Tax Court Memo 2010-104: A New IRS Tool for Valuing Gifts of Undivided Interests in Real Property

Tax Court Memo 2010-104: A New IRS Tool for Valuing Gifts of Undivided Interests in Real Property

A recent Tax Court decision has caught the attention of estate planners and appraisers because of its implications for gifts of undivided interests in real property.  The case at issue is Ludwick v. Comm'r, T.C. Memo 2010-104 (May 10, 2010).  In Ludwick, the court determined that the value of a married couple's respective one-half interests in a vacation home they owned as tenants-in-common and transferred to separate qualified personal residence trusts ("QPRTs") should be discounted at a substantially lower rate than had been used to calculate the value of the interests on the couple's gift tax returns.  This case illustrates the difficulties in valuing gifts like this, and it gives the IRS a new tool in the audit and settlement of cases where valuation of an undivided interest is a contested issue.

The facts are as follows.  In 2000, the Ludwicks purchased unimproved real property in Hawaii.  By 2003 they had constructed an 8000-square foot vacation home.  In December 2004 they established separate QPRTs, and in February 2005 they transferred their respective undivided one-half ownership interests to their respective QPRTs.  At that time the property had a fair market value of $7.25 million and annual operating costs of approximately $350,000.  On their 2005 gift tax returns each spouse reported a gift of $2,537,500, reflecting a 30% discount for lack of control and lack of marketability.  On audit, the IRS allowed a discount of only 15% and assessed a deficiency, which led to the Tax Court action.  At trial the taxpayers' expert concluded that a 35% discount should apply, while the IRS expert testified in favor of an 11% discount.  The court rejected both experts' testimony and determined - using its own formula - that a discount of 17% was appropriate.

A key element influencing this decision was the tenancy-in-common ("TIC") agreement between husband and wife.1  As described in an article authored by the taxpayers' expert after trial,2 the TIC agreement was properly executed and contained standard provisions, but included two sections that directly impacted valuation and that are not typically found in the same agreement.  One section prohibited either co-tenant from seeking a partition of any part of the property, but another section gave each tenant the right to sell its undivided interest to the other co-tenant at a pro rata value of the whole or, alternatively, to sell the property in its entirety.  Not surprisingly, the taxpayers' expert argued that the provision prohibiting partition took precedence over the forced sale provision, and the IRS expert argued the opposite.  The taxpayers' expert states the following about what occurred at trial on this point:  "With minimal discussion about the TIC Agreement at the onset of trial, the parties agreed that a forced sale was indeed possible under the TIC Agreement.  With no further discussion of the TIC Agreement, Judge Halpern appears to have equated the forced sale provision to a partition right, thereby giving each co-tenant the unrestricted right to force a judicial partition of the property."3

There is ample authority that restrictions in a TIC agreement (such as the waiver of the right to partition) support significant discounts - often well in excess of 35% - because of their effect on marketability and control.  But the opinion focused primarily on a partition analysis in determining the value of the gifts.  Another important factor in this case is that Judge Halpern found both experts' testimony woefully insufficient.  This created a vacuum to which Judge Halpern responded with a formula.  He determined how to apply the formula to the facts, using some of the experts' data but developing his own as well.  The result was a formula that started with the fair market value of the property, then applied factors such as (1) a buyer's expectation of a 10% rate of return (discount rate), (2) a projected partition period of two years (including a selling period of one year), (3) operating costs of $175,000 per year, (4) partition costs of $36,250 per year, and (5) one-half of the projected selling costs.  The calculation was further refined to take into account Judge Halpern's determination that there was only a 10% probability that partition would be required, to produce a weighted average.    

This case is distinctive in the degree to which the court provided a well-expressed formula by which to determine the value of the gift, making several assumptions necessary to the computation.  The formula and its detailed application - and of course the government-friendly result - are what will make this case so useful to the IRS in future disputes.  As such it is a lesson to estate planners, both when structuring transactions and later when defending them. 

(a)        Structuring:  No issues appear to have been raised with how the transaction was structured, other than the use of apparently inconsistent clauses in the TIC agreement.  On the one hand the parties agreed to waive their rights of partition, but on the other they agreed that either could force a sale of the property.  According to the taxpayers' expert, the court seems to have viewed the mechanism allowing either investor to force a sale as "providing a virtually risk-free liquidity option" 4 for that investor.  However, in the expert's view, the court gave no consideration to the fact that under either scenario (being able to force a partition, or force a sale) the investors would  "give up their ability to enjoy the amenities of a luxury vacation home without the ability to replicate the existing benefits at one-half the cost; reason that could significantly increase the likelihood of a vigorously contested process."5 

(b)        Defending:  Judge Halpern criticized both experts for failing to provide enough relevant data to support their conclusions.  He faulted the taxpayers' expert for the following:  (1) analyzing discounts in 69 undivided interest transactions but failing to include information about the underlying fair market value or comparables of the properties in those transactions, and the standard of deviation among them, and (2) using income-producing properties (and cashflow data) as comparables, when the property at issue was not a revenue-producing property.6  Judge Halpern also criticized the IRS expert for:  (1) using sales of commercial properties in the eastern United States as comparables, (2) relying on surveys from California real property brokers but no underlying data about the transactions upon which the brokers based their responses, (3) using surveys regarding pooled public TIC interests, which the expert himself even conceded were critically different from the property at issue, and (4) relying on a review of tender offers for majority interests in public companies, and control premiums, which the court dismissed as "unhelpful."

The respective experts' input was unhelpful to their cases in the following additional  ways:

(1) The taxpayers' expert failed to convince the court that a buyer would consider more than just the cost of partition and the marketability risk; in fact, the opinion quotes some of his trial testimony that seems to have conceded the IRS viewpoint.  The court reasoned from this that "a buyer with a right to partition could not demand a discount greater than (1) the discount reflecting the cost and likelihood of partition and (2) the discount representing the marketability risk because, if he did, another (rational) buyer would be willing to bid more.  That iterative process would drive the discount down to the discount reflecting the expected cost of partition and the marketability risk."7 

(2) The taxpayers' expert and the IRS expert provided differing estimates on the costs of a contested partition.  The court adopted neither, instead finding that a contested partition would take two years to resolve (including one year to sell the property) and that the costs made necessary by the litigation would be 1% of the value of the property.  If the taxpayers had been able to prove higher costs of a partition action, the value of the gifts might have been reduced.

(3) The taxpayers did not meet their burden of proof to show that partition would always, or even often, be necessary.  In fact, when IRS counsel suggested that partition was "relatively unlikely," the court notes that the taxpayers' expert seemed to agree.8  From this testimony the court determined that a buyer would expect partition to be necessary only 10% of the time.  If the taxpayers had been able to prove a higher likelihood of partition, the probability rate used in the court's calculation would have reduced the value of the gifts.

(4) The taxpayers' expert and the IRS expert provided differing estimates of the cost of selling the property.  The court chose neither, finding that the selling cost would be 6% of the value of the property.  With the right facts it might be possible to project a higher selling cost, thereby decreasing the value of the gifts. 

(5) The IRS expert testified that a buyer would demand a 10% rate of return to account for the marketability risk; the taxpayers' expert testified that a buyer would demand a return of 30%.  The court stated that the taxpayers' expert presented no evidence to support his conclusion, and therefore the taxpayers failed to meet their burden of proof that anything greater than a 10% rate of return would be expected.  Again, if the taxpayers' expert had been able to produce credible data to support a higher expected rate of return, this might have reduced the value of the gifts.

Working through the elements of Judge Halpern's formula, it is clear that if the taxpayers had been able to meet their burden of proof as to various elements of the court's formula, the computation would have changed and the taxpayers might have enjoyed an overall discount greater than 17% on the value of their respective gifts.  This makes it difficult to predict how Ludwick will apply in cases with different facts, but certainly it provides a framework for how other valuation cases might be analyzed.

Commentators have noted that it is not clear in the Ludwick case whether the result of focusing on the relatively minor costs associated with an uncontested sale of the property is a consequence of the TIC agreement at issue, or a new line of thinking put forth by Judge Halpern for any undivided interest valuation where a co-tenant retains the right to force a partition.  Either way, from a planning perspective, the best advice for avoiding a similar result is to engage knowledgeable attorneys and appraisers when structuring a gift of undivided interests in property.  Also, as the Ludwick case shows, if the parties wish to waive their right to partition, the waiver should be given overriding importance in the TIC agreement, and decisions about whether to allow either party to force a sale should be carefully considered.  Should a valuation dispute arise, experts should be engaged who can heed the lessons of Ludwick and produce data that will keep a court from embarking on its own valuation. 

Morrison & Foerster's Trusts and Estates group provides sophisticated planning and administration services to a broad variety of clients.  If you would like additional information or assistance, please contact Patrick McCabe at (415) 268-6926 or PMcCabe@mofo.com.

© Copyright 2010 Morrison & Foerster LLP.  This article is published with permission of Morrison & Foerster LLP.  Further duplication without the permission of Morrison & Foerster LLP is prohibited.  All rights reserved.  The views expressed in this article are those of the authors only, are intended to be general in nature, and are not attributable to Morrison & Foerster LLP or any of its clients.  The information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.



[1] Presumably husband and wife entered into the TIC agreement in their capacity as trustees of the QPRTs.

[2] "TAM 9336002 Bites Taxpayer," Carsten Hoffman, FMV Valuation Alert dated May 12, 2010.

[3] Id.

[4] Id.

[5] Id. 

[6] The dismissal of income-producing properties and cash flow statements as comparables seems harsh.  Even though the Ludwicks testified that their property was not intended to produce income, this does not preclude the possibility that it could be used to produce income at a future date.

[7] Ludwick v. Comm'r, T.C. Memo 2010-104, §A.2.

[8] Id., §B.1