As we discussed in our previous article, "Why Undivided Interest Discounts Are Like Jellyfish," undivided interest discounts have a long history of resilience. With the recent passage of the Tax Cuts and Jobs Act of 2017, a new window of opportunity has been created to take advantage of the doubling of the gift tax exemption amount.
With this opportunity in mind, we analyze some of the defining characteristics of the undivided interest ownership and explore the most potent analysis to quantify the elusive discounts for lack of control and lack of marketability.
Undivided interest ownership may be divided into joint tenancy and tenancy in common. Joint tenancy is joint ownership between two or more persons with the right of survivorship. Under this arrangement, the parties have identical interests and rights of possession. Under a joint tenancy with right of survivorship, a joint tenant’s property interest cannot be passed to heirs or beneficiaries because it expires at death. For estate tax purposes, property held as a joint tenancy with right of survivorship is taxed under Section 2040 and would not involve any fractionalization or valuation discounts for lack of control or lack of marketability.
Tenancy in common, on the other hand, represents undivided interest ownership that does not feature the right of survivorship. Accordingly, at death of any interest holder, the undivided interest can be passed to the decedent’s heirs or beneficiaries. The interest will be included in the decedent’s gross estate under Section 2033. Absent a provision to the contrary, in the instrument creating the co-tenancy, all co-tenants have equal rights for use and enjoyment. The right to use and enjoy extends to every portion of the property, at any time, under any circumstances. Given that one person’s definition of use and enjoyment may very well conflict with another person’s definition, it is easy to see how harmonious co-existence may be challenging. The problem is made worse by the fact that each undivided interest holder has one vote (regardless of actual percentage ownership), and all decisions require unanimous consent. Accordingly, it is the tenancy in common interest (rather than the joint tenancy) that is subject to the lack of control and lack of marketability discounts discussed throughout this article.
The rights, preferences, and privileges of a shareholder in a corporation or a partner in a partnership are generally set forth in an operating agreement. Furthermore, each state has developed extensive code language that functions to supplement and sometimes supplant the operating agreement. This is not the case for undivided interest ownership where the rights, preferences, and privileges are set forth by each state’s statute. The following examples highlight some of the rights, preferences, and privileges having the biggest impact on undivided interests, and therefore on undivided interest discounts. These rights are generally consistent among the states.
Regardless of the interest percentage held, each undivided interest holder has one equal vote. Given that there’s no concept of majority control when it comes to an investment in an undivided interest, there must be unanimous consent among all of the undivided interest holders to affirm any action. In other words, the 1% owner that has little to no say in a corporation or partnership can single-handedly block any action and cause significant disruption to the operation of the undivided interest.
Another result is that as the number of investors grows, the chance of unanimous agreement significantly declines. The equal-vote concept in conjunction with the unanimous consent requirement is a knife that cuts both ways when it comes to the undivided interest discounts. Having an equal vote provides veto power to any size investor (potentially reducing the lack of control discount), but also increases the chances of management disruption by others (potentially increasing the lack of control discount).
Lacking the protection of a corporate veil, each undivided interest holder suffers from full exposure to personal liability. Most estate planning involving real estate is structured around limited partnerships and limited liability companies to avoid this unlimited personal liability. The exposure may be personally, jointly, or severally. A legally enforceable judgment may be levied against the interest holders. If you happen to be the one with the deepest pockets, and the other co-tenants run out of funds, this situation could be disastrous. One can clearly see how the risk associated with this ownership would have a significant impact on the marketability of the interest.
One of the biggest advantages of real estate as an asset class is the ability to borrow against the real estate, thereby enhancing the returns. This key benefit is lost on an undivided interest holder in real estate, both for individuals and for investment groups. As an individual, you cannot borrow against your undivided interest ownership, as by definition there is no identifiable interest to lend against. Even in situations where all undivided interest holders agree to a loan (an unlikely scenario given the pass-through liability), lenders will expect to be compensated for assuming the additional risk of any one owner becoming disruptive to the property operation. This compensation might be expressed through higher borrowing costs or additional collateral requirements. Similar to the personal liability consideration, the marketability of the interest could be severely impacted by the inability to borrow against the asset.
Each undivided interest holder has the unrestricted right to transfer or sell his or her interest. The transfer of that interest may be to an existing owner of the same property, an heir, or an unrelated outside investor. Of course, for valuation purposes, the standard of fair market value will be determined using the hypothetical willing buyer and the hypothetical willing seller. Not hypothetical are the existing owners with whom one will be co-investing and the potential personality conflicts that may arise. For all the reasons listed here, and despite the absolute right of transferability, the actual market for an undivided interest is extremely limited. Unlike publicly traded securities that have complete liquidity, and investment partnerships that have access to a somewhat liquid secondary market, there is no established market for an undivided interest investment. Furthermore, because there is no reporting process for undivided interest transactions, potential investors have minimal basis with regard to making their investment decisions.
State law has long acknowledged the perils of undivided interest ownership with unlimited personal liability. Accordingly, each undivided interest holder is granted the key right of forcing a judicial partition. The partition can take one of three different forms:
Given the obvious complexities of physically (fairly) dividing real estate or the somewhat random determination of who goes and who stays, the method most commonly used is a court-ordered sale. Despite the significant expenses associated with this process and the time delay in effectuating a sale, the ability to force a judicial partition presents a significant right to the owners of an undivided interest – a right that is not enjoyed by investors in limited partnerships or limited liability companies.
Having performed over 300 undivided interest discount valuations for estate and gift tax purposes coupled with numerous meetings with the IRS, our firm has found great success in supporting valuation discounts for undivided interests in real property. This success comes through 1) sound financial reasoning for the discount in question, 2) thorough discussion and understanding of the unique attributes of undivided interest ownership versus other types of ownership, 3) use of substantial, meaningful empirical data, 4) a clear comparison of the attributes of the subject interest and the empirical data utilized, and 5) use of multiple approaches that examine the potential magnitude of the discount from different financial perspectives.
The first of the three approaches used by Stout is a comparison of the subject interest with over 80 actual undivided interest transactions. This approach looks at actual arm's length, third-party transactions analyzed on attributes of income, size, property type, location, and number of owners. Because there is no primary or even secondary market for buying and selling undivided interests, there is no reporting mechanism for those transactions. The data generally emanates from individual market research, previously published articles, court cases, real estate appraisal reports, or a multitude of other one-off sources.
The varied collection sources reduce the consistency and depth of detail available and have led us to also analyze the real property limited partnerships and real estate investment trusts, in our second approach. These entities’ filing requirements and reporting by the Partnership Profiles publication provide very detailed information on each entity, allowing the data to be sorted by property type, size parameters, and various performance characteristics of the entities. A thorough understanding of the data is required to properly adjust the entity data to the subject undivided interest. For example, the entity data discounts comprise primarily a lack of control component, as the secondary market and short-term liquidations remove much of the lack of marketability component. The entity data can be supplemented by looking at restricted stock studies that isolate this component.
The third approach involves the use of the discounted cash flow technique and explicitly considers the costs involved in a partition process (as well the potential income during that time), the partition time frame, and an appropriate discount rate. Because the undivided interest holder surrenders complete control and lacks marketability for his or her interest over the entire partition time frame, an appropriate discount rate must include an adjustment for this risk factor.
Although these approaches examine the undivided interest from different angles, their conclusions tend to corroborate each other. Additionally, the weaknesses of one approach are often the strengths of another approach.
The new tax act has provided ample opportunity for additional planning. Planning with undivided interests requires a firm understanding of the defining. If you work with a specialist not familiar with their nuances, you might get stung.