 U.S. at 255. One of the Taxpayers' experts called Olson v. United States, an eminent domain case, "a kind of landmark for the definition of highest and best use." Tr. Trans. at 513, Esgar Corp., 103 T.C.M (CCH) 1185 (No. 2012-35). The Taxpayers refer to a four-factor highest and best use test that finds significant use in eminent domain cases.¹⁰ Aplt. Br. 8.

The objective assessment that Treas. Reg. § 1.170A-14(h)(3)(ii) requires does not materially differ from that used to determine the highest and best use of property for just compensation valuation. Cases valuing conservation easements cite eminent domain cases without noting any difference between the two concepts. See, e.g., Whitehouse Hotel Ltd. P'ship, 615 F.3d at 335 (citing both Olson and § 1.170A-14(h)(3)(ii) in its discussion of highest and best use); Hughes, 2009 WL 1227938, at *3 (same). In fact, the Tax Court has gone so far as to state, "The principles and legal precedents governing the determination of fair market value of property in tax cases are the same as those that control the valuation of property in condemnation cases." Stanley Works & Subsidiaries, 87 T.C. at 401 n.8.¹¹

We find no material difference between conservation easement valuation and just compensation valuation in the context of determining a property's highest and best use. Section 1.170A-14(h)(3)(ii) does not preclude reference to eminent domain cases where they inform an objective assessment of the likelihood of future development.

C. Holding Period of State Tax Credits

Finally, the Taxpayers argue that their state tax credits, which they held for about two weeks, were long-term capital assets. Aplt. Br. 41-43. They argue that long-term treatment is appropriate because they held the underlying real properties for longer than one year, they relinquished development rights in those properties through the donation of conservation easements, and they received these tax credits because of those donations. Aplt. Br. 43. They cite no authority clearly supporting this proposition.¹²

The Tax Court correctly concluded that:

AFFIRMED.

² Aggregate is material "consisting largely of rock, gravel, and sand" used in construction or as an ingredient in making concrete. Pioneer Gravel Equip. Mfg. v. Diamond Iron Works, 72 F.2d 161, 161 (8th Cir. 1934).

³ Discussed in more detail below, the before and after method measures a conservation easement's value as the difference between the property's fair market value before granting the easement and the property's fair market value after being so encumbered.

⁴ The properties had historically been used as farmland; however, the parties stipulated that, absent the conservation easements, it was likely that the necessary permits to mine gravel could be obtained. Esgar Corp., 2012 WL 371809, at *4.

⁵ In addition to introducing "credible evidence" regarding the factual issue, § 7491(a) requires that

⁶ We cite this and other unpublished dispositions for their persuasive value only. 10th Cir. R. 32.1(A).

⁷ The Taxpayers' reliance on another Eighth Circuit case, Griffin v. Comm'r, 315 F.3d 1017 (8th Cir. 2003), is unavailing. First, in a subsequent opinion, the Eighth Circuit expressly abandoned Griffin and adopted the approach set out above. Blodgett, 394 F.3d at 1039. And second, the Eighth Circuit's decision in Griffin was based on the fact that the court, on the record before it, could not determine whether § 7491's burden shift played a role in determining the outcome of that case, i.e., whether the evidence was so evenly balanced that the Commissioner could not be deemed to have met his burden. Griffin, 315 F.3d at 1022. On the record before us, we do not believe that the Tax Court clearly erred by concluding that the preponderance of the evidence favored the Commissioner.

⁸ Elsewhere, the Taxpayers attack reliance on eminent domain cases such as Olson v. United States. But Symington, which the Taxpayers call "a landmark conservation easement case," Aplt. Br. 38, cited Olson for the same reasons that the Taxpayers cite Symington. Symington, 87 T.C. at 896-97.

⁹ The Taxpayers argue that contrary conclusions can be drawn from the record. However, there is ample evidence in the record to support the Tax Court's findings.

¹⁰See, e.g., United States v. 1.604 Acres of Land, 844 F. Supp. 2d 668, 679 (E.D. Va. 2011) (analyzing highest and best use for "whether the use is (1) physically possible; (2) legally permissible; (3) financially feasible; and (4) maximally productive") (citing The Appraisal of Real Estate 278-79 (13th ed. 2008)); see also Brace v. United States, 72 Fed. Cl. 337, 350 (Fed. Cl. 2006); Bassett, N.M. LLC v. United States, 55 Fed. Cl. 63, 69 (Fed. Cl. 2002). The Tax Court has considered these factors when determining the highest and best use of eased property. See, e.g., Hughes, 2009 WL 1227938, at *8 (T.C. 2009).

¹¹ The Taxpayers attempt to discredit Stanley Works by pointing out that it was decided under prior tax law, i.e., prior to the enactment of I.R.C. § 170(h) and Treas. Reg. § 1.170A-14(h)(3)(ii). At oral argument, the Taxpayers attacked Symington for the same reason, after praising it as a "landmark conservation easement case" in their opening brief. Aplt. Br. 38. Both Stanley Works and Symington remain persuasive authority because they decided highest and best use based on an objective assessment of reasonably probable uses, something that § 1.170A-14(h)(3)(ii) does also.

¹² Neither did the Taxpayers address the Commissioner's response to this issue in their reply brief, nor did they address this issue at oral argument.

¹³ If this were a like-kind exchange (conservation easements in exchange for tax credits), then this would negate the charitable nature of the Taxpayers' contribution. See United States v. Am. Bar Endowment, 477 U.S. 105, 116 (1986) (A donation "generally cannot constitute a charitable contribution if the contributor expects a substantial benefit in return.").