PIERCING THE PARTITION FICTION FOR FRACTIONAL INTEREST VALUATION

© Keith Schiller, 2000

This article was published by
"Trust and Estates" Magazine
July 2000
It may not be reproduced without
prior consent of the author.

The persistence of the Internal Revenue Service to assert that partition is the proper method for valuation of fractional interests of real property met a significant roadblock in Estate of Brocato v. Comr. T.C. Memo. 1999-424 ¹ yet achieved some reward in Estate of Busch v. Comr. TC Memo. 2000-3 . Ironically, the greater discount was granted with the income producing property while the smaller discount inured to the undeveloped property with zoning and development limitations. The credibility of the appraisers in these cases appears significant to the Tax Court's approach as well as the willingness of the court to consider the numerous factors that enter into the fractional interest discount calculation.

The Brocato court approved the 20% fractional interest discount opined by the taxpayer's expert for undivided fifty percent interests in multi-residential apartment house properties in the Marina District of San Francisco. These properties consisted of two apartment properties ($1,860,000 and $1,238,000 values for 100% interests) and residential flats ($534,000 value for 100% interest)¹. The estate's pre-discount values had been accepted by the Service. The Brocato decision is more in line with the general valuation principles as well as the "all-factors" approach that the Tax Court applies in an extensive line of fractional interest discount cases.

In Brocato, Mr. Paul Talmage, MAI, of Dana Properties, an expert witness for the taxpayers, supported his 20% fractional interest discount based upon an analysis of eight fractional interest sales, where the discounts ranged from 6 to 50 percent. Mr. Talmage had reviewed each of the comparables referenced, including discussions with the principals. One of the properties, in particular, drew the attention of the IRS where a 44% fractional interest discount arose with a 3.6% interest in what the parties to the sale had loosely called a "partnership", but which was, in fact, a co-ownership. The distinction between partnerships and fractional interests is significant for valuation purposes, as cases below confirm. To prove the co-ownership relationship, a copy of the underlying Grant Deed to this comparable was submitted as evidence. Most significant, the appraiser discussed the underlying transactions and explained his reasons for adjusting. In sum, Mr. Talmage presented a balanced approach based on comparable sales of undivided interests.

The Busch decision arises with 90 acres of undeveloped real estate that had been used for agriculture in the rapidly developing Livermore Valley, 30 miles southeast of San Francisco. After the decedent's death, the estate began to pursue a development buyer for the property. Any development would require negotiations and entitlement approvals through the zoning process. The Court's opinion at first addresses the issue of the underlying value. The Estate Tax Return reported a value of $114,500 per acre. The taxpayer's expert witness testified to a $25,000 per acre value. The Court ruled that a $150,000 per acre, less a present value discount for development time (31.6% discount using a 10% discount rate), to a net of $102,611 per acre - $4,190,496 total value before the fractional interest discount.

The Court next turned to the fractional interest issue, where the taxpayer's expert opined to a 40% discount. The Court was most critical of the fact that the appraiser considered co-ownership discounts with real estate the same a partial interests of partnerships that own real estate. It also rejected comparisons to REITS. The taxpayer's expert also testified that partition was feasible under California law. In the author's discussions with trial counsel for the taxpayer following the decision in Busch, the taxpayer's counsel is critical of the Court's decision because: (1) the property could not be physically divided given the minimum zoning requirements; and, (2) there was no evidence to support a partition sale. According to the taxpayer's counsel in Busch, the partition by sale approach was not raised by either party at trial. Moreover, the other co-owner of the property was age 97 years; and, a sale of the property in whole would work a great hardship because of the low basis in the property. She would have vigorously resisted a partition sale. There was no evidence presented on the effect of a partition sale on the market value of the property. The Court estimated $200,000 legal fees to partition. It rejected the taxpayer's argument that the cost of partition is unrelated to the value of the property and related the costs to the value of the property. It reasoned the partition costs are less significant to the discount impact as the property increases in value.

The Brocato decision reflects the willingness of the Court to take a realistic view of fractional interest discounts when presented with an expert's opinion that is based on similar types of properties and interests, and where extreme positions are not taken. When credibility of the expert is questioned, the Court may be forced to grasp for theories that are neither supported by the evidence nor argued by counsel at trial. The Busch Court failed to address the implications of partition to fair market value; and the fiction upon which the partition-setting-the-discount argument is based.

The vulnerability of the partition argument starts with Treasury Regulation §20.2031- 1(b), which is the guiding directive for the determination of fair market value. That regulation states, in part, "The value of property ... is not to be determined by a forced sale price."

A partition sale is a forced sales event. Partition cases arise when the co-owners disagree and there is no other alternative to unwind the relationship. In order to argue that the price generated at a partition sale is indicative of fair market action, the government expert must prove that this forced sales event does not create a forced sales price.

According to The Appraisal Journal article, A Survey of Appraisers Regarding Factors in Discounting Partial Interests (October, 1993):

"It should be realized, however, that a sale in partition is a forced event, and thus does not reflect free market action." (Page 602.)

A partition sale is a means of sale of last resort. It's application as the method of valuation preference by the Service is misplaced.

A partition case exists in an antagonistic environment where co-owners who cannot unwind their co-ownership through a business agreement, exchange or buy-out, go to court to resolve their differences. Apart from the common sense of that proposition, the taxpayer in Brocato introduced testimony from David Gilmore, an experienced real estate litigation attorney who successfully tried through the Court of Appeals the partitioning of real property, to describe the proceedings and perspectives of parties from his experience to partition cases and the procedures involved with this type of case.² He testified that these proceedings are not quick; and, where other alternatives exist to resolve differences, they are taken.

In Brocato, the government's expert had been advised by an attorney with a major San Francisco law firm that partition of apartment house properties of the type owned by the decedent are "slam dunks." He also informed the government's expert that partition cases take about 6 months to litigate, and that the cost of partition is $20,000 per property ($10,000 applicable to the one-half interest). While the Court rejected the "limited scope" of the government's partition-only argument, it received the following facts into evidence as part of the petitioner's criticism of the partition approach:

1. Under California law, partition cases are tried in the county where the property is located. California Code of Civil Procedure §872.110(b)(1). The Calendar Clerk for the Superior Court estimated a minimum of 15 to 18 months, and if more complicated at least 24 months before the partition case even goes to trial in San Francisco. In addition to the time to get to trial (even with no procedural delays), there must be added the time to market the property, plus 30-60 days for notice and hearing the court confirmation of sale, and time for closing escrow after the court approves the sale. After closing, there can still be litigation over the division of proceeds.

2. Under California law, affirmative defenses and cross complaints arise in partition proceedings. Because of the aggravated nature of the proceeding, they should be anticipated. Among the affirmative defenses that arise are equitable defenses, such as waiver, estoppel and unclean hands; and issues of mismanagement or breaches of duty.

3. Estimated cost of partition substantially greater than the figure provided by respondent's appraiser.³

In Busch, the court applied a cost of partition analysis to property that may have been capable of a physical division. The Court then considered the economics of litigation of partition, including legal fees of $200,000 and relative delay.

In order for the Services' expert witness to advance a cogent partition argument, it will be necessary to establish that the partition sale does not result in a forced sales price, or to apply a realistic discount for the effect of the forced sale action. No discount of this type was considered applicable by the government's expert in Brocato. To the contrary, the taxpayer, provided an example where the partition sale resulted in a discount of almost 49% to fair market value. In that example, a partition sale produced a price of $5,050,000 for 70 acres, 16 of these acres which were resold post- partition for about $2 million on the open market six months after the partition sale. The partition buyer also observed that the partition seller paid a full brokerage commission, plus a referee's fee that was greater than the brokerage commission and which was based on a percentage value of the property sold. The 54 remaining acres at the time of trial were for sale with an asking price of $8 million, and believed that price could be obtained, a fact consistent with a discount of 49% when comparing the forced-partition sale to the free-market transaction based on values contemporaneous with the partition sale. The partition buyer has since rejected offers for remaining acreage at even greater prices. Since the sale following the partition purchase, the economy of Palm Springs Area, where this property is located has improved. The purchaser at the partition sale believes that the value of the 70 acres now prices out at $20 million, which is the value opined by an appraiser in the late 1980's. The Busch case does not consider or apply this added discount for the forced-sale effect because the underlying property was capable of physical division, whereas apartment house and most commercial property must be sold in the partition process.

From the standpoint of the prospective real estate investor, the partition process imposes additional risks and expense that do not arise in a free-market transaction. These real-life considerations include:

1. The partition process normally involves a bid, with the potential for an overbid. If a prospective buyer engages in due diligence and spends a lot of money or time to assess the viability of purchasing the property, they can find out at the partition hearing finding that they, in fact, are not the buyer. Depending upon the nature of the property, concerns with hazardous materials, asbestos, termites, roof conditions, soils and other variables may present significant risks to a buyer who does not undertake due diligence.

2. Partition sales are "as-is." The buyer does not receive representations of condition from the seller.

3. The will likely be no opportunity to negotiate entitlement, zoning exception, set-back or other land-use of variance issues with partition sales.

The limitations of partition sales in producing fair value may be evident, for example, under Illinois law, which provides that a partition sale is not approved by the court unless it achieves at least two thirds the fair market value of the property. Chapter 735 Illinois Compiled Statutes 5/17-117. In other words, that state recognizes that a 33 1/3% discount from the forced sale process is within reasonable bounds and worthy of including in the statute to avoid an even worse result. The partition process, in addition to costs and delay, therefore, creates a marketing discount.

Moreover, the Service may now face additional problem of carrying the burden of proof with partition approach, as a consequence of enactment of Code §7491 in the Internal Revenue Service Restructuring and Reform Act of 1998 Act, provided the taxpayer presents "credible evidence" and the other conditions of that section apply.

In order to thoroughly present a partition-based valuation, the IRS appraiser will need to apply a realistic legal fee and expense cost of partition, a litigation timetable that reflects the reality of civil litigation, and the additional discounting impact that forced sales have because they do not produce a fair market price.

The partition approach stays as well from the traditional starting point of comparable sales for the valuation of fractional interests. Estate of van Loben Sels v. Comr. T.C. Memo.1986-501, 52 TCM 731 (1986); Harwood v. Comr., 82 T.C. 239, 267 (1984), aff'd. without opinion, 786 F.2d 1174 (1986); Buse v. Comr., 71 T.C. 1129, 1136-37 (1979). Courts have also recognized the difficulty with finding comparable sales upon which to rely; and, therefore will apply an analysis considering all factors, including partition. Even in the absence of comparable sales, a fractional interest discount can be granted. Mooneyham v. Comr. T.C. Memo.1991-178; 61 TCM 2445 (1991); Williams v. Comr. T.C.Memo.1998-59, 75 TCM 1758 (1998).

While the amount of the fractional interest discount depends upon the facts of the case and is not simply a review of court decisions or treatises, a review of the judicial decisions reveals the scope of issues, not limited to partition, that the courts have applied in arriving at the fractional interest discount.

While courts have considered partition as part of the overall valuation review, a series of cases have rejected partition as the sole basis for the determination, or limited its application severely. Estate of Williams v. Comr., supra; LeFrak v. Comr. T.C. Memo. 1993-526, 66 TCM 1297 (1993); Estate of Cervin v. Comr. T.C. Memo.1994-550, aff'd. (5^th Cir. 1997) 97-1 U.S.T.C. 60,274; Estate of Barge v. Comr. T.C. Memo.1997-188⁴; Pillsbury v. Comr. T.C. Memo. 1992-425, supra, among other cases..

In Williams, the court allowed a combined 44% discount (a 20% lack of marketability discount plus a 30% discount for lack of control) to an undivided 50% interest in timberland. The court applied its own analysis, which included consideration of the limitations and difficulties that arise with fractional interest property; the lack of market for undivided 50% interests; and the delay and expense of partition, among other factors. Judge Colvin reasoned, in part, that the difficulty in finding comparable sales evidences the problem with marketability and the need for the discount, not a failure of proof. He also recognized that the difficulty with the partitioning of real property affects both its marketability and the cost attendant to the litigation.

In Williams, the court approved a 20% lack of marketability discount as part of an overall 44% combined discount for lack of marketability and lack of control. The example, the difficulty to borrow or to control decisions were examples of the loss of control that apply to a fractional interest. The marketability discount was 20% based on the cost and delay from "resorting to partition and related costs to liquidate one's interest." (Page 326.)

In LeFrak v.Comr., supra, the taxpayers gifted undivided interests in apartment and commercial real estate in New York City. Judge Whalen determined that a 30% fractional interest discount based on the lack of marketability and lack of control. Although the court acknowledged the cost-to-partition approach, it rejected using cost of partition as the sole basis for discounting in favor of the taxpayer's assertion that two discounts, lack of marketability and minority interest applied to the fractional interests.

In Estate of Cervin v. Comr., supra, Judge Cohen determined a 20% fractional interest discount for the value of an undivided 50% interest in a farm and homestead, based "on the record as a whole." The taxpayer presented a case for a 25% fractional interest discount (page 2868) based upon factors including lack of control, minority interest in property, lack of marketability, the difficulty of obtaining financing; and, introduced a series of Tax Court decisions and an article on the valuation of fractional interests. The report of Petitioner's expert included no comparable market transactions that he personally investigated and, he admitted he had, "No exposure to sales of fractional interests." The Commissioner's expert testified that the farm was "ripe" for partition. The court stated:

"We are not persuaded by petitioner that partition of the farm is not possible, nor are we persuaded that the farm is "ripe" for partition." (Id at p. 2868.)

The court then discussed the feasibility of partition in kind, in other words, the division of the property, and rejected the Commissioner's argument that a 6.54% discount should apply, based on a 5% discount plus the cost of partition.

In Mooneyham v. Comr., supra, Judge Cohen applied "common sense and precedent" (page 1991-836) in determining a 15% fractional interest discount to the gift of a 50% fractional interest in commercial real property, which was immediately gifted back into a partnership.

In Pillsbury v. Comr., supra, which is cited in Brocato, Judge Cohen determined a 15% discount in the valuation of an undivided 77% interest in residential and an undivided 50% interest in income real estate. Petitioner's expert witness concluded that a fractional interest discount applied to a 77% fractional interest "to account for the disadvantages associated with a fractional interest, such as the lack of general control, lack of marketability, illiquidity, and potential partitioning expenses." The Court recognized that even with a majority undivided interest, "the owner of the property would nevertheless need an agreement or consent from the minority owner in order to exercise all of the rights associated with ownership of the property." While the Court criticized the Petitioner's expert for relying on court decisions and even considering the argument of the Respondent that the report of the Petitioner should be given no weight, the court, nevertheless, based its conclusion on the "record as a whole" and did not limit the discount to cost of partition.

In Estate of Barge v. Comr., supra, the court determined a 27% discount for an undivided 25% fractional interest in timberland. Petitioner's expert argued for a 50% fractional interest discount, or a present value approach based on income capitalization. The court rejected the method proposed by the taxpayer's expert who relied only on articles and had no comparables. The court applied a method of valuation that took into consideration the income capitalization of the property; the length of a partition case (four year period estimated in view of opposition that would be raised within the family to partition); the discount rate; and a $1,325,000 cost of partition. When faced with the choice between no proof by the taxpayer and a more comprehensive analysis of the partition process with over $1.3 million in legal and court fees, and a four-year court proceeding, the court determined a discount in excess of the amount determined by the Commissioner.

In Estate of van Loben Sels v. Comr., supra, the court upheld a 60% fractional interest discount on the fractional interest in real property, based on comparable sales, not partition costs.

The simplistic approach to fractional interest discount valuation as limited to the cost of partition was also considered but rejected in Estate of Yule v. Comr. T.C. Memo.1989-138. While the court noted that there were "few" arm's length sales of fractional interests, it also criticized the Service for its overly simplistic approach to partition proceedings. Accord, Estate of Wildman v. Comr. T.C. Memo.1989-667. In Wildman, the court refers to cost of partition as part of its discussion but determines a 15% fractional interest discount as opposed to the 35% discount asserted by Petitioner and the zero discount asserted by Respondent. The Court then states, "A 15-percent discount is more appropriate here because of the nature and use of the land." (Id. at 1011, emphasis added.)

This extensive line of cases exposes the vulnerability of the partition-approach to fractional interest discounts, unless the appraiser considers all elements of the costs and expense, delay and marketability discount of partition sales as part of an analysis of the various factors that affect fractional interest value. Moreover, the taxpayer with apartment house and commercial rental properties can apply the comparable-sale approach used in Brocato as part of the "all factors" test advocated in that case.

Valuation cases are not determined in the vacuum of law, but are driven by the facts and evidence. In Brocato, Mr. Paul Talmage, the taxpayer's expert, reviewed eight partial interest sales to support his conclusion that a 20% fractional interest applied. This included areview of sales where there was no discount, and as to which he discussed extenuating circumstances of the particular transaction. Each of the comparables were compared.

While not reflected in the decision in Brocato, petitioners also presented the expert testimony of Mr. Ted Gamble, a retired trust officer with Wells Fargo Bank, with an extensive resume with real estate sales, including sales of fractional interest properties as a fiduciary. He had reviewed the feasibility of the sale of over 4,000 individual parcels of real estate, including approximately 1,500 fractional interest properties. He was directly involved in the decision to dispose of the fractional interests, and served on Wells Fargo's trust real estate committee, which had overall responsibility for determining the retention or sale of real estate, which included the fractional interest.

While Mr. Gamble was not the officer making the appraisal, he was on the committee or directly responsible as a trust fiduciary for the property management and prudent disposition of fractional interests. California Probate Code §§ 16000, et. seq. imposes fiduciary duties on trust officers in the management of trust assets, including their acquisitions, retention and disposition.

Mr. Gamble testified to seeing fractional interest discounts of between 25% to 50%. He testified that 30% is a conservative fractional interest discount; and, related an example of the sale of a one-tenth interest in a San Leandro apartment project at a 30% fractional interest discount, in which he signed the sales agreement.

The partition-only approach also fails to consider the fact that it is not possible to borrow against a fractional interest, a fact that reduces the value of the fractional interest. Williams, supra; LeFrak, supra.

Partition is not irrelevant to the analysis of fractional interest discount. The partition approach, where property cannot be divided, may lead to even deeper fractional interest discounts when fully analyzed in all its consequence than a comparable sales approach. In view of the fact that fair market value is the product of both a willing buyer and willing seller, the diminished focus upon partition should not be a surprise. Moreover, when the all-factors analysis is applied with partition as a factor, the result should be a valuation discount that is deeper than indicated from the partition process itself. Williams, supra; Pillsbury, supra. The Brocato case also shows that credible fractional interest comparables exist for multi-residential and commercial property, which in of itself should be a refreshing fact for Tax Court judges who express frustration with the lack of comparable sales data.

1. Keith Schiller, Esq., is a shareholder with Schofield & Schiller, a Professional Corporation of Walnut Creek, California, and attorney for Petitioners in Brocato v. Comr.
© Keith Schiller, January, 2000.

1. While an appropriate discount, the 20% fractional interest discount determined by the court reflects the highest fractional interest discount applied to 50% fractional interest discount cases with commercial or multi-residential rental properties. See, BNA Folio 830-1st (Valuation: General and Real Estate).

2. The Brocato opinion does not refer in its opinion to the testimony of Mr. Gilmore, who was litigation counsel in Melikian v. Aquila Ltd. (1998) 63 Cal. App. 4^th 1364) nor to the testimony of Mr. Ted Gamble, a trust officer, whose testimony is summarized in this article. The impact, if any, of their testimony is not known, although they were supportive of facts and perspectives underlying the opinions of Mr. Talmage.

3. Petitioner in Brocato introduced expert testimony that the cost of partition would be at least $100,000 per property, and that if the partition of all three properties could be consolidated, the cost would be $225,000 to $250,000.

4. Estate of Fittl v. Comr. T.C. Memo.1986-452, 52 TCM 567(e) applies a cost of partition valuation method where the taxpayer introduced no evidence to support its fractional discount and relied solely on cases and articles. In fact, had the Commissioner simply rested, its deficiency could have been upheld as the burden of proof had not been carried.

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