We are all familiar with the concept of minority interests in closely held businesses, but I have not seen that much litigation in divorce cases concerning real estate, in which a litigating party owns less than a 50% share. Often the same valuation theories that apply to corporations, apply to real estate interests. And, a creative use of those, can help your client greatly.
Everyone seems to have a different view of this notion. For example, I once tried a case where both real estate experts did not realize that the building in question was only owned one-half by the husband in the case. Therefore, they valued the entire interest in fee simple. Obviously, the thing to do would be, first to value the whole, and then value the partial interest. However, in that particular case, the judge struck both opinions because the experts valued the wrong interest. Ultimately, the parties had to come up with another appraiser and ended up stipulating to the value.
In In re Marriage of Brenner, 235 Ill.App.3d 840, 601 N.E.2d 1270 (Ill.App. 1992) the husband owned a 50% interest in a business, and the real estate where the business was located. In this particular case the building was not a corporate asset but was owned personally. The appraiser merely testified as to the value of the entire parcel and found it to be $590,000. The trial court accepted that valuation and found the husband's interest to be exactly one-half ($295,000). While the husband on appeal challenged the valuation as being outdated, he did not make the argument that his half was worth less than 50% of the value of the whole. Therefore, the trial court's ruling as to valuation was affirmed. That was a missed opportunity, in my opinion.
Other data is now available. For example, Partnerships Profiles, Inc. conducts studies from transactions of interests in real estate partnerships. This can be useful in valuing undivided fractional interests (UFI). In addition, tax cases need to be consulted to determine trends. Further, it would be virtually impossible to finance a minority interest of real property. The government itself recognizes the need for discounts, even though it might adversely affect its position in, for example, tax or estate cases. "Courts generally allow a discount for the value of a partial interest in real estate. The reasoning is that a discount is appropriate because of problems of control, lack of marketability, and costs of partition of a fractional undivided interest . . . The following factors will influence the amount of the discount:
IRS Valuation Training For Appeals Officers Coursebook, 1998, pages 4-26 through 4-27.
"Due to the nature of the real estate market, the sum of the values of the individual partial interests will usually not equal the value of the fee simple interest. Problems arise in the valuation of undivided partial interests, a legal arrangement in which no co-owner has the right to any specific part of the whole property. When multiple owners hold equal, undivided partial interests in a property, no party can exercise complete control, and the interest of each party is usually not worth as much as the corresponding fraction of the property's market value." The Appraisal of Real Estate, Appraisal Institute, Chicago, Illinois, Twelfth Edition, page 69.
In Estate of Brocato v. Commissioner of Internal Revenue, T.C. Memo 1999-424, it was recognized that, "When dealing with fractional interests in real property, courts have held that the sum of all fractional interests can be less than the whole and have used fractional interest discounts to value undivided interests. (citation) Fractional interest discounts may be necessary to compensate a willing buyer for the lack of control, lack of marketability, illiquidity, and potential partitioning expenses associated with such interests." In that case, a 20% fractional interest discount was the ruling of the court.
"The holder of an undivided interest in property would have to secure the consent of the owner or owners of the remaining interests before being able to sell as a unit. This factor alone could affect valuation regardless of whether real or personal property is involved." In re Estate of Propstra, 680 F.2d 1248, 1252 (9th Cir. 1982) (15% discount for undivided one-half interest).
Anastos v. Sable, 443 Mass. 146, 819 N.E.2d 587 (Supreme Judicial Ct. of Mass. 2004) was a case involving a partnership formed for the purpose of purchasing real estate improved with a manufacturing facility and collecting rent from the tenant. The value of the plaintiff's one-third minority interest was properly held to be less than one-third of the liquidation value. The trial court found that the plaintiff lacked control over the financial, operational and management decisions of the partnership and his interest was illiquid. The trial court further found that there is no ready market for the purchase of a minority interest in a general partnership whose primary asset is real estate. The trial court was affirmed. The proper amount of the minority discount was found to be 40%.
Sometimes a judicial decree for partition is not possible, because the land is in a land trust and is therefore personal property, First Options of Chicago, Inc. v. Stellings, 215 Ill.App.3d 1093, 576 N.E.2d 103, 107 (Ill.App. 1991). And even in the unlikely event of such a sale, it would be a forced judicial sale which it is widely known, produces less of a value than a regular market sale, First Bank and Trust Company of O'Fallon, Illinois v. King, 311 Ill.App.3d 1053, 726 N.E.2d 621, 625 (Ill.App. 2000). "The fair market value of property is the amount of money that a purchaser, willing but not obligated to buy the property, would pay an owner, willing but not obligated to sell the property, without taking into account the values or necessities particular to either party. (citation) Generally, the price paid for the property at a recent sale is the best evidence of value." Hewitt v. Hurwitz, 227 Ill.App.3d 616, 592 N.E.2d 213, 216 (Ill.App. 1992). Further, the costs of partition would have to be added in. Not to mention the tax consequences of a sale.
In Wildman v. Commissioner of Internal Revenue, T.C. Memo. 1989-667, a 20% interest in real property was accorded a 15% minority interest discount, in addition to a 10% discount due to lack of irrigation facilities and the fact that the interest was not comprised of contiguous portions of land. In addition, restrictions on the sale or transfer of the decedent's interest, presented an impediment that a hypothetical buyer would consider and would require adjustment to the price. Also, the terms of the agreement might generate controversy and litigation. This caused an additional 15% discount to be added, resulting in a total discount of 40%.
In Williams v. Commissioner of Internal Revenue, T.C. Memo. 1998-59, an undivided one-half interest was valued. One of the experts credibly testified that banks generally will not lend money to the owner of a fractional interest in real property without the consent of the co-owner. The petitioner's expert testified that the fractional interest should be discounted by 20% due to lack of marketability and 30% for lack of control, and the necessity of resorting to partition and related costs of liquidating one's interest. This is a total discount of 44%. It was noted that the holder of a fractional interest in real estate lacks control because he or she cannot unilaterally decide how to manage it. In addition, it was estimated that partition costs of the various properties ranged from $76,500 - $172,500 per parcel (and this was over 20 years ago). Even the respondent's expert, who attempted to apply no discount, admitted that an undivided one-half interest in real property has a limited market. The United States Tax Court accepted petitioner's valuation evidence and ruled a 44% discount should be applied to value the undivided 50% interest in the properties. There may also be other relevant circumstances; for example, what if your client has a one-third interest, and the other two-thirds are owned by members of a different family? Then his interest is not only not controlling, but is a true minority, because the other two-thirds owners could always vote together to block a sale.
In Estate of Van Loben Sels v. Commissioner of Internal Revenue, T.C. Memo 1986-501, the tax court accepted a 60% discount. The court noted that there were various disabilities associated with the undivided interest, including lack of marketability, lack of management, lack of general control, lack of liquidity and potential partition expenses. The court noted that one expert believed the discount could be as high as 78%.
In fact, even the Illinois Partition Statute permits sales of two-thirds of market value, which is a statutory recognition that a one-third discount from the forced sale process is within reasonable bounds. Piercing The Partition Fiction For Fractional Interest Valuation, Keith Schiller, Trust And Estates Magazine, July 2000.
However, discounts are not always mandated. Logging property was an issue in Branscomb v. Branscomb, 117 P.3d 1051 (Ore. Ct. App. 2005). The husband and wife jointly held a 50% undivided interest in one parcel and a 12-1/2% undivided interest in the second parcel. The husband's appraiser applied a 60% discount to the valuation of the parties' minority shares of both parcels, reasoning that the values should be decreased due to the restrictions on logging imposed by partnership agreements. He used both minority and marketability discounts. The wife's appraiser applied neither. The trial court adopted the husband's value and discount. The Appellate Court held that the 60% discount was inappropriate. In dealing with the discount issue, it was recognized that the minority discount takes into account the degree of control; in contrast, the marketability discount addresses the degree of illiquidity of the interest. This can be reflected by a lack of recognized market, lack of ready marketability or restrictive provisions affecting ownership rights or limiting sale. A marketability discount can apply to either minority or majority interests, and may be imposed in addition to a minority discount in appropriate circumstances. When the interest is part of a smaller family-run enterprise, and when it is sold to other shareholders, the reasons for applying either discount, are less likely to occur. The Appellate Court, therefore, concluded that marketability and minority discounts were both inappropriate in this case. The Court stated, "Our task is to determine the value of husband's interest in the land. Ordinarily, we would determine the value of his share on the open market. Here, on the other hand, under the terms of the agreement, husband would never have to sell his share on the open market; he would either sell it to his partners or, if they do not want to buy it, the entire parcel would be sold, as a single parcel, and he would receive his proportional share. In either case, the factual basis for a minority discount would not exist; no buyer would ever be put in the position of owning a minority interest and assuming a minority risk. If the other partners buy husband out, they simply augment their majority status; they would then become sole owners, neither majority nor minority. If no buyout occurs and the land is sold as a single parcel, then, obviously, no partial interest is put on the market. Nor would the valuation require an adjustment to account for barriers to marketability. Under the agreement, the remaining partners are the market, and there is no reason to believe that the price they would pay . . . would be anything less than full market value. In the alternative, if the other partners declined to buy out husband, the entire parcel would be marketed as a single entity." 117 P.3d at 1058. So, such discounts are not used in every case. It is important to look at any agreements or other circumstances about the particular parcel in question.
As can be seen, there is a great deal of flexibility, but some discount most certainly should be employed in most cases.
Paul L. Feinstein, a Chicago sole practitioner with over 30 years of experience, concentrates his practice in family law with emphasis on divorce litigation, custody and visitation, and appeals. He can be reached at (312) 346-6392. View his Divorce Magazine profile.
Certified Divorce Financial Analyst
Business Valuators / CPAs