How to value fractional interests in real estate

Undivided fractional interests in real estate, such as tenancy-in-common (TIC) interests, can be a challenge to value. It’s not as simple as doing a real estate appraisal of the property as a whole and then multiplying that amount by a TIC owner’s percentage interest. Generally, it requires two valuations: an appraisal of the underlying real estate and then a valuation — applying traditional business valuation principles — of the fractional interest.

Availability of discounts

Most valuators agree that the value of a minority interest in a closely held business should be discounted to reflect lack of both control and marketability. There are some differences, however, between owning fractional and minority interests. Owners of minority business interests may have little say over business affairs. They also can’t force a sale or development of the entire interest or readily sell their own interests. Owners of fractional interests in real estate generally have significant rights with respect to the property, such as the rights to receive a pro rata share of the income, to partition or to veto decisions about property use.

These rights have led the IRS to argue that valuation discounts for fractional interests in real estate should be limited to the cost of partition. After all, marketability discounts reflect a minority owner’s limited ability to convert his or her investment into cash. For a TIC owner, the right to partition provides an exit strategy.

Generally, the U.S. Tax Court and federal appellate courts have rejected the IRS stance as overly simplistic. Among other things, it ignores the fact that partition may not be a viable option. Partition proceedings are often protracted, bitter disputes, and a court-ordered partition or forced sale can diminish the underlying property’s value. Most courts agree that the cost of partition is merely one of several factors to consider in valuing fractional interests.

The IRS recognizes the courts’ approach in its internal documents. The IRS Valuation Training for Appeals Officers Coursebook lists these general factors in determining an appropriate discount for a fractional interest in real estate:

• Size of the interest. The smaller the interest, the larger the discount.
• Number of owners. The more owners, the larger the discount.
• Size of the tract (that is, practicality of partition). The smaller the tract, the larger the discount.
• Use of the land. For example, farmland is generally entitled to a larger discount.
• Availability of financing for undivided interests. The tighter the financing, the larger the discount.
• The costs of partition.

In recent court decisions, valuation discounts ranging from 10% to 60% have been accepted, depending on the facts of the case. The availability of these discounts also creates some interesting estate planning opportunities. (See the sidebar “Divide and conquer: Using fractional interests in estate planning.”)

Valuation methodologies

Valuators use various methods to value a fractional interest in real estate. One of the most common is the discounted cash flow method. Here, the valuator calculates expected future cash flows or other economic benefits derived from the fractional interest and then discounts them to present value. This approach contemplates an eventual partition (if viable) or sale of the property. The valuator estimates the time it would take to bring about an orderly disposition of the property and incorporates an expected growth rate to arrive at a terminal value at the date of partition or sale.

Next, the valuator estimates the owner’s net cash flows between the valuation date and the terminal date, taking into account the cost of partition and other expenses. An appropriate discount rate is applied to interim cash flows and the terminal value to determine the fractional interest’s value as of the valuation date. The difference between this value and the owner’s pro rata share of the underlying property’s value represents the valuation discount.

Business valuator required

Reported valuation discounts for undivided fractional interests in real estate vary dramatically from case to case. Real estate appraisers typically lack experience with fractional interests. So, to support the value of a fractional interest, it’s important to also engage a valuation professional with expertise in applying business valuation methodologies. •