Gifts With Tenant in Common Valuation Discounts

There is a lot of uncertainty these days that surround the ability of a  client to claim valuation discounts for transfers  in a family setting due to the IRS’s proposed IRC 2704 Regulations. Some commentators claim that these proposed valuation Regulations that greatly impact valuation discounts when entity interests [e.g. corporate stock, limited partnership interests, or LLC membership units] are transferred among family members are dead in the water with a Republican controlled Congress. Other commentators fear that some form of the 2704 valuation Regulations will nonetheless become finalized sometime this year. So what do we tell our clients while we wait to see what the IRS does with its proposed 2704 Regulations?

One strategy if the asset that might be transferred is real estate is for the client to transfer a fractional tenant in common interest in the real estate to other family members. Because a legal entity is not the subject of the transfer, the 2704 Regulations do not apply to the transfer. If the title to the real estate was held in an LLC or family limited partnership then the 2704 proposed Regulations would apply to essentially disallow valuation discounts for lack of marketability, and perhaps a lack of control. Not so if the subject of the gift is a tenant in common interest in the real estate.

Thus, it might make sense to pull title to the real estate from an LLC or partnership and transfer a fractional interest in the real estate and legitimately claim a valuation discount associated with that transfer.

The rights of an undivided tenant in common interest holder are derived from state law where the real property is located. One such right is the right to use the subject real property to the exact same level or  right as the other tenant in common interest holders. This right to use extends to every portion of the real property, at any time, and under any circumstances. Moreover, an investment in an undivided interest is not governed by the majority rule concept. Rather, each tenant in common interest holder possesses an equal voice in the property. Consequently, an individual who holds a 99% tenant in common interest in the real estate will not have any more rights than the individual who holds a 1 % tenant in common interest. As a result, there is a practical need for a unanimous consent at all times of the undivided interest holders in order to effectively operate the commonly owned real property. These state law rules all impact the value of the transferred fractional interest.

More to the point, the greater the number of undivided fractional interest holders (given the fact that they must all agree on management decisions) the greater the management challenges, and thus the greater the valuation discount applied to the transferred interest. Restated, because the right to use and possess the real property is unlimited and not based on the percent owned, any undivided fractional interest holder possesses a practical veto on the decisions of any other undivided interest holder. Consequently, the bargaining power of a relatively small tenant in common interest holder can be significant. All of these rights lead a hypothetical buyer to recognize that he/she is simply a passive investor who owns an illiquid investment.

Over the decades the IRS has applied different approaches to the valuation of a fractional interest in a parcel of real property. Initially the IRS was unsuccessful in arguing that family attribution rules should be applied to ignore valuation discounts when fractional interests  in property changed hands between family members. Rev Ruling 81-253. This argument was shot down in Propstra vs US (1981) where a 15 % valuation discount was allowed by the Court. Many estate planning attorneys often treat this a something of a magical rule that entitles a donor to an automatic 15% valuation discount applied to the transfer of any fractional interest, aka the Propstra  15% discount.

Then the IRS tried a different approach when it claimed that the only appropriate valuation would be the cost of a partition of the real property incurred in a legal proceeding brought by one of the fractional interest owners. Rev. Rul. 93-12. Normally the cost to partition a parcel might range from 4% to 6% of the value of the parcel that is partitioned. Again the IRS’ approach was shot down by the Tax Court in Estate of LeFrak (1993). The LeFrak Court held that the appraiser must also consider the cost, uncertainty and delays attendant upon partition proceedings as the basis to allow a fractional interest discount. The Court in LeFrak granted the estate a 30% valuation discount.

A few years later in Estate of Williams (1998) the Tax Court rejected the IRS’ sole use of the cost to partition  valuation approach. The Williams Court found that the cost of partition approach ‘does not give adequate weight to other reasons for discounting a fractional interest in real property, such as lack of control and the historic difficulty of selling an undivided fractional interest in real property.’ After its string of defeats in the Tax Court the IRS finally abandoned the cost of partition approach as the sole basis to value a fractional interest that is transferred. TAM 9994003.

Since Williams the Tax Court has had the occasion to identify a valuation discount for undivided fractional interests in 9 cases. The average valuation discount approved by the Tax Court was 29.4%, with a median discount of 26%. Limited market sales comparisons of fractional interests, the average valuation discount for a  fractional interest in real estate was 35%. For some raw land fractional interest sales, the median discount was 40.3% while for income producing real properties, the median discount was 29.7%.

The point in all of this is that these valuation discounts approved by the Tax Court and through comparative market sales of fractional interests in real estate all come close to the range of valuation discounts that have historically been applied to the transfer of limited partnership interests or LLC membership units. By eliminating the entity wrapper of the real property, a client can avoid the threat of the proposed 2704 Regulations and still obtain a respectable valuation discount associated with the transfer of a fractional interest in real estate. If the fractional interest owners decide to enter into a tenant in common or co-tenancy agreement, the owners should waive their legal right to partition the real property, which waiver will increase the valuation discount associated with the transfer of a fractional tenant in common interest even more.

This is just one way to avoid the proposed 2704 Regulations and continue with wealth shifting planning for families. Let me know if you have any questions.