Estates, Trusts & Gifts
Application of a fractional interest discount to value undivided fractional interests in real property has long been a contested issue. A fractional interest discount arises from the lack of both control and marketability inherent in joint ownership of property. In the past, the IRS has taken the position that a fractional interest discount is limited to the estimated cost of partitioning the property (Technical Advice Memorandum (TAM) 9336002). However, in TAM 199943003 the IRS took the position that the cost of partitioning the property is only one of the methods for determining a fractional interest discount. In addition, many cases have concluded that discounts greater than the cost to partition the property are appropriate in determining fair market value (FMV) of fractional interest in real property.
In a recent case (Ludwick, T.C. Memo. 2010-104), the Tax Court valued a one-half interest in a Hawaiian vacation home at a substantially lower fractional interest discount than the taxpayers had argued for. The court did recognize that the discount should include not only the cost of partition but should also reflect marketability and liquidity risk. The cost-to-partition approach used by the court to quantify the additional risks is a departure from previous court cases. The court used a well-expressed formula, made several assumptions to value the gift, and allowed a 17.2% discount. This case is also the first case on valuation of fractional interest gifts to a qualified personal residence trust (QPRT).
In 2000, Andrew and Worth Ludwick, a married couple, purchased unimproved real property in Hawaii, where they constructed a vacation home. They owned the improved property as tenants in common, each owning an undivided one-half interest therein. In 2004, the Ludwicks executed agreements establishing separate QPRTs and transferring their undivided interests to those trusts. At the time of the transfers, the property had an FMV of $7.25 million and annual operating costs of approximately $350,000. On their federal gift tax return, each reported the value of their 50% undivided interest at a 30% discount for lack of control and lack of marketability. Upon audit, the IRS allowed a discount of 15%. At trial, the taxpayers’ expert concluded that a 35% discount was appropriate, while the IRS’s expert argued for an 11% discount.
Each side provided testimony from their respective experts on valuation of the fractional interest in the property. The taxpayers’ expert presented analyses of sales of 69 undivided interest transactions that occurred between 1961 and 2006. The data were sorted into income- producing and non-income-producing properties. The court rejected these data because they failed to explain how the discounts were calculated and did not provide a measure of standard deviation.
The taxpayers’ expert also provided data about sales of real-property-holding partnerships. The court rejected these data as well because the partnerships were income-producing whereas the vacation home was non-income-producing.
The IRS expert provided data about four sales of undivided interests. The court dismissed the sales data because all four were commercial properties in the eastern United States, so the data were not relevant to a multimillion-dollar vacation home in Hawaii. The IRS expert also provided surveys of California brokers relating to discounts associated with fractional interests in property. The court dismissed the surveys since they did not provide details of the specific transactions.
In addition, the IRS expert provided a professional review of control premium data covering tender offers of majority interest in public real estate companies. The court rejected the control premium data, noting that they were determined by too many factors not relevant to the discount appropriate for the Ludwicks’ property.
After finding the testimony of both experts insufficient, the court asked them the following key question: Why would a buyer of an undivided interest in the property consider the interest worth any less than a proportional share of the FMV of the whole property reduced by the buyer’s cost to partition? Both experts agreed that a buyer would consider lack of marketability and liquidity risks. Per the court, a buyer that had the right to partition could not demand a discount greater than the cost and likelihood of partition and the marketability risk.
The court noted that Hawaiian law provides for partition of real property and that partition will result in sale of the property. Adopting a cost-to-partition approach to determine FMV, the court needed to decide the likelihood of partition, the length of time it would take, the costs to partition the property, and the buyer’s required rate of return (discount rate).
The taxpayers’ expert testified that a contested partition would take two to three years to resolve and would include $10,000 of appraisal costs and $70,000 of litigation costs. The IRS expert testified that a contested partition would take two years to resolve and that estimated costs would include $15,000–$20,000 to proceed with filings. The taxpayers’ expert testified that a buyer would demand a 30% rate of return. The IRS expert testified that a buyer would demand a 10% rate of return. The court rejected the 30% rate of return because there was no evidence to support it. Instead, it adopted the IRS expert’s 10% rate of return.
The court determined the value assuming a two-year partition period with the partition cost to be 1% of the property’s FMV, the cost of selling the property to be 6% of the property’s FMV, a 3% long-term annual sustainable growth rate, annual operating costs of $350,000, and a 10% buyer’s required rate of return. From this, the court calculated a 26.5% discount. It then calculated the value assuming the property would be sold in one year and that the partition action would not be necessary. This resulted in a 16.2% discount. The court then calculated the weighted average of the outcomes with a 10% likelihood of the partition action, resulting in a 17.2% weighted average discount.
The court’s cost-to-partition approach resulted in a substantially lower discount than the taxpayers had argued for. This happened mainly because the taxpayers could not meet burdens of proof for the inputs to the formula, so the court ended up using its own conservative inputs. The judge criticized both experts for failing to provide relevant data to support their conclusions.In Ludwick, the court assumed that petitioners had a right to partition. The opinion did not mention whether a tenancy-in-common agreement existed. After the trial, however, an article authored by the taxpayers’ expert mentioned that a tenancy-in-common agreement existed and was properly entered into by the Ludwicks (Hoffman, “TAM 9336002 Bites Taxpayer”). According to the expert, the agreement contained provisions that “prohibited either co-tenant from seeking partition of any part of the property,” and it “specifically gave each co-tenant the right to sell their undivided interest to the other co-tenant at a pro-rata value of the whole or, alternatively, to sell the property in its entirety.”
If a tenancy-in-common agreement has restrictions such as waiver of the right to partition, no option to sell the undivided interest to the other co-tenant at a pro-rata value of the whole, or no right to sell the property in its entirety, a higher discount can be argued because of lack of marketability and control. The IRS then might conceivably argue that waiver of the right to partition must be ignored for valuation purposes under Sec. 2703.
Ludwick resulted in a significant 17.2% discount partly because there were substantial operating expenses ($350,000 per year). If the operating expenses had been lower, the discount could have been much lower.
To avoid the issues apparent in this case, appraisers should focus on providing persuasive and relevant data along with specifics to support their fractional interest discount conclusions. Ludwick provides a road map for calculating the fractional interest discount in the absence of credible comparable sales data. Appraisers should also be aware that the IRS could use a cost-to-partition approach to argue against fractional discounts greater than 15%. In the event that the IRS takes a cost-to-partition approach, appraisers should be ready with a detailed analysis of the costs of partition and the likelihood of partition based on the local law where the property is located. Since the discount rate is a key driver in the cost-to-partition approach, appraisers should quantify and support marketability and liquidity risks so that a higher discount rate (10% in this case) can be used.
Neal Weber is managing director-in-charge, Washington National Tax, with RSM McGladrey, Inc., in Washington, DC.
For additional information about these items, contact Mr. Weber at (202) 370-8213 or firstname.lastname@example.org.
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