There are two kinds of fractional interests in real property: direct or indirect ownership interests. The difference is whether or not there is an intervening entity. A shareholder in a Real Estate Investment Trust (REIT) is an indirect owner of real property, as is the shareholder in a real property closed-end fund or a partner in a real property partnership. On the other hand, the owner of an undivided interest in real property has no intervening entity. The purpose of this article is to discuss the valuation of undivided interests in the real property itself and specifically the discounts that are applicable to that valuation.

 

Basis of  Valuation: Net Asset Value (NAV)

Since there is no intervening entity, it is logical that the basis of a valuation of an undivided interest in real property should be the net asset value of 100% of that real property. In the Van Loben Sels Tax Court case (see Appendix A), the Court stated, "...where the amount to be included in an estate is the value of the decedent's undivided interest in real property, such value is to be determined by reference to the value of the fee. Furthermore, the preferred method of determining the value of the fee is the use of comparable sales." Numerous other court cases base their findings on the net asset value of 100% of the real property, although they do not discuss that factor as specifically as Van Loben Sels.

An interesting sidelight to the valuation issue is: what experts should be retained to perform these valuations, particularly the discounts from net asset value? Most business valuation professionals are not qualified to value the underlying real property. Therefore, the value of those assets must be based on a well-prepared real property appraisal. Some real property appraisers are qualified (and comfortable) in determining and justifying discounts from net asset values, but many are not. As a result, it is generally necessary to hire a real property appraiser to value the underlying real property and a business valuation professional to provide any appropriate discounts.

 

Discounts Applicable To Real Property Fractional Interests

In general, discounts from the pro rata net asset values of undivided real property interests have two causes: impediments to control and lack of marketability. For a fractional interest in real property, the impediments to control are similar to those found in a corporation or a partnership; that is, any impediments to the unfettered ability to control the use of the assets or the cash flows from the assets. The discount for lack of marketability reflects the time and the cost to convert the interest to cash.

Occasionally, someone argues that undivided interests in real property are marketable and require no discount. We know of no published and documented facts that support the argument, nor have we been able to find arms-length transactions that can be used as comparable sales. On the other hand, we have interviewed executives of two national pulp and paper companies who will not buy, and have not bought, an undivided interest of any kind; bankers who state that they will not loan for such purchases; and even an I.R.S. forester who wrote (regarding one specific case) that he could find no sales of undivided interests.

Discounts applied to the net asset value of undivided real property interests often have been derived from evidence in publicly traded stocks. But, unlike a corporate share holding, the owner of a fractional interest in real property has the ability to seek partition, and therefore control, of his proportional share of ownership. As a consequence, the Internal Revenue Service has often taken the position that no discounts (or only minor discounts) are acceptable or required. The Courts have seldom agreed and have often allowed discounts in a range of 10% to 20% from net asset value. In the LeFrak case (see Appendix A), the Tax Court recites a number of occasions on which it has allowed discounts saying, "We have on several occasions considered the cost, uncertainty, and delays attendant upon partition proceedings as the basis for allowing a discount in valuing fractional interests in real property." Thus, there is little doubt either as a practical matter or based on previous court decisions that some discounts from 100% of the net asset value are required.

 

TAM 9336002

In September 1993, the Internal Revenue Service issued Tax Advisory Memorandum 9336002 concerning an appropriate discount for a 50% undivided interest in a property. The TAM said, "The amount of any discount should be limited to the petitioner's share of the estimated cost of a partition of the property." Prior to this time, most Tax Court decisions dealing with undivided real property interests were strongly influenced by studies of discounts on corporate minority interests and their lack of marketability. In 1994 one valuation professional wrote that TAM 9336002 spelled the end of discounts for undivided real property interests. He believed that basing discounts on partition costs would result in much lower discounts.

I disagree. In fact, the IRS position seems reasonable to me. Partition is a power that a minority owner of a REIT or real property limited partnership does not have. However, it is important to recognize that costs to partition can be significantly higher than the 10% to 20% often allowed by the courts. In addition, a modest discount for lack of marketability is sometimes applicable.

The following chart is an example of the kind of "decision tree" that the hypothetical willing buyer of an undivided real property interest would employ, consciously or unconsciously, in calculating his potential costs to partition. We utilized this particular decision tree in determining the partition costs for a piece of timberland of substantial size. The tree highlights the fact that the partition suit is usually the end of a process, not the beginning. Very likely, prior to the filing of a partition suit, there will have been negotiations and investigations of an out-of-court sale of the undivided interest. Only when these have become fruitless will the added expenses of a partition suit become acceptable. The decision tree illustrates that gaining control and marketability for an undivided interest is a process in which time is the most important cost.

 

The Partitioning Process

It is in the economic self interest of a hypothetical buyer of an undivided interest in real property to consider what his "escape" costs would be if he and his co-owners disagreed about asset or cash flow utilization or if he simply needed cash. He would consider what his costs would be for a partition action. More to the point, a potential buyer would want to estimate the maximum probable cost to partition based on the facts surrounding the particular interest. Obviously, an outcome that was short of the maximum probable cost would be advantageous to all parties.

A major element in determining costs to partition is a careful study of the real property appraisal. Often the real property appraisal will provide key facts that influence the discounts, such as zoning, present and future property uses, and so forth. The real property appraisal may indicate whether or not the property is capable of being partitioned, and if so, how difficult and complex that process may be. Further discussions with the real property appraiser and/or the present owners often shed additional light on that subject. Other experts such as agricultural or forestry experts, or developers might be contacted for their opinions if those types of lands are involved. In Estate of Wildman v. Commissioner (see Appendix A), the Tax Court awarded an additional 10% discount to one of the parties whose land had no irrigation facilities. Therefore, a detailed knowledge of the real property is important.

Often the real property appraisal will help determine expenses of partitioning. In this manner, in various appraisals we have determined that if a specific parcel were to be partitioned additional infrastructure would be required, such as roads or fences; permits would have to be redrawn; and so forth. Where some orange groves were involved, we learned that several additional water wells would have to be dug if the groves were to be divided.

A real property appraisal might reveal whether the complexity of the properties is such that new surveys would have to be made or certain other professional services required. In one substantial size timber holding, a partition action would have required a timber cruise of all the properties, which would have taken 12 months and cost approximately $100,000. A second element that is important to analyze in detail is the number of owners; the sizes of their interests; and the history of ownership. As the IRS Valuation Guide for Income, Estate and Gift Taxes (Commerce Clearing House, 1994, p. 9-23) points out, "...the smaller the (fractional) interest, the larger the discount;" for example, where the small interest makes the land harder to divide equitably and/or less valuable after division.

Often, the history of ownership will indicate other facts and circumstances which would clearly influence the time and cost involved in a partition suit. For example, in one appraisal of a series of undivided real property interests, we learned that "there is a great deal of enmity between the two sides of the family. It has caused a stalemate... Documents show that XYZ, Jr. sued the estate of his father... that there were lengthy discussions of attempts to liquidate (one company) and to partition the properties..."; and despite purchase offers on several of the properties in recent years, none had been sold because two members of the family demanded higher than their pro rata shares of the selling price for their approval. Obviously, the conclusion from knowledge of the past history of the owners in this real property indicates a high likelihood that a partition suit would be bitterly contested and would require a lengthy and expensive court battle.

Another reason to study the background of the owners and their histories together is to determine whether their investment objectives have been similar in the past and whether the historical use of the land has been harmonious and in a direction that maximizes its cash flow. For example, in one assignment we observed some scruffy-looking, mixed variety timberland belonging to our client. It was adjacent to a well cultivated, single species stand of much larger timber owned by a national company. The difference was obvious even to an untrained observer. On inquiring we learned that one of the co-owners of our client would not make the investment to properly cultivate a timber crop. Obviously, this reduced the value of all owners' interests.

It is clear that the two major factors in determining the cost to partition are the time required for each element of the process (not simply the court time) and the legal and other expenses involved during that time. In earlier years, as our company developed its knowledge of costs to partition, we polled a number of attorneys to determine a realistic range of time and cost to partition property. Obviously, both the time and the cost are determined by whether or not the suit is uncontested, contested, or some degree between the two. The consensus of the attorneys was that an uncontested suit, with only minor disagreements among the parties, would cost $10,000 to $15,000 for each party and would require six months to 12 months of time. Where significant disagreements existed among the parties and where lengthy negotiations and the use of additional professionals were required, the costs and time could be much greater. The attorneys "guesstimated" that reasonable ranges for a contested suit might be a $30,000 to $50,000 cost for each party and around three years' time.

In more recent years, in an attempt to pin down more precisely the times involved, our firm has reviewed thousands of civil court records in two Florida counties and analyzed 158 partition suits that were closed between 1978 and 1994. As might be expected, in the majority of cases, the total dollar property values involved were small and the property was basically indivisible, such as a single family residence or a small office building. The time measured was from entry of the case until final judgment. No time for appeals was included. The results of the study are:

 

	Property Type
	Residential	Non-Residential
Number of cases in sample	104	54
Average time	15 Months	17 Months
Median Time	15 Months	12 Months
Mode	15 Months	3 Months
	(13 Occurrences)	(7 Occurrences)
Range of:
Lower Quartile	1 Month to 7 Months	2 Months to 6 Months
Time Span	6 Months	4 Months
Middle 50%	8 Months to 19 Months	6 Months to 22 Months
Time Span	11 Months	16 Months
Upper Quartile	20 Months to 50 Months	23 Months to 66 Months
Time Span	30 Months	43 Months

           

Based on the averages and medians of both property groups, there is not much difference in the time involved between the types of property. Even the time spans of the lower quartile and middle 50% are quite similar. However, the statistical measures of variance and standard deviation indicate that the data in the sample sets is skewed. Simple observation of the ranges of time in the upper quartile shows why the statistical measures indicate such a large spread in the data: The time span is wide, 30 months and 43 months. From a valuation pint of view, the skewed results indicate the high degree of risk (in length of time) involved with pursuing the legal right to partition. Clearly, it is very possible that the time involved could extend over a period of several years. Although no direct comparability is possible from the studies of court cases, we have been able to identify specific cases that provided useful guidelines for the determination of particular discounts for appraisals that we were performing.

A detailed analysis of out-of pocket expenses must also be made. One of the larger expenses, of course, is attorneys' fees, which can only be estimated roughly. A generalized and simplistic rule of thumb might be $10,000 per year of court time for each party, although in more complex cases that could be grossly inadequate. Originally, we developed this amount based on several conversations with attorneys. Interestingly, the court cases we researched occasionally awarded attorneys fees, and the awards were often in the range of $10,000 per year of court time as well.

The Tax Court case Gunn v. Commissioner provides interesting detail on time and costs for a divorce-related sale of a 50% undivided interest in a non-partitionable property. The divorce decree was granted in January 1960, and the final "order for sale" was entered in October 1961, 21 months later. Total fees awarded were $41,500 for three attorneys, a referee, a receiver, and an appraiser. Inflating that $41,500 by the growth of the consumer price index since 1961 results in a 1995 equivalent amount of $212,700! This expense is equivalent to a cost (for each of two parties) of about $61,000 per year of court time.

It is often possible to estimate other expenses more accurately. Once other requirements or results of a partition action have been determined, such as surveys, timber cruises, or additional infrastructure, professionals in those fields can estimate time and costs rather accurately when they are provided knowledge of the properties.

An often overlooked fact is that, while a partition suit is progressing, there are likely to be ongoing expenses for maintaining the property. They also must be included in the costs to partition.

Naturally, all costs should be calendarized as much as possible; that is, the costs should be assigned to the years, quarters, or months in which they most likely would occur.

Finally, a discount rate must be determined through which the value of the cash tied up during the partition suit and the calendarized expenses during that period can be reduced to their present value. The determination of an appropriate discount rate is a subjective decision and is itself the subject of argument among practitioners. We think that often the appropriate rate is the weighted average cost of capital of investors in real property, which in recent years has been in the 11% to 12% range. However, it is important that the discount rate be specific to the property being appraised and that it be well justified in the written report. It is no longer acceptable practice to justify a discount rate by "Our experience is..."

Discounting the forecasted total future expenses to present value results in the dollar amount of the discount. It is important to remember that the process of making marketable an undivided interest in real property begins before a partition suit is filed. The suit is the final step in a process. The suit ultimately results in the owner of the undivided interest having a marketable interest equal in value to some percentage of net asset value. The discount reflects the time and cost necessary to accomplish that end. The magnitude of the discounted present value of the marketable interest alone (before consideration of any expenses incurred along the way) can be understood by assuming a discount rate of 11% and using a standard present value table:

 

Present Value of One Dollar		Discount
Due At The End of Each Year		Implied
@ 11% Discount Rate (Rounded)		(Rounded)
Year 1	$0.901	10%
Year 2	$0.812	19%
Year 3	$0.731	27%
Year 4	$0.659	34%
Year 5	$0.593	41%

 

Our experience using the cost to partition valuation approach is that overall discounts from net asset value will be from 10% to 20% for even the simplest partition suit and from 30% to 35% or more on larger, more complex suits and/or larger properties. Based on the amount of detailed and specific valuation work required to arrive at and justify a credible conclusion, it should be obvious that significant valuation fees are involved as well.

Finally, if it appears that the lands are physically partitionable, and the appraiser's costs of partition are based on that decision, then a further discount for lack of marketability may be appropriate, because ownership of the real property still must be turned into cash. In this regard, the detailed study of the real estate appraisal again becomes important in order to determine the appraiser's assumptions about the marketability of the property. In many cases, the real property appraiser assumes that the parcels can legally and practically be sold on the valuation date. Therefore, no additional time could be forecast. However, most real property appraisals do not include the costs of the sale, which could run from 5% to 10% depending on the nature of the properties involved. It is clear that the Internal Revenue Service's position is that the costs of sale are not includable as expenses. It is not so clear what the rationale is for that position. In appropriate cases, we believe that selling costs really are the cost of marketability and that a percentage reduction is applicable to the net value remaining after application of the cost to partition discount.

 

Case Law Precedents

We have examined a number of Tax Court cases involving undivided real property interests in order to determine what guidance they provide on valuation issues. Eleven of those cases are listed in Appendix A. Our general conclusions are:

a) Other than providing some general guidelines on factors which must be considered, the court decisions are heavily based on particular facts and circumstances.

b) The Courts found justification for discounts from net asset value in every case, with discounts ranging from 14% to 60%. However, the Court was careful to point out in LeFrak that, "...as the question is one of fact, we must remind the parties that the amount of discount must be decided on the basis of the record in the instant case, and not on what a court found reasonable in another case involving different evidence."

c) There was a uniform lack of differentiation between the various elements of the discounts. In most cases, the courts mentioned reasons for discounts, including lack of management control, delay in cash flows, lack of marketability of the interest, potential partition expenses, and other reasons, but did not assign weights to the factors and, therefore, came up with a single number for an overall discount which included all of these factors. From the point of view of a valuation professional, there is considerable confusion among the various courts about the factors which impair value and the relative importance of the factors; although in truth, many of the cases point out shoddy valuation work by the experts and, too often, pathetic justification of the experts' conclusions.

d) Some key factors that have been considered by the Court in determining discounts are:
1. The appropriateness of the real property appraisals, their valuation methodologies, their capitalization rates and so forth.
 2. Comparable sales of undivided interests, if available. (In most cases, they are not.)
3. The number of other co-owners of the properties.
4. The time required to realize an income from the properties or to achieve return on the investment.
5. The time and cost to partition.
6. Lack of management.
7. Lack of "liquidity."

e) None of the cases specifically considered the position of the Internal Revenue Service in TAM 9336002. Therefore, that issue has not yet been decided. However, in LeFrak, the Court stated "We have on several occasions considered the cost, uncertainty, and delays attendant upon partition proceedings as the basis for allowing a discount..."

f) It is clear that careful investigation and justification of the discounts results in generally higher levels of discounts. In several cases the Court chided the experts and attorneys for advocating discounts with little or no reasoning or justification.

 

Conclusion

Historical Tax Court decisions often have allowed some discounts from pro rata shares of net asset value for undivided real property interests. I.R.S.'s TAM 9336002 suggests that the amount of discount should be the cost to partition. Careful examination of the partitioning process, and particularly the time required, demands substantial discounts from net asset value, as the cost to partition is often under-estimated. The hypothetical willing buyer of an undivided interest must consider the substantial time and costs that could be required to gain control of the cash flow and to make the interest marketable.

 

Appendix A

Campanari v. Commissioner, 5 TC 488 (1945)

Interest:	Decedent at her death owned undivided 1/3 interests in 5 parcels of real property in New York City.
Discount:	12 1/2%.
Issues Raised Regarding the Amount of Discount:
	Both the lack of control associated with a minority interest and the lack of marketability of a fractional property interest are mentioned but not differentiated in the discount.

 

Fawcett v. Commissioner, 64 TC 889 (1975)

Interest:	50% undivided interest in a ranch.
Discount:	Some but amount unclear.
Issues Raised Regarding the Amount of Discount:
	Court agrees with a "reduction to reflect the undivided nature of the decedent's interest," but mixes the total discount in with a number of other factors. Recognizes the appearance of control despite the formal ownership.

 

 Gunn v. Commissioner, 49 TC 38 (1967)

Interest:	Two 50% undivided interests in an apartment building owned by four people (two married couples). Upon divorce the court awarded husband and wife a 25% undivided interest each. Property could not be partitioned and a sale of the property is ordered by the court.
Discount:	Not applicable

 

Cervin v. Commissioner, TCM 1994-550

Interest:	50% undivided interest in two parcels of real property: a 657 acre farm, and a homestead in Texas.
Discount:	20%.
Issues Raised Regarding the Amount of Discount:
	The lack of control associated with a minority interest. The lack of marketability of a fractional property interest. The difficulty of obtaining mortgage financing for the purchase. The lack of comparable market transactions. State law regarding the parties' share of partition costs. Zoning restrictions, if any; and the possibility of using the land for other purposes. Partition would involve "substantial legal costs, appraisal fees and delay."

  

LeFrak v. Commissioner, TCM 1993-526 (66 TCM 1297)

Interest:	Gifts of interests in 22 buildings in New York City.
Discount:	20% for minority interest; 10% for lack of marketability.
Issues Raised Regarding the Amount of Discount:
	Judge tries to differentiate between the discounts noting that the fractional interest discount is based on "the cost, uncertainty and delays attendant upon partition proceedings..." Finally, considers each discount separately. Taxpayer claim of 40% minority discount not allowed partially because shareholders of the public companies used (REITs and closed-end funds) do not have the ability to compel partition; i.e., they are not comparable. The 10% discount for the lack of marketability is allowed for no clear reason.

  

Mooneyham v. Commissioner, TCM 1991-178 (61 TCM 2445)

Interest:	Gift of 50% undivided interest in real property.
Discount:	15%.
Issues Raised Regarding the Amount of Discount:
	No distinction among minority ownership position, lack of marketability of interest, or costs of partition, although all these factors are mentioned as being present. Judge strongly criticizes both the attorneys and experts for presenting very poor substantiation of their arguments for discounts. This case is cited in TAM 9449001.

  

Pillsbury v. Commissioner, TCM 1992-425 (64 TCM 284)

Interest:	Decedent owned a 77% undivided interest in one piece of real property and a 50% undivided interest in another.
Discount:	15% on each.
Issues Raised Regarding the Amount of Discount:
	Both the lack of control associated with a minority interest and the lack of marketability of a fractional property interest are mentioned, but not differentiated in the discount. Court refused to allow a discount higher than that claimed on the estate tax return (15%).

  

Van Loben Sels v. Commissioner, TCM 1986-501 (52 TCM 731)

Interest:	Decedent owned undivided interests in California in: Certain real property; land, timber and mineral rights.
Discount:	60%.
Issues Raised Regarding the Amount of Discount:
	A minority interest discount is applicable to a minority undivided interest in real property just as in a closely-held business. Court settled on a 60% minority discount, but admitted to heavy emphasis on the lack of marketability of the undivided interests. The judge provides a list of the "disabilities" of an undivided interest: 1) Number of other co-owners. 2) Time required to realize income from the land     (use) and return on the investment. 3) Time and cost to partition. 4) Prior sale of undivided interest (the estimated discount on that sale). Case also addresses a blockage or absorption discount. It notes that comparable sales showed no significant differences between prices in small sales and prices in large sales (big tracts).

 

Whitehead v. Commissioner, TCM 1974-53 (33 TCM 253)

Interest:	50% undivided interest in ranch.
Discount:	14%.
Issues Raised Regarding the Amount of Discount:
	1) Lack of access to the property (a road); and 2) Impairment due to an undivided interest. Weight of the two factors in the discount not differentiated.

 

Wildman v. Commissioner, TCM 1989-667 (58 TCM 1006)

Interest:	20% undivided interests in non-contiguous parcels of irrigated farm land.
Discount:	40%.
Issues Raised Regarding the Amount of Discount:
	Total discount of 40% comprised of: 15% for costs to partition or sell; 10% for lack of ownership or irrigation facilities; 15% for the restrictions on sale or transfer.

 

Youle v. Commissioner, TCM 1989-138 (58 TCM 1594)

Interest:	Decedent owned a 1/2 interest in Illinois farm land with eight others holding the other 50%.
Discount:	12.5%.
Issues Raised Regarding the Amount of Discount:
	Problems associated with ownership and management of tenancies in common. How many people are involved? What kinds of decisions are made and how have they been made in the past? The discussion of partition includes: the costs involved; the possibility of or difficulty of partitioning (time and cost); and, the importance of State partition law.