Originally published on Forbes.com.
If you are still reeling from hearing about the passing of Hugh Hefner, it might be a comfort to know that the Playboy Building in Chicago is being preserved. It is now called the Palmolive Building, as it was before it became the Playboy Building in 1965. The bad news is that the investors in Palmolive Building Investors LLC have had their 2004 easement deduction of $33 million disallowed. As is not unusual, the LLC lost in Tax Court on a kind of “gotcha”. In this case, it was the mortgages not being properly subordinated to the easement. A classic example of Reilly’s Fourth Law of Tax Planning – Execution isn’t everything but its a lot.
The Numbers
According to the decision, the LLC acquired the Palmolive Building in May 2001 for $58.5 million. This seems to be below a report by the Chicago Tribune on what the building changed hands for in 1989. When the LLC executed the easement deed in favor of the Landmarks Preservation Council of Illinois, there were two mortgages each with an outstanding balance of $55.6 million. When the first of the two mortgages had been taken out in 2003, the building had been valued at $190 million. At the time of the easement donation, the property was valued by the LLC at $257 million, of which $33.41 million (13%) was attributed to the easement. Since the decision was on a motion for summary judgment by the IRS, the Tax Court accepted those values for the sake of argument.
The Problem
The problem, of course, is the mortgages. The regulations provide:
In the case of conservation contributions made after February 13, 1986, no deduction will be permitted under this section for an interest in property which is subject to a mortgage unless the mortgagee subordinates its rights in the property to the right of the qualified organization to enforce the conservation purposes of the gift in perpetuity.
LLC Arguments
The LLC argues that the mortgages burden the property only incidentally, that there is a prohibition against a mortgagee extinguishing the restriction and that the problem is so remote as to be negligible. It also notes that the First Circuit explicitly rejected the IRS position in the Kaufman decision. I covered the Kaufman decision in 2012.
Tax Court Still Thinks It Is Right
It looks like the Tax Court is poking the First Circuit in the eye:
We agree with the Commissioner’s application of the regulation and reaffirm our holdings in Kaufman v. Commissioner (Kaufman I), 134 T.C. 182 (2010), and Kaufman v. Commissioner (Kaufman II), 136 T.C. 294 (2011).
The discussion after that is pretty lengthy, but it boils down to the regulations are good and they were not followed.
What Happens From Here?
I heard from Jeff Paravano of BakerHostetler who represents the LLC. He wrote me:
We are working with IRS counsel to examine next steps available to our client, including settlement possibilities and interlocutory appeal possibilities. An appeal of this issue would be to the Seventh Circuit.
The prospect of the appeal is intriguing, given what happened with the Kaufmans. They won in the First Circuit, so the Tax Court had to take another look at the facts without considering the lack of mortgage subordination. That led to the determination that the easement was worthless since based on the neighborhood (the South End in Boston), there were already substantial restrictions on messing with the facade. I covered that decision also.
A mindset had developed among practitioners that a facade easement had to be worth something. You know. Maybe ten or fifteen percent. Not a lot, but still something. That is not the way it is. Given the level of restriction in some neighborhoods granting a facade easement is like me renouncing my superpowers. In 2014, the IRS settled with a group of appraisers barring them from practicing in the area for five years. They were members of the fifteen percent club.
As it happens in 2000, the Palmolive building was declared a landmark by the City of Chicago.
Built for one of the world’s leading soap manufacturers, this office building (“a monument to cleanliness”) was the first commercial skyscraper built far from the Loop – at the northern end of Michigan Avenue. It is one of the country’s premier Art Deco-style “set-back” skyscrapers, the design of which were influenced by municipal zoning laws and the dramatic renderings of New York architect Hugh Ferris. The building was designed by one of Chicago’s oldest and most prestigious architectural firms, whose other significant buildings include the 333 North Michigan Building, the Chicago Board of Trade, and the former Chicago Daily News Building. A navigational beacon which operated atop the building from 1930-1981 was restored in 2007.
So a trip up to the Seventh Circuit to find out if it will agree with the First Circuit might just stretch out the pain for the Palmolive investors. Maybe being a landmark is not a big a deal in Chicago as it seems to be in Boston and New York.
On the other hand, if they win it would be really something. To make the math easy, let’s say that their deduction is worth about $12 million. And really taking a leap let’s imagine that when they acquired the building in 2001, they got 80% financing. If it broke that way, the investors, in effect, got their equity in the building for free. How great is that?
Other Coverage
Lew Taishoff had something – No Joy Forever – Because Golsen. Mr. Taishoff is most interested in the conflict with First Circuit.
Basically, says Judge Gustafson, we were right and 1 Cir was wrong. ….
With a $33 million deduction up for grabs, will the Palmolives see if Judge Posner is in his usual contrarian mood when confronted with a full-dress T. C., even to so obliging a jurist as Judge David Gustafson? The suspense is killing me.
Vidya Kauri had Palmolive Building Owners Lose $33M Charitable Deduction at Law360.
Ed Zollars at Current Federal Tax Developments also focused on the conflict with First Circuit.
KPMG had a brief summary.
Jacob Mills had Conservation Easements: Easement Deed Fails to Satisfy Perpetuity Requirement on the Fox Rothschild website.
The Preservation Law Digest had a summary with some good advice.
For practitioners, it’s worth reading the court’s decision to see the exact language of the easement that reserved the mortgagee’s rights to insurance proceeds.
I seem to be the only commentator to note that the building involved was once the Playboy Building. It’s those little touches of the story behind the story that I always look for.
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