Ludwick v. Commissioner: Tax Court devises its own weighted approach to value an undivided real property trust

A decision Monday by Judge Halpern of the U.S. Tax Court implies a tougher stance on discounts for real property interests. The facts in the new decision, Ludwick v. Commissioner, are as follows:

A California couple owned a vacation home on Hawaii’s Big Island as tenants in common. In 2005, they transferred their separate, one-half interests into a qualified personal residence trust. At the time, the Hawaii property had a fair market value of $7.25 million, with annual operating costs of $350,000. On separate gift tax returns, the couple discounted their respective half-interests by 30%—but the IRS permitted only a 15% discount, reduced to 11% at trial.

Both parties retained experts in valuation of fractional interests (Carsten Hoffman for the taxpayers and Stephen Bethel for the IRS). Each expert analyzed sales of undivided interests and partnership interests; Bethel also reviewed broker and attorney surveys and public company transactions.

Unfortunately, Judge Halpern’s opinion held “we do not find the analysis of either expert convincing,” It faulted both experts for not explaining their conclusions and comparables convincingly. Notably, the court asked the experts why a buyer of an undivided interest would consider paying less than FMV; both experts explained the marketability and liquidity risks. “Certainly a tenancy in common is not the ideal way for two strangers to own a vacation home,” the court observed. “That does not mean, however, that a buyer would discount an undivided interest by any more than the cost of liquidating his investment.”

So, the court struck out on its own, and valued the undivided half-interests, using a 10% rate of return (from Bethel), a two-year partition period, annual operating costs of $175,000 (half the total), plus additional costs. The court also found only a 10% chance of partition, however, and valued the interests under a non-partitioning scenario. After weighting its two approaches, the court concluded the separate half interests were each worth just over $3 million, for a total discount of about 17%.

The complete digest of Ludwick v. Commissioner, T.C. Memo 2010-104 (May 10, 2010) will appear in the next Business Valuation Update™; the Tax Court’s opinion will also be available at BVLaw™. Note: Our thanks to Ted Israel (Eckhoff Accountancy Corp., San Francisco) for alerting BVWire to this important new Tax Court case.

And…if you’re concerned about tax, and other valuations, join the experts at the Claremont in Berkeley

Judge David Laro (of the Tax Court) joins an impressive lineup of speakers at the 24th Annual Valuation Roundtable of San Francisco meeting on May 21 in Berkeley, California. Steven Wood (Insight Economics) Robert Dunn, and Stephen Etter (Greyrock Capital and UC Berkeley) will join Judge Laro to address the conference theme: “Practicing Business Valuation in the Wake of the Great Recession.” For more information contact David M. Eckstein at deckstein@fmv.com.

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