Court Allows Significant Valuation Discounts for Undivided Interests in Real Estate
Over the last 20 years much of the focus of estate planning has been on the ability to discount assets -- that is, to value an interest in property for something less than the underlying net asset value of the property itself. Discounting has long been recognized in the context of family-owned operating businesses, where lack of marketability and lack of control can often result in discounts in the 35% - 45% range. Such discounts, however, may also be employed in certain non-business contexts, like family limited partnerships, where a partnership owns and manages a portfolio of marketable securities, and in the joint ownership of real estate.
For example, by holding real estate as tenants-in-common (as distinguished from a joint-tenancy with right of survivorship,) it may be possible for married couples to generate significant discounts. When a married couple equally shares an undivided interest in real estate as tenants-in-common, each spouse's interest will pass, at death, according to the terms of his or her will, as there is no "survivorship" feature in a tenancy-in-common. Because of this aspect, valuation discounts may be available for the separately held interests. Another benefit of dividing real estate in this manner is that certain married couples may realize substantial tax savings through maximizing each spouse's federal estate tax exemption.
A recent U.S. Tax Court decision, Ludwick v. Commissioner1, illustrates the extent to which valuation discounts may be applied to reduce taxes on gifts of undivided interests in real property between spouses. In Ludwick, a married couple established separate, individual Qualified Personal Residence Trusts ("QPRTs") as part of an estate planning strategy to limit their overall estate and gift tax exposure. A QPRT is a type of trust to which a grantor will contribute his or her residence and retain the right to live in the residence for a certain period. After the retained period expires, the remainder interest in the property will pass to the grantor's children (either outright or in trust). Under certain circumstances, however, a grantor might continue to live in the residence by paying market rent to the new owner. A QPRT can reduce future estate taxes because the value of the home (which is the subject of the gift) is reduced by the value of the grantor's retained interests. In addition, since the property is removed from the grantor's gross estate upon contribution to the trust, any appreciation in value after the date of contribution would also pass outside of the grantor's estate. The QPRT will only be successful if the grantor actually lives to the end of the retained term; if the grantor dies before the end of the term, the home will revert to the grantor's estate. The QPRT is thus a mortality gamble: the grantor will typically pick a term that he or she is likely to outlive.
The Ludwicks each transferred their separate one-half undivided interests in a Hawaiian vacation residence to their respective QPRTs. In calculating the gift tax due on the transaction, they each applied a valuation discount of 30% to their respective shares of the property to reflect the disadvantages associated with owning undivided fractional interests.
The IRS agreed that some discount should be available for lack of control and marketability of such an interest, but disagreed with the taxpayers about the appropriate size of the discount, claiming that it should be limited to the cost of petitioning a court for partition of the property. At trial the IRS argued for an 11% discount.
At the trial, both sides presented expert testimony regarding the amount of the discount. The Court found neither expert persuasive. One of the problems with supporting discounts in residential properties is the lack of sales data on which to base a discount; fractional interests in residences are simply not frequently sold. The Court ultimately settled on a discount of approximately 17% for the value of the undivided interests. Its conclusion was based on its estimate of the operating costs for the property (substantial in this case; $350,000 annually for a vacation home valued at $7.25 million), the costs of selling an interest, and the amount of time it would take to sell an interest.
Although here the taxpayers ultimately obtained a much lower discount than what they hoped for, a 17% over-all discount for a fractional interest in a residence is still quite substantial. For example, a residence worth $1,000,000 if held in joint tenancy could be lowered, for transfer tax purposes, to $830,000 (assuming a 17% discount) when held as a tenancy in common. This is an astounding result for such a simple and inexpensive action.
Even greater discounts may be appropriate for fractional interests in commercial real estate or income-producing residential property, where there is more data to support the reduction in value.
1 Ludwick v. Commissioner, T.C. Memo 2010-104