                         T.C. Memo. 2007-218



                       UNITED STATES TAX COURT



  TERRENE INVESTMENTS, LTD., DEERBROOK CONSTRUCTION, INC., Tax
                 Matters Partner, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 4797-04.                Filed August 7, 2007.



     Lawrence Sherlock and William Grimsinger, for petitioner.

     Thomas Fenner, for respondent.



                         MEMORANDUM OPINION


     HOLMES, Judge:    This is a single issue case: what was the

fair-market value of a 31.41-acre property near Houston on

November 15, 1998?    The property’s former owner says it was

$1,801,618.   The Commissioner says it was $301,000.   Both parties

agree the property held valuable sand and gravel deposits, but to
                               - 2 -

extract the property’s value we must sift through conflicting

expert witness testimony and many subsidiary issues.

                            Background

A.   Sand and Gravel

     This case arises from beneath the floodplain of the San

Jacinto River, the short river in southeastern Texas that flows

into Galveston Bay and on whose banks the Republic of Texas won

its independence in 1836.   The river today meanders past what

became the City of Houston, and its floodplain is filled with

sand and gravel.   These deposits are valuable when found near a

big city like Houston with a strong local construction industry.

But, though the market for sand and gravel in Houston is large,

neither production nor consumption is highly concentrated, and

prices are set on a wide variety of terms.    Some is sold by the

cubic yard and some by the ton; some is sorted by degrees of

coarseness and sold at difference prices--prices that fluctuate

significantly over time and can vary by length of contract or

distance to a buyer’s worksite.

     The value of a particular sand and gravel mine depends on

the particular type of deposits it holds.    Gravel is generally

more expensive than sand in the Houston market because of its

relative scarcity, and when it’s sorted before sale, coarser

gravel usually commands a higher price.     Sand is usually

classified descriptively as concrete sand, mortar sand, and bank
                                - 3 -

sand.   Concrete sand is the coarsest and most valuable, and is

used to make concrete; mortar sand is less coarse and is used by

bricklayers; and bank sand is very fine and is typically used

only to stabilize pipe bedding and create foundations.    Sand and

gravel of different grades can also be mixed into an aggregate

used in construction.

     Sand and gravel are both dry mined with a backhoe or wet

mined with a dredge.    Dredges are more expensive than backhoes,

but they dig up more sand and gravel, and do it more quickly.

Because the water table is so high along the San Jacinto, they’re

also the equipment most often used.     What comes out of a dredge,

though, is a watery mix of sand and gravel, which has to be

pumped to a plant where the water can be drained off and the sand

and gravel sorted by size or combined for aggregate before sale.

Dredges in the Houston area can mine sand and gravel to depths of

60 to 70 feet, but operators regard a deposit as mined out--

whatever its depth--when their dredges run into the thick layer

of clay that lies beneath almost the entire San Jacinto

floodplain.   Everyone in the industry understands that even the

sand and gravel above this clay cannot all be mined economically.

One constraint is the need to set aside some land for the

workplant, another is a legal requirement of setbacks for pit

walls adjoining a public road, and a third is the common-law

obligation not to undermine the property of one’s neighbor.
                                 - 4 -

     Property owners in this market rarely mine their own

deposits, instead leasing their land to sand-and-gravel operators

for a royalty.   But royalties are no more standardized than sales

of sand and gravel--some royalties are paid as a flat rate per

ton or cubic yard, and some are calculated at different rates

based on the different grades of sand and gravel actually

produced.   Some royalties fluctuate with the market and some are

set for the life of a contract.

B.   The Hamblen Road Property

     The property at issue in this case is a 31.41-acre tract

located on Hamblen Road in Harris County, Texas.   This tract was

less than half of a larger parcel bought by an agent of a family

named Wilkerson at a tax foreclosure auction in 1994.    The

Wilkersons had spotted white pines growing on the property before

deciding to make a bid.   White pines are valuable trees, and the

Wilkersons thought that they might be bidding against people who

didn’t see their value.   They were right--their agent

successfully purchased the entire property for a little over

$50,000, and the Wilkersons quickly cut the timber and sold it

for about $45,000.   In 1996, they transferred the entire parcel

to a partnership named Terrene Investments, Ltd., that their

family controls.   Terrene is a limited partnership formed under

Texas law, with its principal place of business in Texas, and

under the Internal Revenue Code it is classified as a TEFRA
                                   - 5 -

partnership.1      Its partners were Deerbrook Construction, Inc.--

the tax matters partner (TMP)2--and four Wilkerson family trusts.

       Jim Wilkerson and his son Dennis owned another piece of

property along the San Jacinto River, and in 1997 they noticed

that there was a sand-and-gravel operation mining land adjacent

to this other property.       They investigated, and learned that the

mine’s operator was paying royalties to the landowner.         This made

them wonder if their own property might have some sand or gravel

too.       Sand and gravel deposits are detected, and their volume

estimated, by taking core samples.         The Wilkersons decided to

have core samples taken from their land next to the already

operating sand-and-gravel mine.       But that coring turned up only

the sand-and-gravel equivalent of a dry hole.         The Wilkersons

didn’t give up--they suspected that they might be luckier with

the Hamblen Road property.       And they were right.    Geotest



       1
       Unless otherwise noted, all section references are to the
Internal Revenue Code in effect for 1998; all Rule references are
to the Tax Court Rules of Practice and Procedure.

     TEFRA is the Tax Equity and Fiscal Responsibility Act of
1982, Pub. L. 97-248, 96 Stat. 324, one part of which governs the
tax treatment and audit procedures for most partnerships. See
TEFRA secs. 401-407, 96 Stat. at 648-671. TEFRA requires that
all “partnership items”--a term defined by section 6231(a)(3) and
(4)--be determined at the partnership level; its general goal is
to have a single point of adjustment during an audit rather than
making separate adjustments for each partner. See H. Conf. Rept.
97-760, at 599-601 (1982), 1982-2 C.B. 600, 662-63.
       2
       Each TEFRA partnership is supposed to designate one of its
partners as the “tax matters partner” to handle TEFRA issues and
litigation for the partnership.
                                - 6 -

Engineering, Inc. drilled holes in the property and its analysis

of the core samples showed that 50 acres of the property were in

the San Jacinto’s floodplain.    Geotest estimated that this part

of the Hamblen Road property contained almost four million tons

of valuable deposits down to a depth of between 60 and 70 feet.

Jim pressed his son to start mining the deposits, but Dennis

resisted.   They then decided to have Terrene divide the property

into three parcels--one parcel was the approximately 24 acres

that analysis had shown did not have recoverable deposits,

another was 19 acres in the floodplain that lay south of Hamblen

Road, and the third was the remaining 31 acres of floodplain

property north of the road.

     Terrene donated the 19-acre parcel to the Assemblies of God

Foundation in 1997, after talking with an Assemblies of God

minister who also owned a local sand-and-gravel operation.

Before donating the parcel, Terrene had it appraised

--an appraisal that put its value at $2,500,000, which Terrene

deducted on its 1997 partnership return and which the IRS never

challenged.

     This case concerns the value of the 31-acre parcel lying

north of Hamblen Road.    After more fruitless attempts by Jim

Wilkerson to persuade his son to get into the mining business,

they decided to have Terrene donate this parcel to the Assemblies

of God Foundation, too.    Terrene again had it appraised, and the
                                - 7 -

two appraisers whom it hired both valued the parcel at about $2.7

million.   The Wilkersons were a bit skeptical, and talked with

several people in the business before they had Terrene claim such

a large deduction.    Having convinced themselves that the

appraisals were correct, they had Terrene donate the parcel to

the Assemblies of God Foundation in November 1998, and claim a

$2.7 million charitable contribution deduction on its 1998

partnership return.    Their initial skepticism was justified when

the return was chosen for audit.    The Commissioner determined

that the fair-market value of the donated land was only $150,000,

and he mailed Terrene a notice of Final Partnership

Administrative Adjustment (FPAA).    Terrene timely filed its

petition, and the case was tried in Houston on the valuation

question alone.

                             Discussion

     The question before us is really a question of just what

effect the four holes drilled into the 31.41-acre parcel of the

Hamblen Road property had on its value.    Under section 170, the

amount of the deduction for a contribution of property to a

charity is its fair-market value (FMV) at the time of donation.

Sec. 1.170A-1(c)(1), Income Tax Regs.     The regulations define FMV

as “the price at which the property would change hands between a

willing buyer and a willing seller, neither being under any

compulsion to buy or sell and both having reasonable knowledge of
                                - 8 -

relevant facts.”    Sec. 1.170A-1(c)(2), Income Tax Regs (emphasis

added); see also United States v. Miller, 317 U.S. 369, 373-74

(1943).   In determining FMV, we look to the “highest-and-best

use” for the property in question.      See McMurray v. Commissioner,

985 F.2d 36, 40 (1st Cir. 1993), affg. in part and revg. in part

T.C. Memo. 1992-27; Browning v. Commissioner, 109 T.C. 303, 323

(1997); Van Zelst v. Commissioner, T.C. Memo. 1995-396, affd. 100

F.3d 1259 (7th Cir. 1996); McLennan v. United States, 24 Cl. Ct.

102, 108 (1991), affd. 994 F.2d 839 (Fed. Cir. 1993).     The

parties agree that the highest-and-best use of the Hamblen Road

property is mining it for sand and gravel.

     There are three widely accepted methods of estimating FMV

for any property:   comparable sales, income capitalization (or

discounted cashflow), and replacement cost.     Our first step then

is to decide which of these methods works best here.     We

immediately discard the replacement-cost method, which both

parties agree is inappropriate in valuing mineral reserves.     That

leaves us to choose between the comparable-sales and discounted-

cashflow (DCF) methods.   Comparable sales uses market data, and

looks for sales of property in the same market with similar

characteristics that were made at arm’s length.     See Rev. Proc.

79-24, 1979-1 C.B. 565.   DCF requires us to prepare a reasonable

estimate of future income over time and discount it to present

value.    Figuring out a reasonable estimate of income for a sand-
                               - 9 -

and-gravel property in turn forces us to estimate a number of

factors:

     •   total volume of minerals on the property,
     •   setbacks,
     •   size of work area,
     •   slope of pit walls,
     •   natural waste,
     •   rate of extraction,
     •   royalty rate,
     •   discount rate, and
     •   residual value.

A.   Parties’ Positions

     The Commissioner’s proposed value of $301,000 is based on

the work of its expert, Edwin Moritz.    Moritz is a member of the

American Institute of Minerals Appraisers and the Society of

Petroleum Engineers, and has appeared as an expert witness on the

FMV of sand-and-gravel properties in other courts.    He relies on

the Uniform Standards for Professional Appraisers Practice

(USPAP), the Uniform Appraisal Standards for Federal Land

Acquisitions (UASFLA), and caselaw for the proposition that the

comparable-sales approach is best.     See Cloverport Sand & Gravel

Co. v. United States, 6 Cl. Ct. 178, 189 (1984).     After searching

the deed records in the county where the Hamblen Road property is

located, Moritz identified five sales that he said were possibly

comparable.   Moritz interviewed the buyers and sellers in each of

these transactions and concluded that three of them were in fact

comparable.   He adjusted the prices involved to account for

various differences with the Hamblen Road property and then used
                               - 10 -

a weighted average that produced a value of $9,050 per acre.

Multiplying by the number of acres in the parcel at issue led to

an appraised value of $284,300.

     Moritz also used the DCF approach.   He first developed a

hypothetical mining plan.    His plan used 50-foot setbacks to

create an adequate buffer between the pit and adjacent property,

and assumed a work area of approximately seven acres, to be set

on a portion of the property that could not, in his view, be

economically mined.   Moritz also believed that the pit walls

would have to remain at a 32-degree slope in order to be stable.

His mining plan calculated that with the setbacks, pit-wall

slope, and operating area, the property contained 1.9 million

minable tons of aggregate.    He then took another 10% off to

account for normal waste.    He estimated that the mine would

produce 150,000 to 200,000 tons annually, and generate royalties

of $0.50/ton.   Using a 28% discount rate to compute present

value, these estimates, assumptions, and conclusions taken

together led him to a value of $326,000 for the mining interest.

He computed the residual value of the property to be $1,000 per

acre and discounted that to a total present residual value of

$9,900, which gave a final DCF value of $335,900.    Moritz finally

weighted the two values--two-thirds of the comparable sales value

and one-third of the DCF value--and came up with a final estimate

of $301,000.
                              - 11 -

     Terrene contends that the FMV on November 15, 1998 was

$1,801,618.   Terrene first argues that no comparable sales exist,

so we must use only the DCF method.    Terrene also argues--

crucially as it turns out--that the type of interest to which we

should be applying that method is a royalty interest, not an

operating interest.   Terrene’s expert, Gerald Ebanks, began with

the field logs and samples that were part of a Geotest report

that wasn’t contested by either party.    Based on these soil

borings, Ebanks created an isopach map3 of the aggregate across

the property.   He then subtracted a 25-foot nonminable setback

next to Hamblen Road, multiplied the remainder by 12% to reflect

the increase in the volume of sand and gravel once they’re

brought to the surface, and finally determined that the total

minable deposits were 3,973,149 tons.    He estimated that a

prudent slope of the pit walls and the usual operations of a mine

would reduce the total tons of minable aggregate to 3,637,000.

Unlike Moritz, Ebanks did not include a work area in his

calculation because he assumed that the operator would build a

workplant somewhere on the 24-acre parcel still owned by Terrene

that was sand-and-gravel-free.   Ebanks’s hypothetical mine

operator would produce at a much higher rate than Moritz’s--


     3
       An isopach map depicts the thickness of deposits (in this
case, sand and gravel deposits) as contour lines, called
isopachs. Think of it as a topographic map, except that the
contour lines are subterranean. Ebanks’s isopach map assumes
that changes in the thickness of sand and gravel deposits between
boreholes are linear.
                               - 12 -

360,000 tons each year.   He also used a higher royalty rate of

$0.75/ton and a lower discount rate of only 9%.   These estimates,

assumptions, and conclusions taken together yielded an FMV of

$1,801,618.

     The Commissioner tries to undermine Terrene’s valuation by

noting that Ebanks had never appraised a tract of real property

before, and had previously testified as an expert witness only

about the value of oil-and-gas interests.   But we find that both

experts were at least reasonable in their work--there were no

questions of “junk science” here.   Unable simply to rely on one

expert or the other, we weigh their conflicting conclusions in

light of other credible evidence in the record and a close

examination of their premises.   We look first to the

reasonableness of the methods they chose, and then to the

reasonableness of the assumptions they made.   The answer we

reach, not surprising in a valuation case, is somewhere between

what both of them proposed.

B.   Comparable Sales

     The comparable-sales approach uses sales of similar

properties to estimate FMV.   “It is generally accepted that

comparable sales provide the best evidence of value.”

Cloverport, 6 Cl. Ct. at 189; Van Zelst, T.C. Memo. 1995-396.

Moritz identified five sales as potentially comparable to the

Hamblen Road property.    He himself discarded two of them as not
                              - 13 -

made at arm’s length.   One sale that Moritz did use (his Sale #4)

was of a 41-acre property in the same area as the Hamblen Road

property, but this sale was made before either the buyer or the

seller knew there was sand and gravel beneath the property.

Moritz’s Sale #5, 50 acres and located even closer to Houston

than the Hamblen Road property, was likewise made at a price

negotiated before either party knew the property held valuable

deposits.

     Given the ignorance of the buyers and sellers in these

sales, we will not treat them as comparables.   One of the

requirements of FMV is that both the buyer and seller be informed

regarding all the factors relevant to the land’s value.      Foster

v. United States, 2 Cl. Ct. 426, 446 (1983); see also sec.

1.170A-1(c)(2), Income Tax Regs. (both buyer and seller must have

“reasonable knowledge of relevant facts”).   We find that Moritz’s

Sales #4 and #5 fail this requirement.   That leaves only Sale #3,

a 60.48-acre parcel that was sold for $150,000.   This property

was known by both buyer and seller to have sand and gravel

deposits, but the parcel was contaminated by oil and was burdened

with oil pipeline easements and leases that restricted its

development.   Though the Hamblen Road property’s own mineral

rights were also severed (Texaco owned them in 1998), there was

no active or pending oil-and-gas drilling at the time of the

donation, leading us to find that Sale #3 was not comparable

either.
                               - 14 -

     Without comparable properties, we turn to the DCF method.4

C.   Discounted Cashflow

     The DCF method calculates a cashflow from a property and

then discounts it to the present.   In the case of the Hamblen

Road property, using the DCF method means creating a hypothetical

mining plan--estimating the volume of recoverable sand and

gravel, figuring out how long it would take an operator to mine

it, finding a reasonable royalty rate and residual value, and

then applying an appropriate discount rate to the resulting

cashflow.

     1.     Volume

     The parties disagree about almost all the component factors,

even the gross volume of valuable sand and gravel beneath the

property.    Geotest Engineering concluded that the property holds

3,899,696 tons of sand and gravel, a number it reached using its

own core samples and the “average end area” method.   Ebanks and

Moritz also started with Geotest’s core samples, but Ebanks used

them to create his isopach map.   He then used this map together

with a planimeter5 to get a gross volume, while Moritz used the

Geotest core samples to calculate an average of the net aggregate



     4
       See Cloverport, 6 Cl. Ct. at 194 (“Because the plaintiff’s
property is an income producing property capable of producing a
stream of income derived from what both parties concede is the
property’s highest and best use, the income capitalization
approach is a preferable valuation method”).
     5
       A planimeter is a mechanical device used to calculate the
volumes of irregularly shaped three-dimensional shapes.
                               - 15 -

thickness of the property.   Each man then reduced the gross

volume he had calculated to reflect a number of factors.    What

was left were two competing final recoverable volumes.

     We find that all the different methods used by Geotest,

Ebanks, and Moritz are reasonable for making volume estimates on

this property.   But neither Ebanks’s nor Moritz’s method is

transparent.   Ebanks’s final volume number reflects assumptions

about the required setbacks and set asides for a workplant area

with which, as discussed below, we disagree.   Moritz’s final

volume number reflects a set of different assumptions, but we

disagree with some of them, too.   This creates a problem, because

neither expert’s volume computations are adjustable using

information from the record.   Geotest’s number has the signal

advantage of being both reasonable and adjustable, so it’s the

number we begin with.   We therefore find that there were

3,899,696 tons of valuable deposits beneath the Hamblen Road

property.6

     The parties do agree that no reasonable mining plan could

lead to the recovery of every last one of those tons.    But their

agreement stops there, and so we must review each of the factors

affecting the total recoverable volume that they dispute.



     6
        We do not adopt Terrene’s suggestion to add another 12%
to this number as an adjustment for an increase in volume of the
sand and gravel when they are mined, because Geotest’s reported
numbers already take this adjustment into account.
                                - 16 -

          i.   Setbacks

     The first of these is setbacks.     Setbacks are strips of

unmined land between pit walls and property lines, and they can

vary in size.     Legal restrictions in Texas require a 25-foot

setback for pit walls adjoining a public road,7 but the setbacks

for pit walls not adjacent to a public road are up to the

operator and property owner.     The evidence showed setbacks in the

Houston area range from 5 to 50 feet.     Some of this variance

depends on what type of soil is present on the property--the more

compact the soil in a pit wall, the less likely it is to collapse

and the narrower the setback can be.     And some of the variance

simply lies in an operator’s risk preference.     (The risk being

that the walls collapse and damage adjoining land.)

     We begin by finding that Hamblen Road, a public road, runs

along the southern edge of the property for 1,022 feet.      On the

other sides, there is a private road on the east (1,600 feet), a

railroad easement on the west (1,550 feet), and the remaining 24-

acre parcel on the north that Terrene decided to keep (695

feet).8    Other than along Hamblen Road, then, the precise size of

the setback is entirely discretionary.     We do think that prudence



     7
         See Tex. Nat. Res. Code Ann. sec. 133.044 (2005).
     8
       The parties introduced good maps of the property, which
show it to be quadrilateral--but it’s not a rectangle, and
there’s nothing in the record describing the angles involved,
making areal calculations of parts of the property necessarily
imprecise. We also round to the nearest whole number here and
throughout our calculations.
                              - 17 -

would impel a reasonable operator and landowner to consider

factors such as minimizing disturbance to the neighbors.    And we

found credible the testimony of both a local operator who used

50-foot setbacks and one who used 100-foot setbacks.   Questioning

by Terrene’s attorney, though, brought out that the 100-foot

setbacks were dictated by a real-estate developer who wanted to

build roads around the pit once it was exhausted and filled with

water, to accommodate what he was planning to call lakefront

homes.   Neither party suggested that what was left of the Hamblen

Road property after it was mined out would be of interest to

homebuilders, so we find it most likely that an operator would

minimize setbacks to maximize his volume of minable material.

Terrene claims that local industry practice is to leave 5-foot

setbacks where not required by law.    This seems rather small, and

not in accord with the most credible evidence.   We therefore find

that a 10-foot setback on the western and northern edges is

appropriate, and that a 25-foot setback on the eastern edge--

where there is a private road--would be most reasonable in light

of the legally mandated 25-foot setback on the property’s

southern boundary.

     The effect this would have on the volume of recoverable

deposits is unclear, because the Geotest report does not describe

its formula for calculating minable material in great detail.

Therefore, we resort to an indirect, and necessarily imprecise,
                              - 18 -

way of determining how much material will be unrecoverable due to

these setbacks.   We can calculate the approximate acreage taken

out of the evaluation by these setbacks:

     • southern edge: 1022 feet and 25-foot setback
       yields 0.59 acres;

     • eastern edge: 1575 feet (1600 feet - 25 feet
       already counted) and 25-foot setback yields 0.90
       acres;

     • northern edge: 670 feet (695 feet - 25 feet
       already counted) and 10-foot setback yields 0.15
       acres; and

     • western edge: 1515 feet (1550 feet - 35 feet already
       counted) and 10-foot setback yields 0.35 acres.

The setbacks therefore take up a total of 1.99 acres, which we

round to 2 acres.

     We also have to make some assumptions about the distribution

of the deposits beneath the property, which is inherently

unknowable until mining begins.   Ebanks prepared his isopach map

using the data from the four boreholes taken on the property plus

three of the boreholes on the neighboring tracts.   This map

suggests that the thickest deposits are in the southwestern

corner of the parcel and the thinnest in the northwestern corner,

but without enough variation to allow one to easily calculate

different volumes for different parts of the property.    Because

the adjustment for setbacks affects the entire perimeter of the

property, we find that it is reasonable to assume for these

calculations that the sand and gravel are uniformly distributed.
                                  - 19 -

Dividing 3,899,696 tons by 31.41 acres, we get 124,155 tons of

sand and gravel per acre.      Thus, a loss of 2 acres of land to

setbacks will reduce the available volume by 248,310 tons.

       ii.     Work Area

     The next factor reducing recoverable volume is the need for

some land to be set aside for a workplant to sort the excavated

material.    We find credible the evidence that most plants are

built on the property being mined.         Terrene disagrees, arguing

that we should not make any adjustments for a workplant because

one might be set up next door on property that is still owned by

Terrene or on the tract already given to the Foundation.           We are

unpersuaded.    No evidence exists that shows Terrene ever

contemplated such an offer during its talks with the Foundation,

and we find that it would not be practical to have a plant on the

previously donated parcel because it lies on the other side of a

very busy Hamblen Road.

     A closer question is the size of the work area.         The

Commissioner urges us to find that roughly seven acres would be

needed, while Terrene claims it would take only three.

Voluminous testimony on this exact point convinces us that four

acres would suffice.       Local operators Enloe and Vestal credibly

testified that, in their experience, operators on plots the size

of the Hamblen Road property usually used about three-to-four

acres to set up their work area.      According to witnesses, the
                               - 20 -

most logical place for a worksite would be the northern section

of the property as it has the least amount of saleable materials.

As an operator might need additional land outside the work area

to put access roads in, we opt for the high end of local custom.

The Commissioner’s argument for almost double that amount of land

seems unreasonable.    Using our tons-per-acre number from the

previous section, the reduction attributable to a work area is

496,620 tons.9

         iii.   Pit Slope

     We next turn to the issue of the pit wall’s angle of repose.

Terrene argues that local practice is to use nearly vertical

walls to maximize recovery, while the Commissioner argues for a

much more gentle slope as necessary to create stability and

prevent the walls from collapsing.      In support of his position,

the Commissioner argues that while packed sand mixed with clay

can remain stable at steeper slopes, the soil on the subject

property is much too loose to hold.

     We disagree.    Credible testimony at trial indicates that

most operators in the Houston area dig pits with almost vertical

walls, because enough clay is present in the pit wall to make it

more cohesive than ordinary soil and because the water that fills

a pit when the mining is finished produces a lower difference in



     9
         The math: 124,155 tons/acre x 4 acres = 496,620 tons.
                                  - 21 -

pressure between the wall and pit than would a hole filled only

with air.       Both these factors make the pit wall more stable.    It

also keeps the soil of the pit’s edges moist and therefore even

more cohesive.       Although some portions of the pit walls may well

crumble over time, that crumbling is why the setbacks are needed.

We also take judicial notice that the Houston area more closely

resembles a swamp than a desert--there is plenty of water in the

area to fill in the property when mining is done.       We therefore

find in favor of Terrene on this point, and agree with its

experts that the pit walls can be left at a 75-degree slope.

Ebanks credibly testified that at this angle, approximately 3% of

the volume would be lost, so we will subtract another 94,643

tons.10

          iv.    Waste

     The final reduction we must consider is the waste that

inevitably occurs during extraction and processing.        Terrene

makes no adjustment; the Commissioner wants us to use 10%.

Neither side introduced any especially compelling evidence on

this point, but we found Moritz credible in saying that some

waste is inevitable in any mining operation and that 10% is the

industry’s rule of thumb.      So by a bare preponderance of the

evidence, we side with the Commissioner.       Using the



     10
       The math thus far: 3,899,696 - 248,310 - 496,620 =
3,154,766. 3,154,766 (tons remaining after setbacks and work
area accounted for) x 97% = 3,060,123.
                               - 22 -

Commissioner’s 10% waste allowance leads to another reduction of

306,012 tons.11

     Our conclusion after all these calculations is that there

are 2,754,111 tons of recoverable deposits.

     2.   Rate of Extraction

     We must next determine how long the mining will take.    The

Commissioner’s computation reflects his assertion that it would

take approximately six-to-eight months to begin operations, while

Terrene argues that it would take only three.    We find in favor

of Terrene on this point because the Assemblies of God Foundation

could have moved quickly to start mining the property since it

had already leased the neighboring property.    We will use three

months as our hypothetical delay for site preparation.

     The parties also butt heads over how much such a mining

operation could produce--the IRS contends an upper limit of

200,000 tons annually, while Terrene argues for 360,000 tons.

Moritz’s estimate for the Commissioner was largely based on

unnamed producers whom he had interviewed.    Ebanks also

interviewed local operators, some of whom backed up Ebanks with

their testimony.   Ebanks noted in particular one local operator

who explained that the Hamblen Road property would be considered

small by some operators--not so small as not to be of interest,



     11
       3,060,123 (tons remaining after setbacks, work area, and
pit slope accounted for) x 10% = 306,012.
                               - 23 -

but small enough to have an impact on the rate of production

since smaller operators use lower-volume equipment and are

somewhat less efficient.    We found credible the evidence Terrene

offered that one nearby quarry produces at about 25,000

tons/month on a 28-acre parcel, and that one large operator whom

Ebanks interviewed estimated 40,000 tons/month would be

reasonable for an operator working on the Hamblen Road property.

The 30,000 tons/month that Terrene suggests seems, in these

circumstances, to be reasonable.     We therefore find for Terrene

on this point, and will use a 30,000 tons/month extraction rate.

This amount could have easily been absorbed into the Houston

market, where annual consumption of sand and gravel exceeded 60

million tons in the late 1990s.    Cf. Cloverport, 6 Cl. Ct. at

199.    Given our prior finding of 2,754,111 tons of recoverable

materials, extraction at this rate would mean that the operation

would take place over 92 months.12

       3.   Royalties

       The royalty rates for sand and gravel in the Houston area

are not uniform.    Some operators pay a single rate based on

volume; others pay different rates for the different materials

(e.g., concrete sand, masonry sand, etc.).    Local operators

around Houston paid anywhere from $0.25 to $1.00/ton to


       12
       2,754,111 divided by 30,000 equals 92 months with
rounding. If production began after a three-month delay for site
preparation, the hypothetical income stream begun in 1998 would
peter out by the end of 2006.
                              - 24 -

landowners in late 1998, with higher royalties typically going to

sand-and-gravel mines located very close to construction sites

due to the low value-to-volume ratio of sand and gravel and the

cost of transportation.

     The Hamblen Road property is small, so we find it most

reasonable to assume that its deposits would mostly be sold as

aggregate, in contrast to a variety of differently priced grades

of sand and gravel, and would attract a single price and yield a

single royalty per ton.   Ebanks credibly testified that the

average royalty rate paid to the Assemblies of God Foundation for

materials mined from the first property donated to it was

$0.71/ton, which was paid during a 14-month span which includes

November 15, 1998.   We think this is the best evidence of a

reasonable royalty for sand and gravel from the subject property,

especially since it falls well within the range in the local

market.   We therefore find that $0.71/ton is a reasonable royalty

rate to use in the hypothetical mining plan.

     At $0.71/ton, the value of the royalty interest in the

expected 2,754,111 tons that can potentially be sold from the

subject property is $1,955,419.   However, we must take into

account that this number represents a value received over time as

the sand and gravel is mined and sold.   To arrive at the figure

Terrene may properly claim as a charitable deduction, we must
                               - 25 -

discount this royalty stream back to its net present value on

November 15, 1998.

       4.   Discount Rate

       The single largest source of the disparate valuations

claimed by the parties is the discount rate each applies.      When

plugged into a present-value analysis, the rate spread of 19

percentage points yields a difference in valuation of more than

$600,000.    Ebanks used a 9% discount rate, which he arrived at by

taking the prime rate as of November 1998 and adding 1%.    Ebanks

used this formula for most of his past valuations and believes it

to be an acceptable practice for valuing businesses in the

extraction industry.    Moritz reached for a much higher number--

28%.    He cited a “sensitivity analysis” of between 24% and 59%, a

range that he said reflected the risk perceived by the market in

developing the Hamblen Road property.

       Coming up with such a high discount rate was due to two

fundamental choices that Moritz made.    The first was to treat the

relevant cash stream to be discounted as a cash stream from a

mining operation rather than a royalty interest from a mining

operation.    As the Commissioner conceded in his brief, the owner

of a royalty interest bears much less risk than does an operator;

that by itself makes a 28% discount much too high.    Moritz’s

second choice--to try to derive the discount rate from the

purchase price of two of the properties that he used in his
                               - 26 -

comparable-sales analysis--was no less flawed.    The reason is

that the properties he used--his Sales #3 and #5--were properties

that, as we have already discussed, were not comparable to the

Hamblen Road property.   Implicit in his conclusion that the

appropriate discount rate is 28% is that those sales’ purchase

prices reflect only their value to a mining operator.    But as we

discussed above, Sale #5 was made at a price agreed to before

either side knew there were sand and gravel deposits beneath the

property, and Sale #3 was of a property contaminated by oil-and-

gas drilling.   For the same reasons we rejected those properties

as comparable sales, we reject them as sources from which one can

derive a reasonable discount rate in this case.

     On the other hand, there is some risk that an operator may

suffer interruptions that will affect the stability of the

royalty stream which the property’s owner would receive.    An

addition of only 1% to the going prime rate hardly takes this

into account.

     We thus also reject Ebanks’s analysis, if only in part.      He

started his calculation of a discount rate using the prime rate

in November 1998.   The cases seem fairly consistent in saying

that a court should instead begin with the appropriate risk-free

rate.13   We will start with a rate of 4.5%, which was the average


     13
        See Jones & Laughlin Steel Corp. v. Pfeifer, 462 U.S.
523, 537 (1983) (“the discount rate should be based on the rate
                                                   (continued...)
                             - 27 -

rate on three-year and five-year Treasury notes on November 13,

1998, the business day before the date of donation.14   Then we

add risk premiums to that to create an implied rate of return for

buyers of comparable properties.   As explained by the AICPA:

             The discount rate is the rate of return
          that Investors require as a condition of
          purchasing the type and class of property
          being appraised. The rate may vary,
          depending on economic and other conditions,
          but generally should be based on market
          rates, reflecting the rate of return demanded
          by buyers of comparable properties. In
          addition, the following factors should be
          considered in determining the discount rate:

               • Recovery of the investment over its
                 estimated economic life

               • A safety factor to recognize
                 additional risk, management
                 burden, and lack of the buyer’s
                 liquidity

               • An investment factor to recognize the
                 property’s quality of income, its
                 marketability, and tax advantages

AICPA Audit and Accounting Guide, “Guide For the Use of Real

Estate Appraisal Information”, sec. 3.27 (May 1, 1997).



     13
      (...continued)
of interest that would be earned on ‘the best and safest
investments’”) (citation omitted); Sauers v. Alaska Barge &
Transp. Inc., 600 F.2d 238, 246 n.15 (9th Cir. 1979); Estate of
Adams v. Commissioner, T.C. Memo. 2002-80.
     14
        Federal Reserve Statistical Release, H.15 - Historical
Data, http://www.federalreserve.gov/releases/h15/data.htm. We
use the average of the three-year and five-year notes because the
total length of the hypothetical royalty stream is approximately
eight years, with the average royalty payment coming at
approximately year four.
                              - 28 -

     The property here, to be precise, represents an illiquid

eight-year stream of royalty payments from a smallish parcel of

land.   Part of the risk is the risk of inflation, but

inflationary risk is presumably reflected in the rate on the

Treasury notes.   The parties left us with little in the way of

estimating noninflationary risk to the value of the income stream

(i.e., the probability that the income stream would be

interrupted).   At a minimum, we think that we have to add in

another 3%, which was the spread between Treasury notes and

corporate bonds rated Baa back in November 1998.    Federal Reserve

Statistical Release, H.15 - Historical Data,

http://www.federalreserve.gov/releases/h15/ data.htm.    But we

also think that the risks associated with interruptions of

operations on the Hamblen Road property--interruptions like

flooding, malfunctioning equipment, small-operator bankruptcy,

etc.--and the risk of interruptions in getting a mine started in

the first place require an additional risk premium of 4%.     The

final discount rate that we will use, then, is 11.5%, which (as a

reality check) is reasonably close to discount rates in other

cases involving royalty interests.     See, e.g., Zuhone v.

Commissioner, 883 F.2d 1317, 1324-1325 (7th Cir. 1989) (7.5% over

Treasury rate for the year in question; hypothetical operation),

affg. T.C. Memo. 1988-142; E. Minerals Intl. v. United States, 39

Fed. Cl. 621, 631 n.12 (1997) (6.5% over Treasury rate; existing
                              - 29 -

operation), revd. on other grounds sub nom. Wyatt v. United

States, 221 F.3d 1090 (Fed. Cir. 2001); Cloverport, 6 Cl. Ct. at

200 (5% over Treasury rate; existing operation).

     5.   Other Factors

     Moritz raised a parade of improbable specters that might

also diminish the value of the property.    For example, he

included in his report the possibility of the property’s being

subject to wetland regulation, cited social pressure as a factor

for lowering the value, and noted other regulatory risks that

might dampen the appraised value.   We take none of these claims

seriously.   It was well established in the record that property

all along the San Jacinto River was being mined for sand and

gravel in the late 1990s.

     6.   Residual Value

     After the mining operations have ended, the property will

have some remaining value, even if it is just a pool of stagnant

water surrounded by a fringe of dry land.    Ebanks did not address

this issue in his report.   Moritz came up with a future value of

$1,000/acre for the property.15   We accept his figure.


     15
       Moritz calculated this figure by first using Harris
County’s appraisal value of $157,100, which came to $4,600 per
acre. He then adapted his comparable-sales approach. Sales #2
and #4 were sold after being depleted of sand and gravel
resources; Sale #4 sold at a price 67% less than its original
value as vacant floodplain land. In reviewing county records,
Moritz saw an appraisal range of between $500 and $1,500 per acre
for depleted mining property. By extrapolating the pit-discount
figure, Moritz concluded that the subject property could
reasonably be expected to fetch $1,000 per acre once the deposits
                                                   (continued...)
                                    - 30 -

D.   Tables

                      Table 1.1 - Computation Formulas
       A                    B              C                 D
     Year              Tons Mined       Royalty      Present Value at
                                                         11/15/98
1    1999                315000        B1 * 0.71     C1/((1.115)^0.63)
2    2000                360000        B2 * 0.71     C2/((1.115)^1.63)
3    2001                360000        B3 * 0.71     C3/((1.115)^2.63)
4    2002                360000        B4 * 0.71     C4/((1.115)^3.63)
5    2003                360000        B5 * 0.71     C5/((1.115)^4.63)
6    2004                360000        B6 * 0.71     C6/((1.115)^5.63)
7    2005                360000        B7 * 0.71     C7/((1.115)^6.63)
8    2006                279111        B8 * 0.71     C8/((1.115)^7.63)


Subtotal               sum(B1:B8)      sum(C1:C8)         sum(D1:D8)
Plus Residual Value                                        $13,148
TOTAL DISCOUNTED VALUE                                    D10 + D12

                          Table 1.2 - DCF Analysis


                                                     Present Value at
     Year              Tons Mined       Royalty          11/15/98
     1999                315,000        $223,650          $208,826.56
     2000                360,000        $255,600          $214,043.88
     2001                360,000        $255,600          $191,967.61
     2002                360,000        $255,600          $172,168.26
     2003                360,000        $255,600          $154,410.99
     2004                360,000        $255,600          $138,485.19
     2005                360,000        $255,600          $124,201.97
     2006                279,111        $198,169           $86,363.07


Subtotal               2,754,111      $1,955,419         $1,290,467.53
Plus Residual Value                                        $13,148.00

TOTAL DISCOUNTED VALUE                                   $1,303,615.53




     15
      (...continued)
had been depleted, which is within the range of prices in the
county. Once discounted to present value at 11.5%, at the end of
eight years--the property’s useful life as a mine--it has a
present value of $13,148.
                             - 31 -

                           Conclusion

     We find that the value of the Hamblen Road property on

November 15, 1998, was $1,303,616.


                                     Decision will be entered

                              under Rule 155.
