The US Tax Court released the Costello case yesterday and it is a great example of how much tax you may have to pay when you either get "too greedy" or don't follow the tax rules or both. David and Barbara Costello purchased a large farm (according to the Tax Court 73.6 acres is a large farm) in Maryland in April, 2000 for $1,682,556. The 73.6 acres included a residence and three-car detached garage. They added a stone and pavement driveway, poured a concrete floor for the garage, replaced the residence roof, thoroughly landscaped the area adjacent to the house and made other capital improvements necessary to make the property a fully functional farm. The total costs of these improvements were $295,000 resulting in a total farm investment of $1,977,556.
Real estate values started to rapidly escalate in the area and the Costello's heard about a program offered by Howard County called Agricultural Land Preservation Program (ALPP). One of the options was that a permanent easement could be placed on property and the development rights could be sold to another party. This is what the Costello's did.
They sold 15 of their 17 development rights to a Kennard Warfield, a developer, for $2.4 million. Later, they added one more development right for a total price of $2.56 million (or $160,000 per development right). On October 20, 2006, the deed for easement and the plats transferring the development rights were recorded in Howard County land records. The Costello's had received a down payment of $1.2 million from Mr. Warfield and the remaining $1.36 million was paid soon after recording the easement.
In May, 2007, the taxpayers obtained an appraisal from Bruce Dumler indicating the value of the land including 25 development rights (remember they only had 17 rights; they would need to purchase 8 more to get 25) was $7.69 million. The value of the land without the rights would only be $2.1 million. Mr. Dumler issued his report on July 1, 2007 with an effective date of December 1, 2006. It appears that Mr. Dumler had no clue that any easement had been filed on the property in October and never purported to value an easement.
Based on the appraisal, the taxpayers included an unsigned Form 8283 listing a non-cash donation of $5,543,309 and reported a long-term capital of gain of $1,029,441 on the sale of the development rights. The Form 8283 was unsigned since they could not get Howard County to sign off on the Form due to Howard County officials not believing there was a valid donation.
After Howard County declined to sign Form 8283, Mr. Dumler prepared an addendum to his original appraisal dated March 25, 2008 reciting that he "valued the conservation easement which has been contributed to Howard County by the property owner". In the addendum, he reduced the $5,543,309 value down to a $3.03 million to reflect the sale for $2.56 million. At this point, the taxpayers got Howard County to sign off on the Form 8283 and filed an amended tax return.
As you can guess, the IRS was not happy with any of these values, so they audited the returns for 2006, 2007 and 2008 and assessed additional tax of $1,293,282 and penalties of $258,656.
To summarize the findings, the Tax Court essentially agreed with the IRS on almost all aspects of their audit as follows:
- The taxpayers had not obtained a "qualified appraisal";
- Even if they had a qualified appraisal, they did not provide an appropriate appraisal summary on Form 8283;
- The taxpayers were not in substantial compliance with the reporting requirements;
Even if the Tax Court allowed the Form 8283 to stand as is, the taxpayers enjoyed Quid Pro Quo from the sale of the development rights. There was no charitable transfer of development rights to Howard County. Rather, the taxpayers simply sold their development rights to Mr. Warfield for $2.56 million. Since there was a sale of the development rights where the taxpayer recorded no tax basis, the Tax Court calculated the tax basis for the development rights at $1,977,556. Now, this is where I think the Tax Court was actually generous to the taxpayers. They allotted the full purchase price to be offset against the sales proceeds. But remember, the taxpayers only sold 16 of 17 development rights, retained all of the ground as a farm including the residence. In my opinion, the actual cost that should have been allowed is likely less than $1 million, but again, I think the Tax Court was being generous with the taxpayers.
Finally, the Tax Court found the taxpayers had bungled the whole appraisal, etc. so badly that they sustained all of the tax penalties. The bottom line is the taxpayers ended up with $2.56 million from the sale and had to us about half of it to pay back the IRS. Not a good day in court.