Tax Court uses cost-to-partition approach to value fractional interest discount.

• Author: Weber, Neal A.

Application of a fractional interest discount to value undivided fractional interests in real property has long been a contested issue. A fractional interest discount arises from the lack of both control and marketability inherent in joint ownership of property. In the past, the IRS has taken the position that a fractional interest discount is limited to the estimated cost of partitioning the property (Technical Advice Memorandum (TAM) 9336002). However, in TAM 199943003 the IRS took the position that the cost of partitioning the property is only one of the methods for determining a fractional interest discount. In addition, many cases have concluded that discounts greater than the cost to partition the property are appropriate in determining fair market value (FMV) of fractional interest in real property.

In a recent case (Ludwick, T.C. Memo. 2010-104), the Tax Court valued a one-half interest in a Hawaiian vacation home at a substantially lower fractional interest discount than the taxpayers had argued for. The court did recognize that the discount should include not only the cost of partition but should also reflect marketability and liquidity risk. The cost-to-partition approach used by the court to quantify the additional risks is a departure from previous court cases. The court used a well-expressed formula, made several assumptions to value the gift, and allowed a 17.2% discount. This case is also the first case on valuation of fractional interest gifts to a qualified personal residence trust (QPRT).

Background

In 2000, Andrew and Worth Ludwick, a married couple, purchased unimproved real property in Hawaii, where they constructed a vacation home. They owned the improved property as tenants in common, each owning an undivided one-half interest therein. In 2004, the Ludwicks executed agreements establishing separate QPRTs and transferring their undivided interests to those trusts. At the time of the transfers, the property had an FMV of $7.25 million and annual operating costs of approximately $350,000. On their federal gift tax return, each reported the value of their 50% undivided interest at a 30% discount for lack of control and lack of marketability. Upon audit, the IRS allowed a discount of 15%. At trial, the taxpayers' expert concluded that a 35% discount was appropriate, while the IRS's expert argued for an 11% discount.

Analysis

Each side provided testimony from their respective experts on valuation of the fractional interest...