Take-Away: As we approach the end of the calendar year, at a time when end-of-the-year gifts might play a more prominent role than in years past, a gift of a fractional interest in real estate with substantial valuation discounts should be considered by the donor.

Background: As has been reported over the past 2 months (or more) this might be a critical time for clients to engage in significant estate planning, not only to exploit the historically low interest rates, but also in anticipation that there may be dramatic transfer tax law changes coming in 2021. Clients, with good reason, are always reluctant to gift income producing assets. One non-income producing asset that a client might consider gifting before 2020 comes to a close is a fractional interest in their residence or a second home like a cottage. It is possible that valuation discounts associated with the transfer of fractional interests might disappear in the coming years if there is a change in the Tax Code.

Caution: What follows is a discussion of exploiting a gift of a fractional interest, i.e. a tenant-in-common interest, in real estate in Michigan. What it does not address, but cannot be overlooked, is the possibility of the uncapping of a parcel’s taxable value on its transfer. While normally the transfer of title to real estate among family members often does not result in an uncapping of the real property’s taxable value, caution always needs to be taken, as Michigan’s Property Tax Act uncapping rules are bizarre at best, and seemingly riddled with illogical conclusions.

Sampling of Valuation Discounts: The U.S. Tax Court has long recognized and allowed the use of valuation discounts when it determines the fair market value of fractional interests in real property. A fractional discount will be allowed if a tenant-in-common interest in residential real estate is transferred for purposes of determining the value for gift tax purposes. While the IRS has regularly argued that the discount available for a transfer of a tenant-in-common interest was limited to the cost of a legal partition action [Technical Advice Memo, 9336002] the Tax Court has repeatedly found that more is involved in ascertaining the value of a fractional interest than just the cost of pursuing a legal partition of the real estate.

  • In LeFrak v. Commissioner, Tax Court Memo, 1993-520 (1993), the Court allowed a 20% minority interest and a 10% lack of marketability discount for gifts to the donor’s children of less than 10% tenant-in-common interests to each child in apartment and office buildings (30% aggregate discount).
  • In  Estate of Brocato v. Commissioner, Tax Court Memo, 1999-424 (1999) the Court allowed a 20% valuation discount on a 50% tenant-in-common interest in multi-family residential properties, even mentioning that other factors besides lack of control and lack of marketability, including blockage and forced-sale discount factors should be considered.
  • In Estate of Forbes v. Commissioner,  81 Tax Court Memo 1399 (2001) the Court allowed a 30% valuation discount for fractional tenant-in-common interests, noting that there are limited buyers for undivided interests in a single parcel of real estate, and also the possibility of conflicts among the multiple owners, all of whom were family members.
  • In Ludwick v.Commissioner, Tax Court Memo, 2010-104 (2010), the Court was less generous finding a 17.2% valuation discount with regard to the transfer of 50% tenant-in-common interests in a Hawaiian vacation resident that was contributed to a qualified personal residence trust. The lower valuation discount was attributed, in part, to the Court weighing the likelihood of a sale of the residence without the need for a legal partition action.
  • In Estate of Mitchell, Tax Court Memo, 2011-94 (2011) the IRS stipulated to the following fractional discounts in a beachfront parcel and a ranch: (i) 32% discount for the 5% gifted interest in the beachfront property; (19% discount for the retained 95% retained interest held by the decedent at the time of death; (iii) 40% discount for the 5% gifted interest in the ranch property, and 35% valuation discount for the 95% retained interest held by the decedent at death.

There was even a 60% valuation discount allowed in one older case, Van Loben Sels v Commissioner, Tax Court Memo (1986).