Value based on “Second Best Use” – A new game-changing standard, or an outlier?
The Tax Court (Judge Halpern) recently issued a third opinion in the ongoing conservation easement litigation between Whitehouse Hotel Ltd. (“Whitehouse”) and the IRS. The Whitehouse trilogy of opinions have been heavily-scrutinized and studied by the easement community because they provide unique perspective on the divergence between the manner in which the Tax Court and the Circuit Courts of Appeal view conservation easement issues, a dichotomy we addressed in our recent article, Circuit Courts Speak on Conservation Easements, But Is the IRS Listening? What has been lost in the discussion, however, is Judge Halpern's statement in the most recent opinion (Whitehouse III) that “the highest and best use of the [easement property] may have been luxury hotel development; but even if [the court] were to accept that as a fact, it does not rule out the possibility that the value of the parcel on that date was dictated by its second best use.” Depending on how this phrase is interpreted in subsequent decisions, the “second best use” concept could have a far-reaching impact on conservation easement valuations.
When there is no substantial record of marketplace sales of comparable easement rights (usually the case), the Treasury Regulations provide that the fair market value of a conservation easement is deemed to be the difference between the fair market value of the property that the easement encumbers immediately before granting the easement (the “Before Value”) and the fair market value of the encumbered property after granting the easement (the “After Value”). Under the Regulations, the “before-and-after” valuation must take into account the “highest and best use” (HBU) of the property in question. HBU is defined as the use of property which is physically possible, legally permitted, financially feasible and maximally productive. The Tax Court has often cited the US Supreme Court's opinion in Olsen v. U.S., 292 U.S. 246,255 (1934), for the proposition that a property's highest and best use is the highest and most profitable use for which it is adaptable and needed or likely to be needed in the reasonably near future (see Hilborn v. Comm'r, 85 T.C. 677, 689 (1985)). Also, as the 10th Circuit stated in Whitehouse II, “A property's highest and best use is the ‘reasonable and probable use that supports the highest present value.'” 615 F.3d at 335 (citing two Tax Court opinions).
There is normally little dispute over the After Value of easement property, because in most instances very little economic activity can occur on the property once it is encumbered by a conservation easement. However, the Before Value is frequently hotly contested. At the center of the contest is the question of the HBU of the property, which often drives conservation easement valuations. Taxpayers that can substantiate their HBU assumptions are likely to prevail in their case. However, if the Tax Court's statement in Whitehouse III is applied literally, a taxpayer may lose their case even when they can substantiate their alleged HBU of the property. This is because Whitehouse III suggests that fair market value should be determined by the “second best use” of the property as opposed to its highest and best use.
Absent additional guidance from the court, it is unclear if Whitehouse III sets a new standard of fair market value. However, taking Whitehouse III literally, most conservation easement appraisals which have relied on the traditional HBU analysis are vulnerable. Future conservation easement appraisals face the same dilemma. The taxpayer in Whitehouse recently appealed Judge Halpern's decision, so we hope to see clarification in Whitehouse IV (and possibly Whitehouse V). We recently submitted an article for publication in Taxation of Exempts, which addresses Whitehouse I – III. For a copy of this article as well as our take on any future Whitehouse decisions, please click here.