This year and next may go down in history as the best for tax-advantaged
gifting, particularly of fractional interests in real estate. LLCs,
FLPs and tenancy-in-common structures all work, and in each case,
current economic conditions argue for low values and low expectations,
which means greater discounts on top of low value pro rata interests.
Tax leverage can be legitimately quite extreme. The deepest discounts
generally apply for the more restricted entity interests, but simple
deeded structures can also obtain some pretty significant discounts.
The recent case of
Ludwick[1] might give a practitioner pause,
though, since its half-interest in a Hawaii vacation home ended up with
only a 17% discount. Will the Service use this case to go after
vacation home discounts in particular, and maybe tenancy-in-common
interests in general? Proper use of Judge Halpern's model usually
tells a different story…
SUMMARY
We had a recent opportunity to help a client who faced that exact problem – and the subject vacation home
was in Hawaii. Support supplied by the taxpayer (the appraisal was
not
ours)
claimed a 31% discount but was extremely weak, having less than one full
page of case-specific facts – the rest was boilerplate. It is easy to
see why IRS selected it for audit.
The agent indicated that Ludwick would be applicable, and the discount should therefore have something to do with 17%. (See
Ludwick, a Wake-up Call for Lawyers for a detailed examination of Judge
Halpern’s memorandum.) A bit of a gift in one sense, since we didn’t have to deal with the taxpayer’s appraisal at all.
We supplied counsel with the same mathematical model that Judge Halpern spelled out quite explicitly in
Ludwick,
but with the inputs and assumptions adjusted for the fact pattern
particular to the case
at issue. The model was used directly by counsel in forming their
arguments, and it showed discounts as great as 36%; the parties settled
on 25% (see detail, below). This was a successful outcome, but it might
have been even more favorable if we had been able to make a proper
investigation and assemble all the facts.
How are you going to gift an interest in that vacation home in light of
Ludwick?
Just short the discount (pretend 17% is correct) and hope
for the best? Blind application and a conclusion below, say, 20%,
drastically understates discounts for most situations, especially in the
current real estate market. The
Ludwick decision actually supports much greater discounts in most cases; it’s attention to the facts that makes all the difference.
It is clear that the taxpayer would have been better off if the
appraisal submitted with the gift tax return were attentive to the facts
and persuasive in developing its opinion of value. It is likely that a
greater concluded discount would have been acceptable to the IRS in the
first place, and the tax savings would have been far in excess of the
higher cost of such an appraisal.
DETAILED ANALYSIS
This case concerned a 50% interest in a Hawaii condo. The taxpayer’s
appraiser claimed a 31% discount, and the IRS agent countered with 17%.
The agent cited
Ludwick; his argument focused on the $40,000
cost of partition in the valuation model, but excluded operating costs
and the time element. He dismissed deducting selling commissions as
“usually paid by the seller.” The date of value was October 2008, and
the date of the eventual sale was December 2008.
Ludwick considered a partition model, where costs (court and
operating), revenues (none) and the eventual sale are discounted to
present value, taking into account a 90% chance that the parties
(hypothetical buyer and current holder of the other half) would simply
agree and sell the whole property rather than going to court.
In this instance, the present value part eluded the agent, as did the
premise of value. His dismissing the deduction of selling commissions
ignored the fair market value postulate of a hypothetical transfer of
the interest at the date of value, and
then an eventual sale
(whether voluntary or court-ordered), in which the new
interest holder is indeed one of the sellers. That eventual cost, along
with other costs, reduces proceeds and forms the basis for a pricing
decision using the partition method.
We prepared a valuation model for use by counsel, which followed Judge Halpern’s model in
Ludwick.
It showed two scenarios, one with a partition action and one in which
an action was not necessary, and three variations using differing
assumptions. The partition period was 1.5 to 2 years, and the
nonpartition (agreeable sale) period was 1 year. Actual operating and
estimated partition costs were deducted for each year, and selling costs
were deducted from estimated sale proceeds at the end of the period.
Market value was
grown at 3% in one variation, and held flat in the others; market
conditions did not support any growth, and further investigation might
have supported an expected value decline.
One more key variable is the rate used to discount cash flows and sale back to present value. The 10% rate used in
Ludwick (and in other notable cases) is far too low; it is a rate that would be applied to a fee interest in real estate, not to a
lawsuit
involving a fee interest in real estate. There is a catalog of risks
that must be considered, which raises the discount rate to at least 15%
or more. Our scenarios used both 10% and 15%, the latter based on case
facts.
Counsel was able to present a model that addressed the specific case
using Judge Halpern’s method, and concluded a 36% discount. Our
conclusion might have been greater if we had been able to make our own
investigation of case facts, but the IRS settled at 25%; under the
circumstances, a very good day.
CONCLUSIONS
We have been called in on a number of these cases where the appraiser
had claimed a discount in, say, the 30% range, and on further analysis,
we either agreed or thought it should’ve been greater. But if all the
facts are not available, then this sort of rebuttal can’t be
well-supported when the audit comes around. It still argues for a
settlement, and like the above situation, the IRS typically settles for
something more favorable to the taxpayer. An even better outcome would
be obtained by having a well-supported valuation in the first place.
Methods of engaging appraisers to produce good results are presented in
detail in
Reappraising the Appraisal Process: A Guide to Successful Results [3].
Our
approach is to pay attention to the facts, give the IRS what they
need to work with (and what they need to be persuaded by), and
conclude the
right discount. It works.
References:
[1]
Ludwick v. Commissioner, T.C. Memo. 2010-104
[2] LISI Estate Planning Newsletter #1687 (Leimberg Information Services, Inc. Subscribe at
www.leimbergservices.com
[3]
Dennis A. Webb, Susan A. Beveridge “
Reappraising the Appraisal Process: A Guide to Successful Results,” Estate Planning,
(September 2010): 11-18.
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