Undivided fractional interests in real estate, such as tenancy-in-common (TIC) interests, present valuation challenges. It can be much more complicated than multiplying an owner’s interest percentage by the real estate’s appraised value for the property as a whole. There are two common methods to determine the value of a fractional interest in real estate, 1) a sales comparison approach performed by a real estate appraiser using similar fractional interest sales, or 2) an appraisal of the underlying real estate followed by application of a fractional interest discount by a business appraiser. The latter method is discussed below.
Discounts in general
Most business appraisers agree that the value of a minority interest in a closely held business should be discounted to reflect a lack of both control and marketability. However, between owning fractional interests in real estate differs from owning minority interests in a business. Minority business interest owners may be unable to influence business decisions. They also can’t effectuate sale of the entire business or readily sell their own interests. Conversely, owners of fractional interests in real estate can have significant ownership rights, such as the rights to receive a pro rata share of income, to partition, or to block other owner’s property use decisions.
These increased rights in comparison to minority business interests led the IRS to attempt to limit fractional interest discounts in real estate to the cost of partition. While marketability discounts reflect a minority interest business owner’s limitations on selling, a TIC owner has the right to partition as an exit strategy.
U.S. Tax Court and federal appellate courts have seen the IRS argument as too simplistic. It ignores the fact that a partition action may not be a viable option. Partition proceedings can be protracted and contentious, leading to diminution in value. Therefore, the cost to partition is just one of several factors to consider for fractional interests.
The IRS Valuation Training for Appeals Officers Coursebook lists some general factors to consider when determining an appropriate fractional interest discount or real estate:
Tax court decisions for acceptable valuation discounts have ranged from 10% to 60% , depending on the facts specific to each case. Acceptability of these discounts by tax courts has created additional estate planning opportunities.