Factors to consider in determining a fractional interest discount are often considered collectively. This size of the discount is inversely proportionate to the percentage owned, the number of owners, the parcel size, and the availability of financing.

Valuing fractional interests in real estate

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:

  • Size of the interest

  • Number of owners

  • Tract size for a partitioned interest

  • Land use

  • Financing options for undivided interests

  • Costs to partition

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.

Valuation methodologies

Real estate appraisers often use a sales comparison approach to value undivided fractional interests in real estate, which is related to the market approach to business valuation. Business appraisers use often use a discounted cash flow analysis method, which is under the income approach to valuation. Under this method, the appraiser calculates expected future cash flows, and other economic benefits, derived from the fractional interest. The appraiser estimates the time required for an orderly sale of the property and incorporates an expected growth rate to arrive at a terminal value at the date of partition or sale.

Next, the appraiser 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 necessary to sell. An appropriate discount rate is applied to the owner’s net cash flows and the terminal value to determine the fractional interest’s fair market 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 implied valuation discount.

The right expert

Reported valuation discounts for undivided fractional interests in real estate vary dramatically from case to case. Since many real estate appraisers lack experience with fractional interests, it’s important to also engage a valuation professional with expertise in this area. Methods used to determine undivided fractional interest discounts for real estate utilized by real estate and business appraisers both have their merits. A firm that is competent using methods under both real estate and business appraisal disciplines can offer you the best of both worlds.
© 2013(rev. 2020)

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