(Whitehouse Hotel Limited Partnership et al. v. Commissioner - Fifth Circuit )
By Lance S. Hall, ASA *
In 1997, Whitehouse Hotel Limited Partnership ("Whitehouse") donated a historic preservation façade conservation easement on the Maison Blanche building in downtown New Orleans to a Section 170 qualified non-profit, and claimed a $7.445 million charitable-contribution deduction. The Internal Revenue Service claimed that the conservation easement donation had a fair market value of $1.15 million, and sought an undervaluation penalty of 40 percent on the remainder. In Whitehouse Hotel Limited Partnership v. Commissioner (131 T.C. No. 10, October 30, 2008), the Tax Court largely agreed with the IRS and applied a 40-percent undervaluation penalty. Whitehouse appealed and the Fifth Circuit remanded the case back to the Tax Court for revaluation and added an odd mixture of strongly worded advice for the Tax Court to reevaluate its positions on the rejection of certain valuation approaches, the property’s highest and best use, and the Taxpayer’s reasonable and good faith reliance on expert advice which would eliminate any undervaluation penalties.
The Maison Blanche building was constructed between 1906 and 1908 and was listed on the Vieux Carr? Historic District and the Canal Street Historic District. The Maison Blanche building was also designated as a City of New Orleans landmark. Whitehouse purchased the building (and related structures) in 1995 for the purpose of renovating the property into a luxury hotel (Ritz-Carlton), among other things. Contiguous to the Maison Blanche building was the six-story Kress building which was purchased at the same time and which was an integral part of the renovation plans. On December 27, 1997, Whitehouse conveyed the conservation easement on the Maison Blanche building to the Preservation Alliance of New Orleans. On December 28, 1997, a day after the conveyance and in preparation for the renovation of the property into a luxury hotel, Whitehouse "converted the Maison Blanche and Kress buildings into a single, indivisible condominium unit." The conservation easement donation met all the requirements of Section 170. The only question before the Court was the amount of the deduction.
Highest and Best Use (combined or not)
Even though the conservation easement was only applicable to the façade of the Maison Blanche building, the Taxpayer’s expert also considered the impact on the fair market value of the Kress building which, as a practical matter, precluded Whitehouse from increasing the height of the Kress building to accommodate an additional 60 hotel rooms. The IRS’s expert disagreed, claiming the easement only encumbered the Maison Blanche building. Moreover, the IRS’s expert argued, a hypothetical buyer of only the Kress building was not bound by the conservation easement agreement.
By combining the Maison Blanche building with the Kress building, the Taxpayer believed that the highest and best use of the combined property was a luxury hotel (among other things). The IRS’s expert disagreed and concluded that the highest and best use of the Maison Blanche building was a non-luxury hotel and retail complex. Further, according to the IRS’s expert, the highest and best use of the property did not change before or after the conservation easement conveyance.
Before and After Valuation Approaches
For the "before" valuation, the Taxpayer’s expert considered three different valuation approaches for the "before" value: "replacement-cost, income, and comparable-sales." In determining the "before" value, the Taxpayer’s expert took a weighted average of the indications to arrive at a value of $41 million. In contrast, the IRS’s expert only utilized the comparable-sales method, which indicated a "before" value of $10.3 million. 
In determining the "after" value, the Taxpayer’s expert felt there were no reasonably comparable "after" sales and, therefore, utilized only the replacement-cost and income approaches in arriving at a weighted average value of $31 million, resulting in an indicated value of $10 million for the conservation easement donation ($41 million "before" value minus the $31-million "after" value. As the IRS’s expert did not believe the highest and best use of the property changed as a result of the conservation easement, he again arrived at a value of $10.3 million for the property, which resulted in a value of zero for the conservation easement donation.
Issues on Appeal
On appeal, the issues before the Fifth Circuit were (a) whether the Maison Blanche property should be valued alone or combined with the Kress building (and related properties), (b) the highest and best use of the property, (c) the valuation approaches that should be utilized, (d) whether the IRS’s expert was qualified, (e) whether a deviation from Uniform Standards of Professional Appraisal Practice (USPAP) would render the IRS’s expert’s valuation report unreliable, (f) whether the burden of proof should be shifted to the IRS, and (g) whether the Taxpayer had shown sufficient reasonable cause to rely on experts and, thus, avoid any gross undervaluation penalty.
Combining the Maison Blanche and Kress buildings
As stated by the Fifth Circuit,
Whitehouse owned both the Maison Blanche and Kress buildings on the day the easement was conveyed; because of the easement, Whitehouse could not build on top of the Kress building; the easement prohibits any future owner of the Maison Blanche building from obscuring its wall adjacent to the Kress building and, therefore, any successor who, like Whitehouse, owned both the Maison Blanche and Kress buildings could not build on top of the Kress building; any successor who separately owned the Kress building would not be bound by the easement; and, the condominium regime, established the day after conveyance of the easement, combined the Maison Blanche and Kress buildings into a single, indivisible unit of property.
Given these facts, the Fifth Circuit noted,
The easement's not burdening the Kress building does not, however, render that building irrelevant for easement-valuation purposes, because the relevant determination is the effect of the easement on the fair market value of the entire contiguous property owned by Whitehouse:
The amount of the deduction in the case of a charitable contribution of a perpetual conservation restriction covering a portion of the contiguous property owned by a donor ... is the difference between the fair market value of the entire contiguous parcel of property before and after the granting of the restriction. 26 C.F.R. - 1.170A-14(h)(3)(i) (emphasis added [by Fifth Circuit])
Moreover, "the relevant inquiry is whether, when the easement was conveyed, it was reasonable and probable that a hypothetical buyer would determine the amount he would pay for the Maison Blanche and Kress buildings, including in the light both of the pending condominium agreement's combining the two properties into one legal unit and of the pending development's combining the two properties into one functional unit."
"Therefore, regardless of the easement's not burdening the Kress building, it affected the fair market value of the Maison Blanche and Kress buildings. Accordingly, the tax court erred in not determining that effect"
Highest and Best Use
The "before" valuation must consider the highest and best use of the property without regard to the restrictions under the conservation easement. The Fifth Circuit noted that the Tax Court did not rule whether the highest and best use of the property was for a luxury hotel, as the Taxpayer’s expert contended, or a non-luxury hotel/retail complex as asserted by the IRS’s expert. Accordingly, the Fifth Circuit remanded this issue to the Tax Court for consideration and explanation. This remand included the observation that the conversion to a luxury Ritz-Carlton hotel was already underway, which contradicts the IRS’s expert’s opinion that the highest and best use was for non-luxury hotel/retail complex. The Fifth Circuit suggested, "on remand, the tax court will have the opportunity to ‘make the subsidiary findings necessary to render its ultimate conclusions comprehensible, or, if necessary, to modify its conclusions to conform to the evidence’. Curtis, 623 F.2d at 1054."
The Fifth Circuit observed that the Tax Court rejected the replacement-cost and income approaches to value. In rejecting the replacement cost method, the Tax Court noted that this method "is of little use when reproduction of the property is unlikely." "The court stated it was unconvinced by Whitehouse that ‘the owners of the building would want to, or would be required to, reconstruct that 100-year-old structure if it were destroyed’. Further, the court explained that, even if the building would be replaced if destroyed, reliance on the replacement-cost method would still be inappropriate because it ‘is a poor indicator of value when estimating the value of older, special purpose buildings, since any estimate of obsolescence ... is subjective’."
In rejecting the income approach, the Tax Court recognized, "it is an unsatisfactory valuation method where the property has no track record of earnings that provides past income data to evaluate. Without such information, the appraiser must rely on data from similar properties, which reduces the appraisal's reliability."
While it is clear that the Fifth Circuit found such reasons to reject the replacement cost and income approaches highly questionable, it merely stated "Because we must remand for re-valuation, we do not reach whether the tax court erred in rejecting the income and replacement-cost methods. On remand, the tax court should reconsider all three methods, including which may be applicable, in determining the easement's value."
Qualification of IRS Expert
While the IRS’s expert had not previously valued conservation easements, the Fifth Circuit noted that "He is a licensed appraiser in Louisiana with over 25 years' appraisal experience, and he has appraised: 50 to 70 hotels between 1990 and 2000; commercial properties neighboring the Maison Blanche building; and the Maison Blanche building itself three times prior to the present case." Accordingly, "Whitehouse's contention that [the IRS’s expert] was not sufficiently qualified to offer expert testimony on the easement's value fails."
The Fifth Circuit phrased the issue as follows: "the threshold question is a legal one: whether strict compliance with USPAP is a pre-requisite for admissibility." In answering this question, the Fifth Circuit stated, "USPAP compliance [is] relevant to the weight [the IRS’s expert’s] report should be given, instead of whether it should be admitted." [emphasis Fifth Circuit’s]
Burden of Proof
While acknowledging that under certain circumstances the burden of proof should be shifted from the taxpayer to the IRS, the Fifth Circuit noted, "The tax court need not decide whether the burden shifted where, as here, both parties offered some admissible evidence." As a result, the Fifth Circuit concluded, "because there is no indication that the tax court's decision turned on the allocation of the burden, there was no error in the tax court's [sic] not addressing the burden of proof."
The Fifth Circuit began its discussion acknowledging that upon remand and revaluation, there may be no need to address the undervaluation penalty and "consistent with the constitutional prohibition against advisory opinions, it is questionable whether we should reach this issue." However, apparently, the temptation was too great. The Fifth Circuit noted that under Section 6664(2), a gross undervaluation penalty should not be assessed "if : ‘(A) the claimed value of the property was based on a qualified appraisal made by a qualified appraiser, and (B) in addition to obtaining such appraisal, the taxpayer made a good faith investigation of the value of the contributed property’." [emphasis Fifth Circuit’s] Further, the Fifth Circuit noted that the Tax Court had concluded that the IRS’s expert was qualified. However, the Tax Court rejected testimony from Whitehouse’s representative because he had joined Whitehouse two years after the return had been filed.
Despite not having direct knowledge of Whitehouse’s reliance on outside expert advise, the Fifth Circuit noted that case law allows an entity’s representative to testify on the entity’s "subjective beliefs ... as long as those beliefs are based on the collective knowledge of [the corporation's] personnel." As such, "[Whitehouse’s representative] may have been competent and credible ... to testify to facts within the limited partnership's knowledge."
As a result, the Fifth Circuit strongly suggested to the Tax Court, "Given that Whitehouse offered proof that it relied on its accountants' and attorneys' opinions ... a possible issue on remand is whether Whitehouse needed to prove more to show reasonable cause. That is yet another question for the tax court to address, if necessary, on remand."
It is interesting that one Judge  dissented from this way of thinking saying, "the court's opinion, which describe and characterize issues that we ultimately do not decide, are unnecessary to resolve this case and have no bearing on the judgment. Federal courts are only permitted to rule upon an actual ‘case or controversy,’ and lack jurisdiction to render merely advisory opinions beyond the rulings necessary to resolve a dispute. Whether or not the Tax Court finds the extended discussion helpful does not change the fact that it is dicta and amounts to an impermissible advisory opinion."
Summary and Conclusion
Recognizing abuse in this area, the IRS is vigorously attacking almost all conservation easement donations with significant success. façade easement cases are especially difficult. As the Fifth Circuit noted, "Notwithstanding ... regulatory guidance, valuing preservation easements remains, most understandably, a complex and difficult undertaking that continues to challenge appraisers and the IRS." In Whitehouse, we see an expansive Fifth Circuit providing advice to the Tax Court on issues not directly at issue (given the remand for revaluation) in order to bring order to the chaos currently surrounding conservation easement valuation. While, at the end of the day, Whitehouse may ultimately be a victory for the Taxpayer, practitioners can rely on the fact that the IRS will continue to vigorously attack conservation easement contributions for the foreseeable future.
 No. 12104-03
* Mr. Hall is a Managing Director of FMV Opinions, Inc., a national valuation and investment banking firm with offices in New York, San Francisco, Irvine, Chicago, and Dallas. Mr. Hall heads up FMV’s estate and gift tax valuation practice. He may be reached at firstname.lastname@example.org.
 Keep in mind that the Taxpayer’s expert valued the Maison Blanche, Kress and related structures as a combined entity which included a luxury hotel (among other things), whereas the IRS’s expert valued only the Maison Blanche building as a non-luxury hotel/retail complex, thus, the dramatic differences in the "before" and "after" values.
 Judge Garza