Tax Court Upholds Daubert Challenge to Appraisal Expert
In April 2011, the court ruled in favor of the IRS (Respondent) in a conservation easement donation case. In Boltar, L.L.C. v Commissioner, 136 T.C. No. 14 (April 5, 2011) a motion in limine to exclude the Petitioner’s (Taxpayer’s) expert was upheld due in part to the advocacy of the expert for his client.
Overview of the Case
In a conservation easement donation case, the IRS moved to exclude the taxpayer’s experts’ report as unreliable and irrelevant under Federal Rule of Evidence 702 and Daubert v. Merrell Dow Pharm., Inc., 509 U.S. 579 (1993).
The Court held that taxpayer’s experts failed to apply the correct legal standard by failing to determine the value of the donated easement by the before and after valuation method, failed to value contiguous parcels owned by a partnership, and assumed development that was not feasible on the subject property. The IRS’s motion to exclude Petitioner’s report and expert testimony was granted.
Facts of the Case
Two parcels (Northern Parcel and Southern Parcel) of approximately ten acres each were acquired in 1999. In 2002, the Shirley Heinze Land Trust, Inc. (Shirley Heinze) quitclaimed 10 acres located east of the Southern Parcel (the Eastern Parcel) to Boltar.
At the date of the subject easement, the Southern Parcel was encumbered by a 50 foot wide utility easement and the Northern and Southern Parcels were encumbered by an access (golf cart) easement. On December 29, 2003 an easement (Subject Easement) restricting the use of eight acres on the eastern side of the Southern Parcel was granted to Shirley Heinze. The Subject Easement prevented any use of the property that would significantly impair or interfere with the conservation values of the property. Approximately three acres of the Subject Easement, approximately nine acres of the eastern portion of the Northern Parcel, and all of the Eastern Parcel are forested wetlands.
At the valuation date, the Northern and Southern parcels were zoned R-1 (one single family home per acre). The Eastern Parcel was zoned as a Planned Unit Development (PUD) as part of a three phase proposed development.
Boltar claimed a charitable contribution of $3,245,000 related to the Subject Easement. The fair market value of the easement was reported as $3,270,000 and was reduced by $25,000 as a claimed enhancement in value to adjacent parcels owned by Boltar.
The real estate appraisal (“Taxpayer Appraisal”) attached to Boltar’s 2003 tax return determined that the highest and best use of the subject property was residential development and determined the Subject Easement value as the difference between the “Foregone Development Opportunity of 174 Condominiums on Finished Sites, Discounted to December 31, 2003” (Scenario B) $3,340,000 less the “Value of Raw Vacant and Developable Land” (Scenario A) $68,000. The Taxpayer Appraisal relied on a site plan for a condominium project situated on approximately ten acres and erroneously assumed the Subject Easement was zoned PUD.
In the final partnership administrative adjustment (FPAA), one of the IRS’s valuation engineers determined the fair market value of the Subject Easement was $42,400. The engineer opined that the Taxpayer Appraisal failed to determine the value of the Subject Easement before and after the grant of the easement. The engineer concluded that the highest and best use of the subject property was for “development of single-family detached residential homes, but not until the surrounding properties are developed,” partly because the Subject Easement was landlocked with no direct access to a public road.
The Court quoted IRS Regulations Section 1.170A-14(h)(3)(i):
The value of the contribution under section 170 in the case of a charitable contribution of a perpetual conservation restriction is the fair market value of the perpetual conservation restriction at the time of the contribution. … If no substantial record of market-place sales is available to use as a meaningful or valid comparison, as a general rule (but not necessarily in all cases) the fair market value of a perpetual conservation restriction is equal to the difference between the fair market value of the property it encumbers before the granting of the restriction and the fair market value of the encumbered property after the granting of the restriction.
The Court commented that “while there may be cases in which the before and after methodology is neither feasible nor appropriate, petitioner has not provided any persuasive reason for not applying it in this case.”
The Court then commented that “In the context of this case, the task of the appraisers was to determine the fair market value of the eight acre parcel and the contiguous parcels owned by Boltar before and after the easement was granted.” The opinion went on to say:
Petitioner quotes this Court’s cases, Symington v. Commissioner, 87 T.C. 892 (1986), StanleyWorks & Subs. v. Commissioner, supra, and Hughes v. Commissioner, T.C. Memo. 2009-94, to emphasize the necessity of considering highest and best use by determining “realistic” or “objective potential uses”, to which the subject property is “adaptable” and which are “reasonable and probable” uses. We conclude, however, that the [taxpayer] appraisal’s valuations fail to apply realistic or objective assumptions.
The Taxpayer’s Appraisal’s highest and best use, prior to the conservation easement encumbrances, was a ten acre, 174-unit condominium development yet the Court noted “In support of the argument that the 174-unit condominium project assumed by the [taxpayer’s] report could not be physically placed on the subject property, respondent points out that the site plan for the proposal assumes ten acres, whereas the subject property was only eight acres, and the [taxpayer’s] experts ignored the effect of a preexisting 50-foot-wide utility easement for a gas pipeline across the property.” To make matter worse, the taxpayer’s experts “erroneously” concluded that the eased parcel was “within the city of Hobartand zoned PUD, which it is not.”
Addressing the taxpayer’s report and experts, the Court stated “Petitioner’s experts, however, did not suggest any adjustments or corrections to their calculations but persisted in their position that the original appraisal was correct, even when admitting factual errors. (By contrast, respondent’s experts conducted research in areas that were not within their specific expertise, acknowledged weaknesses, and corrected errors during their analysis.) Neither petitioner nor the Integra experts suggested any quantitative adjustment in response to their admitted errors or the problems addressed in respondent’s motion in limine. They simply persist in asserting an unreasonable position.”
The Court further noted that the Taxpayer’s Appraisal of the highest and best use for its “before” value, the condominium development, resulted in a value of $400,000 per acre. However, nearby property that could also be developed into condominiums was selling for only $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.”
Failure of the Taxpayer’s Appraisal Expert and the Daubert Challenge
The IRS aptly summarized the deficiencies of the taxpayer’s appraisal analysis as:
- Failure to properly apply the before and after methodology
- Failure to to value all of petitioner’s contiguous landholdings
- Failure to take into consideration zoning restraints and density limitations and
- Failure to take into consideration the pre-existing conservation easements.
As a result, the [taxpayer’s expert] saw nothing wrong with a hypothetical development project that could not fit on the land they purportedly valued, was not economically feasible to construct and would not be legally permissible to be built in the foreseeable future.
The IRS asserted that the Taxpayer Appraisal had departed from the legal standard to be applied in determining the highest and best use of property and instead determined a value “based on whatever use generates the largest profit, apparently without regard to whether such use is needed or likely to be needed in the reasonably foreseeable future.”
Boltar argued against a Daubert exclusion because:
- Daubert applies to jury trials
- The IRS had previously accepted the methodology used in the Taxpayer Appraisal and stipulated that the version attached to the partnership return was a qualified appraisal
- Tax Court Rule 143(g) mandates receipt of the report in evidence
- The matters complained of by the IRS do not affect admissibility of the Taxpayer Appraisal into evidence
The Tax Court refuted every argument of the taxpayer against a Daubert exclusion. The Court concluded that the Taxpayer’s Appraisal was not admissible under Rule 702, because it was not the product of reliable methods and the authors had not applied reliable principles and methods reliably to the facts of the case.
The Tax Court noted:
In most cases, as in this one, there is no dispute about the qualifications of the appraisers. The problem is created by their willingness to use their resumes and their skills to advocate the position of the party who employs them without regard to objective and relevant facts, contrary to their professional obligations.…
Justice is frequently as blindfolded to symbolize impartiality, but we need not blindly admit absurd expert opinions. [emphasis added]
After decades of warnings regarding the standards to be applied, we may fairly reject the burden on the parties and on the Court created by unreasonable, unreliable, and irrelevant expert testimony. In addition, the cottage industry of experts who function primarily in the market for tax benefits should be discouraged. Each case, of course, will involve exercise of the discretion of the trial judge to admit or exclude evidence. In this case, in the view of the trial judge, the expert report is so far beyond the realm of usefulness that admission is inappropriate and exclusion serves salutary purposes. [emphasis added] …
We are not inclined to guess at how their valuation should be reduced by reason of their erroneous factual assumptions. Their report as a whole is too speculative and unreliable to be useful.
Although the [taxpayer’s] experts determined that sales of comparable land nearby were occurring at approximately $12,000 an acre, their conclusion would assign a value of approximately $400,000 per acre to the subject property.…
If the report and their testimony were admitted into evidence, we would decide that their opinions were not credible. The assertion that the Eased Parcel had a fair market value exceeding $3.3 million on December 29, 2003, before donation of the easement, i.e., that it would attract a hypothetical purchaser and exchange hands at that price, defies reason and common sense. [emphasis added]
The Court concluded that the Taxpayer’s Appraisal failed to apply realistic or objective assumptions, did not consider potential residential use of the property and thus did not value the property at its highest and best use after the easement was granted, and did not consider the effect on contiguous property owned by Boltar.
Valuation of the Easement
After excluding the Taxpayer’s Appraisal and testimony, the Court found the record contained factual evidence and the report and testimony of the IRS’s valuation expert. There was no credible evidence that a higher density development than single-family residential development was a use to which the property was adaptable, given the preexisting easements and existing zoning. There was no evidence that justified a value higher than the amount determined in the FPAA.
Lessons from the Case for Users of Appraisal Reports
Quoting from L. Paul Hood, attorney and co-author (along with Timothy R. Lee, ASA of Mercer Capital) of The Business Valuation Reviewer’s Handbook: Practical Guidance to the Use and Abuse of a Business Appraisal from his post “Daubert Challenges and the Tax Court”:
Ouch! This is a very, very important decision and highlights the risk of trial for either party, especially where there is a wide chasm between the positions of the experts. While there are certainly two sides to every story, it certainly appears that in the opinion of the entire Tax Court, the appraisers in this case were guilty of hubris by even failing to address their own factual errors and other problems with the report except to continue to assert the correctness of their positions. What are some of the takeaway lessons from Boltar?
- It is critical that the appraiser be objective and reasonable. How do you know when your appraiser is not being objective and reasonable? It requires you to be objective and reasonable as well, even when you are zealously advocating your client’s position. Co-opting your appraiser into being an advocate is the absolutely wrong approach. This is one of the reasons why I believe that a trial appraiser should not also serve as a rebuttal expert. I believe that simultaneously serving in both capacities compromises the expert in the eyes of the court. I far prefer to keep my trial expert “above the fray” and suggest hiring a separate rebuttal expert where it is determined that one is needed, even though it admittedly adds to the cost. What if your appraiser’s conclusion of value differs greatly from that of another qualified appraiser on the other side (and by this, I don’t necessarily include the work of the IRS valuation engineers, many of whom are not qualified appraisers)? It puts the onus on you to consider the possibility of having another appraiser conduct a “review” (this is a technical valuation term of art) of the subject appraisal. On balance, reviews are suggested every time that there are large differences between the conclusions of value of qualified appraisers. True, this adds expense that the client may not go for, but it’s so important in my opinion that you should go on record in writing as having suggested it so that if your appraiser is wrong, you at least can say “I told you to get a review.”
- It is imperative that your appraiser correct errors and carefully consider how the errors affect the conclusion of value. Appraisers are human too and do make mistakes from time to time. Errors can easily be made, and in appraisal reports, errors can cascade into bigger errors as they factor themselves in at each level of the analysis, throwing the conclusion of value off even further. In Boltar, the appraisers apparently didn’t consider how their errors affected their analysis, which the Tax Court termed “fatal.”
- Where an appraiser is not following a required valuation approach format, such as that for conservation easements, or the appraiser desires to use a technique that is “cutting edge” and hasn’t been vetted with the appraiser’s peers, warning bells should go off! I normally wouldn’t permit my clients to be guinea pigs unless they understood that and were nevertheless willing to do so. I strongly encourage appraisers who are “inventive” to publish articles and speak about their technique first to their peers. I really don’t care too much about whether the technique is criticized, because appraisers are notorious in criticizing each other’s work. As long as the technique is being used by other appraisers, I’m comfortable with it being employed as long as it is done correctly and consistently.
The bottom line is to rely upon experienced and respected firms and professionals.
Mercer Capital’s work product is of the highest quality. Our professionals have been designated as expert witnesses and have testified in federal and state courts and before various regulatory bodies, including U.S. Federal District Court (Several Jurisdictions), County and State Courts (Numerous States), U.S. Tax Court, U.S. Bankruptcy Court, state regulatory bodies, and the American Arbitration Association.
To discuss a valuation issue in confidence, contact us at 901.685.2120.
A resource for attorneys and other users of appraisal reports:
A Reviewer’s Handbook to Business Valuation: Practical Guidance on the Use and Abuse of a Business Appraisal
To read the case, see Boltar, LLC v. Comr., 136 T.C. No 14 (April 5, 2011) at http://www.ustaxcourt.gov/InOpHistoric/Boltar.TC.WPD.pdf.
Originally published in Mercer Capital’s Value Matters (TM) 2011-02, released May, 2011.