Appraisal Institute Annual Meeting IRS Valuation Topics

2. Appraisal Institute Annual MeetingIRS Valuation Topics August 15, 2013

3. 2011 president of the Appraisal Institute • Past president of the Chicago Chapter of the Appraisal Institute • Past National Chair of Education Committee of the Appraisal Institute • Past National Chair of the Audit Committee of the Appraisal Institute • Approved Appraisal Institute instructor for 26 courses in the Appraisal Institute’s QE, AE, CE, and USPAP curriculums. Includes courses prepared for IRS issues such as Conservation Easements. Presenters:Joseph C. Magdziarz, MAI, SRAAppraisal Research, Inc. – Rockford, Illinois

4. 2007 president of the Appraisal Institute • National Chair of International Relations Committee of the Appraisal Institute • He also holds the CCIM designation from the CCIM Institute. • He served on the American Real Estate Society Board from 2007 through 2012, and was recently re‐elected to serve a term expiring in 2017. Presenters:Terry Dunkin, MAIDunkin Real Estate Advisors - Lutherville, Maryland

5. Co-Chair 2010 – 2013 IRS Valuation Summit in Los Angeles, California • 2011 President of the Beverly Hills Estate Planning Council • 2012 LDAC Discussion Leader • Active as Southern California Chapter Board Member, Committee Chair, and Regional Representative Presenters:Eric Garfield, MAIWTAS – Los Angeles, CA

6. More than 30 years experience as a commercial real estate broker. • He is a good client for appraisers and retains hundreds of appraisers each year to prepare valuations for IRS-related transactions. • Frequent lecturer to appraisal groups, non-profits, universities, and others. • Previously a columnist for the San Diego Daily Transcript where he reported on trends in real estate donations. Presenters:Chase Magnuson, CCIM, CIPS, SRESReal Estate for Charities – Washington, DC

7. Organization of IRS Valuation Section - Dunkin • Appraiser Penalties – Garfield • What are issues for donations - Magnuson • Do’s and Don'ts in Conservation Easements - Magdziarz • Common Problems with Valuations for IRS – Dunkin & Magdziarz • Tax Court Decisions – Garfield • Mitchell • Boltar • Mohammed AGENDA:

8. Overview of IRS Valuation Division • Engineering and Valuation • Appraisal Standards • What they do • Standards

9. Engineering and Valuation SpecialistsTerritory Map

10. Engineering and Valuation • The primary function of the Engineering Program: • Provide specialists with expertise and specialized training in technical or industry-specific issues. • Provides valuation services for a variety of purposes. • Coordinate the use of outside fee or contract appraisers and experts.

11. Appraisal Valuation Standards The IRS Appraisers, Business Valuation Specialists, engineers and foresters adhere to Generally Accepted Appraisal Standards which include: • USPAP • IRS Valuation Standards

12. Where does IRS Valuation Teamget its work? Referrals from: • Estate and Gift Tax Program • SBSE (Small Business – Self-Employed Division • LB&I (Large Business and International Division) • TEGE (Tax Exempt and Government Entities Division) • Collection • Counsel (Office of IRS Chief Counsel)

13. What Does IRS Valuation Group Do? Appraisers mostly involved with income tax and estate and gift tax issues. Work includes: • Write Appraisals • Review of appraisals (Reasonableness) • Experts in litigation (sometimes testifying expert) • Appraiser penalty investigations • Outreach (seminars and meetings) • Contact representatives (COTR)

14. Typical Internal Referral for Appraisal Assistance • When the appraiser or BV Specialist gets a valuation assignment, the first thing they will do is ask for the appraisal. • Assigned appraiser then reads the report. Addresses following: • Does the report read well—is it easy to follow? • Does the report logically leads the reader from the initial presentation of the data to the value conclusion? • Are conclusions supported by facts and the analysis of the facts? • Is there a good market analysis? • Does H&BU make sense? • Is the issue worth pursuing? • Assigned appraiser then makes report to referring department.

15. Appraiser Penalties 15

17. 6695A Appraiser Penalty Prior to PPA penalties subject to IRC 6700 or IRC 6701 IRC 6695A Originated with the Pension Protection Act of 2006 Not intended for minor differences of opinion Treated as a separate case from originating tax case Practitioner has opportunity to support their work 17

18. 6695A Appraiser Penalty 6695A. Substantial and gross valuation misstatements attributable to incorrect appraisals. 6695A(a) Imposition of penalty. – if – 6695A(a)(1) a person prepares an appraisal of the value of property and such person knows, or reasonably should have known, that the appraisal would be used in connection with a return or claim for refund, and 18

19. 6695A Appraiser Penalty 6695A(a)(2) the claimed value of the property on a return or a claim for refund which is based on such appraisal results in a substantial valuation misstatement under chapter 1, a substantial estate or gift tax valuation understatement, or a gross valuation misstatement , with respect to such property, then such person shall pay a penalty in the amount determined under section (b). 19

20. 6695A Appraiser Penalty 6695A(b) Amount of Penalty. – The amount of the penalty imposed under subsection (a) on any person with respect to an appraisal shall be equal to the LESSER of – 6695A(b)(1) the greater of – 6695A(b)(1)(A) 10 percent of the amount of the underpayment attributable to the misstatement described in subsection (a)(2), or 20

21. 6695A Appraiser Penalty 6695A(b)(1)(B) $1,000, or 6695A(b)(2) 125 percent of the gross income received by the person described in subsection (a)(1) from the preparation of the appraisal. 6695A(c) Exception. -- No penalty shall be imposed under subsection (a) if the person establishes to the satisfaction of the Secretary that the value established in the appraisal was more likely than not the proper value. 21

22. 6695A Penalty Summary 22 Should the practitioner be afraid or worried about performing work for the taxpayer or the IRS? At the end of the day, no, if the work performed is a reflection of the market’s perception of value as of the date of valuation, analysis and conclusions are well prepared, issues disclosed, and fully presented!

23. DONATIONS • Use of appraisals • Methods and reporting requirements. • Form 8285

24. CONSERVATION EASEMENTS • What are conservation and historic preservation easements & why are they donated • Methodology • Problems with easement appraisals • Highest and best use • Incorrect methods

25. COMMON PROBLEMSIN APPRAISALS FOR THE IRS • Writing • Grammar • Clarity • Highest and Best Use • Case Studies • Valuation Red Flags

26. Writing • It is important that appraisals written by IRS appraisers and taxpayers’ appraisers are well written. A well written appraisal is easy to follow and will hold the reader’s interest. It is easier to understand the analysis and the conclusions reached.

27. Grammar • “The residence was a merely composed of homesteaders, miners, loggers and cattle and sheep ranchers.”

28. Grammar • “As mentioned several times throughout this review, the valuation of the subject property consisting of 40 acres and should have concluded from the fee simple valuation on page 155 at a value of $110,000 based on the appraiser’s calculations.”

29. Is this the word you want to use? • “The subject property consists of two contiguous tracts which contain 41 acres and 76 acres, respectfully.”

30. What are you saying? • “The appraisers’ approach, which is labeled as Scenario “B,” the foregone development opportunity, is the before value, and that the after value, Scenario “A,” value of the raw land less the cost to remove the land from the flood plain, is the after value. In fact, Scenario “B” is not applicable, Scenario “A”, without deducting the cost to remove the land from the flood plain, is the before value, and there is no after value calculated.”

31. Highest and best use Is highest and best use explained and supported? • Legally permissible • Physically possible • Financially feasible • Maximally productive (use that generates highest land value) • Not the best three out of four!

32. Some H&BU Problems • Estate Gift- House and land appraised as apple orchards. • House on 10-acres w/direct ocean view in area of million dollar homes. Brand new mansion next to the subject as of appraisal date. • Subject- appraised as “old” barely producing apple orchard. Lower value- Did not use residential acreage that had direct ocean views. Used other orchards- bottom line- Highest & Best Use-high end estate land more valuable. • Adjustment $5,000,000 higher

33. Case #2 • 1- acre oceanfront residential site- donated to a municipality. • Appraised as buildable-with incorrect legal description offered by owner. One week before the owner donated piece of subject reducing size, never told appraiser. Appraiser never checked with municipality to verify property. • Consequences-Highest and Best Use reduced to open space, non-buildable land- large adjustment-lower value.

34. Case #3 • Estate Gift- 10-acre marina on the ocean • Highest and Best Use- Marina on the Ocean • Problem areas-land value too low- zoning allows for residential development. • Oceanfront land in demand for residential development. Value higher if appraised as vacant for residential development • Problem- appraiser states in the report :

35. Case #3 continued • "However when a comparison of the Income Approach for the marina operation with the Market Data Comparison Approach for the land in the Cost Approach, it is concluded that the total site is under utilized. There is a strong potential for a combination residential/tourist accommodation/commercial use in conjunction with the marina operation, which is considered to the Highest and Best Use. A specific redevelopment plan needs to be defined and is beyond the scope of this appraisal assignment.”

36. Some Valuation Red Flags • Conclusions based on opinion and not facts Facts Trump Opinion • Reliance on unconventional analysis (not widely used or accepted) will raise a red flag. • Extreme discounts for marketability, fractional (minority) interest, blockage, undivided interest, that are not well supported by data and analysis.

37. continued • If analysis is thorough and explained and consistent with the conclusions reached, we are more likely to accept. If not, we will spend the time to look into the issues. • If analysis explains why some potential comparables were not used rather than simply not commenting on those potential comparables, we may conclude that the rationale makes sense. • If all comparables are adjusted in one direction, we will get curious. • Are assumptions reasonable? • Does it make sense that past earnings growth will continue?

38. So, What’s my Point? • If an Appraisal is well written and easy to follow, • If it logically leads the reader from the initial presentation of the data to the value conclusion. • if conclusions are supported by facts and the analysis of the facts • If H&BU makes sense The appraisal will probably not be challenged

39. COURT CASES • Mitchell • Boltar • Mohammed • Astleford

40. Mitchell v. Commissioner – T.C. Memo. 2011-94 (April 2011) • Summary: • Two Properties – An Ocean-front house in Montecito, CA and a 4,000 acre ranch property in Santa Ynez, CA • Both Properties were subject to long-term leases. • IRS claimed leases were not at market and should be ignored. • Issues were: • Treatment of leases. Use of sales and adjustmentsMethodology

41. Mitchell v. Commissioner – T.C. Memo. 2011-94 (April 2011) • Properties: • Beachfront property – 2 acre lot with 4,000 s.f. house in Montecito. 167 feet of ocean frontage. Leased for 5 years with three 5-year options. First year rent was $190,000 with 3.5% adjustments annually. • Ranch – 4,000 acres in Santa Ynez Valley. Leased for $32,000 per year. Lease was 5 years with four options to renew. Rent increased $1,000 per year.

42. Mitchell v. Commissioner – T.C. Memo. 2011-94 (April 2011) Appraisals and Valuation Method – Beachfront Property: • Taxpayer appraiser valued the Beachfront property at $14.5 million in fee simple assuming the lease did not exist. He then increased the fee simple value at 3.5% annually to the end of lease term and options. As the rent was below market, he assumed the lease would continue through all the option periods. The PV of the reversion was $4.6 million at a 9.5% discount rate. PV of income was $1.4 million. Total value of leased fee was $6.0 million. This was a very tradition discounted cash flow analysis. • IRS appraiser valued Beachfront property at $12.5 million using a lease buyout analysis. He indicated that a $250,000 payment would be adequate make the tenants terminate. He essentially ignored the lease because he noted that the lease was not really valid as expenses exceeded income.

43. Mitchell v. Commissioner – T.C. Memo. 2011-94 (April 2011) Appraisals and Valuation Method – Ranch Property: • Taxpayer appraiser valued the ranch using a similar method and valued the leased fee interest in the ranch at $3.5 million. He estimated fee value at $13.0 million. • The IRS Appraiser valued the leased fee interest in the ranch at $20.0 million. He used the same type of lease buyout analysis. Court Value Decision: The Court adopted both of the Taxpayers conclusions which relied on the traditional DCF analysis. The IRS reports were disregarded due primarily to flawed methodology.

44. Mitchell v. Commissioner – T.C. Memo. 2011-94 (April 2011) What are lessons learned? • Do not try to use unusual methods (like a lease buy-out analysis) unless you have a very strong case for using it. The Court cited the Appraisal of Real Estate repeatedly as a reference for proper methodology. • The Court looked at the leases and the interactions historically with the parties and found that the leases would be considered by any buyer. Based on the actions of the tenant and the owner, the Court determined that there was a low probability that the leases would be terminated voluntarily or even with relatively small consideration. • Ranch had been used by the tenant for many years and was negotiated at arms length • The tenants at the Beachfront property had attempted to buy the house on several occasions and the owner had rejected all offers. They finally offered to lease the property and the owner accepted.

45. Mitchell v. Commissioner – T.C. Memo. 2011-94 (April 2011) What are lessons learned? (Continued) • Be careful of comparable sale selection. The Court found that sales that were not current were less reliable and gave more credence to report with the most recent sales. Also, sales from the immediate market area were more weighted than sales from outside the area. • Be careful of adjustments that are not reasonable. One reason IRS appraiser’s opinion on the ranch was rejected was an adjustment of a sale 6 years prior using a 2% per month (24% per year) increase from 1999 to 2005. The Court’s analysis suggested 4% per year more reasonable. • When dealing with leased properties, you have to look at the leases carefully unless they are obviously arm’s length. For example, a Walgreens leased property would not require a lot of due diligence. However, what if the leased property included some parties in a family on both sides of the lease? These are important facts that should be discussed with the appraiser.

46. Boltar LLC v. Commissioner • Excluded Expert’s Report under Federal Rules of Evidence and Daubert • Emphasized “Gatekeeper Role”

47. Boltar LLC v. Commissioner • The Boltar case resulted in the taxpayer’s report being excluded by the Court. • The property was a Conservation Easement. However, the lessons learned here are valid in all types of work when dealing with the IRS. Careful adherence to IRS rules and regulations are important. However, following proper methodology and avoiding mistakes is also important. • In the Boltar case, the IRS challenged the report of the Taxpayer. The IRS “filed a motion in limine to exclude the petitioner's expert report and testimony as neither reliable nor relevant under the Federal Rules of Evidence and Daubert. • The Tax Court determined that the Taxpayer’s expert’s report was “so far beyond the realm of usefulness that admission is inappropriate and exclusion” is proper. The Taxpayer had no other expert report, and the Court relied only on the IRS valuation. The result was the Taxpayer lost a $3.0 million dollar deduction from the donation.

48. Boltar LLC v. Commissioner The Property: • The property was 8.5 acres in Lake County, Indiana. Part of the land was wetlands. Part was in the City of Hobart and part was in Lake County. The County portion was zoned for low density single family development. The City portion was zoned PUD. There were no utilities available to the property and it was land locked with no legal access.

49. Boltar LLC v. Commissioner The Appraisals: • The Taxpayer appraiser valued the property at $3,340,000 under the highest and best use for development of 174 condominiums. This was based on a site plan for a ten acre parcel (Scenario A). Scenario B valued the property as vacant development land at $68,000. The Taxpayer appraiser stated that the value of the easement was the difference between the Scenario A and B values. It was not defined as a “Before and After” analysis as required by the regulations. The value estimated for the easement was $3,245,000 and also reflected mitigation costs. • The IRS appraiser concluded that the highest and best use was for low density single family development. The easement was valued by the IRS appraiser at approximately $30,000. This was based on a “before” value of approximately $400,000 and an “after” value of about $70,000.

50. Boltar LLC v. Commissioner Problems: • Appraiser assumed that all property was in City of Hobart which it was not. • The Court indicated that the highest and best use established by the taxpayer Report was not reasonable. The Court cited other court cases noting that highest and best use must be “realistic” and reflect “objective potential uses,” and such uses must be “reasonable and probable.” • In establishing the highest and best use, the Taxpayer appraiser relied on a ten-acre site plan even though the subject property was only 8.5 acres. • The site plan ignored a 50 foot gas pipeline which crossed the property. The plat map showed that 6 of 29 proposed buildings could not be built. • The Taxpayer appraiser valued the property before the easement at $400,000 per acre. The Court noted that nearby land for similar development was selling for $12,000 per acre. According to the Court, such “factual errors” defy “reason and common sense” and “demonstrated [a] lack of sanity in their result.”