Fractional Interest Appraisals in the Context of Estate Planning
June 9, 2016
Whether gifting an interest in real property to an heir or paying estate taxes, the rights held by the ownership interest are extremely important. If that ownership interest is less than 100%, it can have a tremendous impact on the potential tax savings.
Fractional ownership is simply a percentage ownership in an asset. Owners of fractional shares in an asset share the benefits of that asset, such as usage rights, income sharing, priority access and/or reduced rates.
Why is this important? Because there are issues that affect ownership of a fractional interest that do not apply to 100% fee ownership in real estate. Fractional interests are generally discounted for issues pertaining to a lack of control and a lack of marketability.
Furthermore, determining the value of a fractional interest investment in a business entity owning real property is not as simple as applying the pro rata ownership percentage of the to the fractional shares.
What Impacts the Fractional Value?
The two valuation adjustments that are most common to the valuation of a fractional interest are (1) the discount for lack of control (DLOC) and (2) the discount for lack of marketability (DLOM). In many circumstances, valuation analysts consider these two discounts both individually and collectively and refer to the aggregate valuation adjustment as a “combined discount.”
Discount For Lack Of Control (DLOC)
A fractional interest in a business enterprise that has little or no voice in company affairs, by definition, suffers from a lack of ownership control.
A controlling interest, on the other hand, has a number of rights not afforded to a non-controlling interest. Some of these rights include the ability to:
- Buy and Sell assets
- Declare dividends and distributions
- Sell or close the company
- Hire and fire employees
- Alter the debt structure
- Change the strategic direction of the company
- Appoint management
- Determine management compensation and perquisites
- Set policy and change the course of business
- Acquire or liquidate assets or recapitalize the company
- Block any of the above actions
Entity documents (e.g., articles of incorporation, partnership agreements, LLC operating agreements, or tenancy-in-common agreements) typically delineate the rights that are controlled by certain owners. For example, many partnership agreements place specific decision-making power in the hands of the general partner or managing member, leaving the limited partners or members with little responsibility for operating the business.
It can be very difficult to quantify the amount of a DLOC. One of the methods used is a comparison with the price-to-value discount taken against the unit net asset value of publicly-traded real estate limited partnerships (RELPs) that are sold on the secondary market, such as those surveyed by Partnership Profiles, Inc.
Discount for Lack of Marketability (DLOM)
Given two investments identical in all other respects, the market will accord a considerable premium to the one that can be converted into cash quickly. Without market access, an investor’s ability to control the timing of potential gains, avoid losses, and make changes to their investment portfolio is severely impaired.
As a result, shares of publicly-traded companies possess a much higher degree of liquidity than fractional interests in closely-held companies. A discount for lack of marketability (DLOM) is required to induce a hypothetical willing buyer to purchase the fractional interest.
Fractional interests are difficult to market and sell. Most often, the co-owners elect to simply liquidate the assets and divide the proceeds. Nevertheless, they do occur when the parties involved are knowledgeable about the inherent risks and limitations. In addition, a fractional interest in real estate is nearly impossible to finance.
Comparable sales are limited, but empirical data that quantifies the DLOM have been developed from studies of transactions involving restricted stock. Due to the illiquidity of the fractional interest during the fixed period, the restricted stock generally sold for a discount from the ordinary shares which are freely traded on one or more public markets.
Unless there is a statutory, contractual, or other reason that prevents it, the value of a non-controlling interest in a business enterprise is usually less than the pro rata share of ownership. This may be directly related to the magnitude of the fractional interest involved in relation to the remaining interests, as well as their relationship to each other and to the purchaser (i.e., family members, etc.). As much as we would like to assume otherwise, when owners are related family members, they all-too-often fail to agree in matters regarding the property.
The good news is, in the context of estate planning, the reduced value as a result of fractional ownership equates to a lower tax liability. The key is to have an appraiser who is well-versed in these valuations, as there are many different ways to arrive at a value (we will look at the main ones in a subsequent post). You want to be sure yours did it correctly to minimize your client’s tax liability – and your legal liability.