Appraisal Considerations for Undivided Interests in Real Property
Fractional (or undivided) interests in real property are common subjects of estate and gift planning.
Since they are typically transferred at a value that incorporates a discount from a pro-rata share of the property's total value to reflect a lack of control and marketability, these transactions are often challenged by Internal Revenue Service (IRS), as evidenced by the recent Ludwick1 case. This article discusses the steps that should be taken when planning to transfer undivided interests as part of any estate or gift planning program.
An undivided interest is a direct fractional interest in real property. Unless there is an operating agreement in place that dictates the respective owners’ rights and restrictions, state law generally governs owners’ rights (e.g., the right to occupy, use, operate and lease the property).
The reason that undivided interests typically sell at a discount relates to an owner’s difficulty in selling its interest and an inability to sell the property without the other owners’ consent. A buyer of an undivided interest lacks the ability to solely control the property and, as a result, typically faces the following impediments:
- an inability to obtain normal bank financing to purchase the interest;
- potential disagreement with co-owners related to the extent of repairs and maintenance;
- potential disagreement with co-owners regarding the sale or leasing of the property; and
- potential disagreement with co-owners that could lead to a lengthy and costly judicial partition.
When transferring undivided interests as part of a taxable transaction, it is critical that proper planning be performed and a qualified appraisal be prepared by a qualified appraiser2 as of the date the transaction is consummated. If the asset is being gifted, the taxpayer is required to attach the appraisal to the gift tax return and disclose that there is a valuation discount. If the asset is being donated to charity, then the appraisal must be attached to the individual income tax return if the value is greater than $5,000.
When preparing to transfer an undivided interest, many taxpayers consult with an attorney and draft an operating agreement (often referred to as a "tenancy in common" agreement). A properly prepared operating agreement serves to clearly define owners' rights and restrictions. Clauses can include mechanisms to settle disputes and remove the legal right to partition. The removal of owners’ rights can result in a reduction in the value of the undivided interest. A competent attorney can assist the taxpayer with understanding the benefits stipulated in the agreement and properly prepare a clear and concise document.
In addition to meeting the qualified appraisal requirement, it is important that the appraisal report carefully consider the specific facts and circumstances. The report should provide details regarding the nature of the real property and clearly detail the rights and restrictions associated with the undivided interest, including the terms and conditions associated with any operating agreement. The report should also detail how the various approaches to value were considered and how the underlying assumptions were developed and supported. The following three approaches are commonly considered and reconciled to reach the ultimate conclusion.
Transaction Analysis: This method involves examining historical sales of undivided interests that have been reported through various studies. As part of this analysis, the individual transactions are examined and compared to the subject interest and relevant adjustments are made to reflect differences. From an IRS review perspective, it is critical that the type of property, age of the transaction, relationship of the parties involved and transaction terms be carefully considered.
Real Estate Partnership Analysis: This method involves examining the combined adjustment for both lack of control and marketability observed in historical transactions involving minority interests in Real Estate Limited Partnerships (RELPs). When preparing a defensible appraisal, it is critical that each transaction be compared and contrasted with the subject interest and adjustments be made for the type of assets, holding period, reputation and experience of management, level of control, sales restrictions, stability of cash distributions, profitability of the property, and leverage of the property, among other factors.
Partition Cost Analysis: This method estimates the total economic costs to partition and sell a property (as well as the feasibility of partitioning a property). From an IRS review perspective, it is important to properly value the underlying property and support assumptions, which include careful consideration of appreciation rates, years to partition, cost to partition, cash flows during the partition period and the applicable discount rate.
In the Ludwig case the Court concluded a discount of 17% but discounts can often far exceed this amount. However, it should be noted that this case had a unique set of facts. While there was a section of the tenancy in common agreement that prohibited either co-tenant from seeking a partition, another section specifically gave each co-tenant the right to sell his/her undivided interest to the other co-tenant at a pro rata value or to sell the entire property. The Court appears to have equated this provision as an absolute right to force a quick judicial partition of the property thereby significantly mitigating the discount.
In conclusion, the taxpayer should be prepared to have IRS challenge his/her appraisal. It is important that a qualified appraisal report be obtained that clearly describes the underlying property and the subject interest, including rights and restrictions. Furthermore, if an operating agreement is used, it is critical that it be clearly drafted.
1Ludwick v. Commissioner, Case No. 3281-08, 3282-08, U.S. Tax Ct., May 10, 2010
2Both terms are defined in Internal Revenue Code 170(f)(11) and dictate what minimum information needs to be included in a Qualified Appraisal report and the minimum experience and educational requirements for a Qualified Appraiser.