guest post by: Mark Palmer
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 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…
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 Ludwickdecision 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.
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.
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 .
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 rightdiscount. It works.
 Ludwick v. Commissioner, T.C. Memo. 2010-104
 LISI Estate Planning Newsletter #1687 (Leimberg Information Services, Inc. Subscribe at www.leimbergservices.com
 Dennis A. Webb, Susan A. Beveridge “Reappraising the Appraisal Process: A Guide to Successful Results,” Estate Planning, (September 2010): 11-18.