Correct. Your 50% (1/2) will appraise at a discounted percentage based on the particular factors in your situation.
"Valuation discounts for transfers of undivided interests in real property have been the subject of case law for over 80 years.3 Throughout this period, not unpredictably, the Internal Revenue Service, on a variety of grounds, has resisted such discounts. Most recently the position has been that any discount should be limited to the cost of a partition action.4 This position has been thoroughly rejected by every court that has dealt with the subject.5 For instance, in Estate of Barge,6 a gift tax case in which the only issue was the proper discount of a gift of a 25 percent undivided interest in timberland, the Tax Court refused to rely on the cost of partition of the property, but based its opinion on the present value of the expected cash flows from the future harvesting of timber until partition would be likely to occur, arriving at a value equivalent to a 26 percent discount.7
In the most recent case of Estate of Williams v. Commissioner,8 the Tax Court likewise rejected the cost-of-partition limitation and discounted the value of gifts of one-half interests in two parcels of timberland by 20 percent for lack of marketability and an additional 30 percent for lack of control, applying the discounts seriatim for an effective 44 percent discount. The large size of the discount reflects the fact that the government submitted no appraisal testimony on the magnitude of the discount, but, instead, conceding a mere five percent discount, contended that taxpayer failed to meet the burden of proof because taxpayer had offered no evidence of actual sales of fractional interests. In rejecting this contention, the court emphasized that a banker credibly testified that banks generally will not lend money to the owner of a fractional interest in real property without the consent of the co-owners and that the inability of the appraisers to find sales of fractional interests in comparable real property showed that there was no market for fractional interests in such real property. The court further noted favorably the testimony by taxpayer's appraiser that the holder of a fractional interest in real property lacks control because such holder cannot manage it unilaterally.9
After Williams, and its immediate antecedents, the issue is not whether a discount will be allowed, but based on the facts of each particular case, what will be the size of an appropriate discount. l0
III. Rationales For Discounts
The premise for fractional interest discounts is that each tenant-in-common, regardless of the size of such tenant's interest, is entitled to possess and use the co-owned property and, without resort to partition, cannot "oust" the other co-owners.ll This forced sharing .of access (rather than lack of access) has the potential to create significant confusion and upheaval.12 Further, since even a co-tenant with the smallest fractional interest has a right to operate the property subject to the identical right of each of the other co-owners, all co-owners must agree to all decisions related to the property if the operation is to be a success. A co-tenant thus has a veto, and disagreements can lead to gridlock.13 Judgment creditors of any co-tenant may secure a lien on such tenant's undivided interest and compel partition. In addition, the identity of a co-tenant can change with death or divorce. Finally, as noted in the Williams case,14 financial institutions will not provide a loan on undivided interest property where the property is the sole collateral unless all undivided interest holders sign the loan documents.
With the foregoing disadvantages in mind, why would a hypothetical willing buyer15 purchase a fractional interest without a sizable discount?
Each co-tenant, even one with just a minor or "sliver" interest, has the power to compel partition. The right of partition cuts both ways. It is valuable to the co-tenant desiring partition, less so to those in favor of the status quo. In a partition action, the court may partition the real property in kind, under which the property is physically divided in equitable proportions.16 If, however, division in kind is inconvenient, !he court may alternatively allot the entire property to a co-tenant who will accept it and pay to the other co-tenants cash for their pro-rata shares. As a final possibility, if division in kind is inconvenient and the interests of all co-tenants will be promoted by a sale of the entire property, the court may order a sale and a pro-rata division of the proceeds.17 Where more than one co-tenant entitled to partition seeks allotment of the entire property to himself, a Virginia trial court does not abuse its discretion in refusing allotment to either of them and ordering the property to be sold.18
Once the partition action begins, absent agreement of all co-tenants, the sales process is out of the hands of each co-tenant, and whether a cotenant agrees to the bid subsequently confirmed by the court is irrelevant.19 As in any judicial sale, the trial court can accept bids until the final decree is entered. 20 In practice once the special commissioner of sale has been authorized by the court to sell the property, 21 such commissioner solicits bids over a reasonable period of time and generally accepts the highest non-contingent, reasonable bid subject to confirmation by the court. In such a system, a co-tenant has no veto but is limited to outbidding the highest bidder. To say that such co-tenant is a "willing seller" is problematic. Also, since the period of bidding is limited in practice, taking the property off the market until it improves is usually not an alternative. Because the sales process is placed outside the control of any co-tenant in a partition action, in many cases the mere threat of partition will cause the co-tenants to agree to sell the property.
Not only does the partition process lead to a forced sale, it is also fraught with the possibility of high costs22 and significant delays.23 The prospect of delay depresses the investment desirability due to the uncertainty of what the underlying property will likely be sold for at the end of the partition process. Since the property in partition is tied up over an extended period of time during which market conditions may fluctuate, opportunities for favorable sales may be lost. Several studies, including one involving private placement of Rule 144 stock (forced holding period of two years - 24% discount), a later one involving 160 Rule 144 securities (overall average discount 20%, those companies with less then $10 million in market value having an average discount of 31%), and one involving liquidating secondary market limited partnerships (discount 26%), have in analogous situations attempted to quantify the discount associated with forced time delay similar to that inherent in the partition process.24
In summary a willing buyer will not purchase an undivided co-ownership interest for a price equal to the overall value of the property times the amount of the percentage interest, but will insist upon a discount because forced sharing of control is intrinsic to a tenancy-in-common and there is uncertainty whether a sale in partition, due to its forced nature and the costs and delays involved, will yield a price truly reflective off air market value.
IV. Application of Discounts
Although not entirely free from discussion,25 in a gift tax setting under current law, discounts are applied with "blinders" on, that is, you look simply at what is being transferred, not who is doing the transferring or who is getting the transfer26 or the existence of other transfers by or to the same persons or what is being retained.27 Accordingly, where the owner of an undivided 50 percent interest in real property gives the interest to the other 50 percent co owner, such gift would be viewed in isolation, and its value for gift tax purposes would be entitled to a discount.
On the other hand, an undivided interest transferred at death will be aggregated for estate tax valuation purposes with all other interests owned at death by decedent in the same property.28Thus, fractionalization of decedent's interest in a parcel occurring post-death will not result in discounts in valuing the parcel on decedent's estate tax retum.29 For example, where decedent devises equal percentages of decedent's vacation home to decedent's children, the full fair market value of the home will be includible in decedent's estate.
Similar to the gift tax situation, decedent's property is valued without regard to the identity of the beneficiary. The principle as stated in Propstra v. United States30 is as follows:
Because the estate tax is a tax on the privilege of transferring property upon one's death, the property to be valued for estate purposes is that which the decedent actually transfers at his death rather than the interest held by the decedent before death or that held by the legatee after death.31
In an earlier case, Estate of Lee v. Commissioner,32 cited in Propstra,33 the Tax Court had declined to aggregate, for purposes of determining whether decedent had a controlling interest, decedent's 50 percent undivided interest in common stock with a like interest owned by her husband-beneficiary.34 In Estate of Andrews v. Commissioner,35 the Tax Court refused to attribute decedent's siblings' 80 percent stock interest to decedent, holding that the value of decedent's 20% interest was entitled to a combined 60% discount for lack of control and lack of marketability.36
In Estate of Pilsbury v. Commissioner,37 the Tax Court, in allowing a 15 percent discount, stated that it would not apply attribution principles to combine a 77 percent undivided interest in real property held in trust for decedent with the other 23 percent interest held by the same trustee for the benefit of issue of decedent's late spouse.38 Finally in the Estate of Bonner v. Commissioner,39 the Fifth Circuit held that the value of undivided fractional interests in real and personal property owned outright by decedent were entitled to a fractional interest valuation discount for estate tax purposes inasmuch as such interests did not have to be aggregated with the remaining interests (in such property) which were held by a QTIP trust established for decedent's benefit by his wife and included in decedent's estate under Sec. 2044 of the Internal Revenue Code.
V. Size of Discounts
Discount percentages in cases allowing fractional interest discounts have ranged from 5 to 60 percent, with quite a few decisions at 10 percent and 15 percent.40 More recently, the spread seems to be between 15 to 20 percent.41 Setting the size of the discount is largely a matter of expert opinion; however, one nationally known planner simply obtains an appraisal of the value of the overall property, multiplies the ownership percentage by such overall value and then discounts by 20 percent (without using an expert for the discount).42
Any appraiser hired to determine an appropriate discount in a given case should be thoroughly familiar with discount strategies related to more sophisticated techniques.43 In particular, the appraiser should be sensitive to the time value of money and have knowledge of relevant studies related to forced holding periods.44 In addition, the appraiser should have facility with various valuation methodologies including the capitalization of cash flow and holding company methods., The appraiser should consult with a lawyer who has expert knowledge concerning tenancies-in-common and the partitioning process in the locality of the property. Besides developing a data base concerning the ease of divisibility of the parcel in question, sales of comparable fractional interests, if any, the availability of financing for the interest and costs, time and forced control issues, the appraiser should note any special difficulties related to the size, type and use of the property and the number of owners and their percentage interests.45
VI. Planning Observations
In every potentially taxable estate, the planner should consider advising the client to fractionalize real property. As between spouses, suitable regard should be given to converting all survivorship tenancies46 to tenancies-in-common.47 At the death of the first spouse, the bypass trust can then be funded with discounted undivided interests maximizing the use of the shelter. The funding of the QTIP share with an undivided interest will permit a discount in connection with the valuation of that interest at the death of the survivor.48
Fractionalizing a residence between spouses who both live there should not cause any transfer tax difficulty, but fractionalizing a residence between a donor-parent and a child may cause inclusion in the parent's estate as a retained interest under Code Section 2036 (a)(I).49
As noted at the beginning, annual exclusion gifts of undivided interests in real property leverage the exclusion and depress the value of the interest retained.50 Transfers of undivided interests in real property to minors can be made through the Virginia Uniform Transfers To Minors Act.51
With regard to the assessment of the tax risks associated with gifts of"sliver" undivided interests by the dying client, note should be taken of Estate of Murphy v. Commissioner,52 a much criticized case53 in which the Tax Court disallowed a minority discount for a 49.6 percent stock interest where decedent had given .9 percent of the stock to each of two children eighteen days before her death (reducing her holdings from 51.4 to 49.6 percent). In direct opposition to the Estate of Murphy decision and without mentioning it, the Tax Court in Estate of Frank v. Commissioner54 permitted a discount (combined 45%) for decedent's 32.14 percent block of stock remaining after he gave 18.16 percent of the stock to his wife just two days before his death, the transfers having been effected through a power of attorney held by decedent's son. The Frank case involved transfer of an 18.16 percent block rather than a 1.8 percent block of stock as in Murphy; however, it is difficult to see how this main distinguishing fact could produce opposite results.55 Since at worst death-bed gifts of undivided interests will be respected even if the discounts are disallowed, and at best discounts will be allowed on both the gifts and decedent's retained undivided interest, it is hard to see any downside with regard to this manner of gifting.
Where each spouse transfers a fractional interest in the family home to such spouse's qualified personal residence trust (QPRT),56 the value of the gift (the remainder interest) will be entitled to a discount. A single homeowner can get the same result by establishing two (or more) QPRTs each to contain a fractional interest in the home.57
Enhanced discounts for partnership interests in a family limited partnership (FLP) would be available where the FLP owns an undivided interest in real property as a tenant-in-common.
In making fractional interest gifts with encumbered property, the amount of the encumbrance may be deducted.58
Finally, planning consideration should be given to maximizing the number of co-tenants and decreasing the percentage retained as these factors may influence the size of the discount permitted.59
The law is clear at present that a valuation discount is properly applicable both to the gift of an undivided interest in real property and to the valuation of an undivided interest in real property remaining in decedent's estate at death. Discounts in the 15 to 20 percent range involve little tax risk. It is expected that experienced discount appraisers familiar with the disadvantages of tenancies-in-common, including forced access and forced sale issues, will be utilized more frequently in the future resulting in increased discounts.
Transfer tax planning using fractional interest gifts is relatively inexpensive, simple and quick to implement and easy to explain and understand. Such planning is appropriate in a wider range of situations than more sophisticated techniques. As a result, use of and uses for this flexible planning tool will multiply." http://www.vsb.org/site/sections/trustsandestates/winter1998b