Ludwick v. Comm'r

T.C. Memo. 2010-104

UNITED STATES TAX COURT

ANDREW K. LUDWICK, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

WORTH Z. LUDWICK, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 3281-08, 3282-08. Filed May 10, 2010.

Paul H. Roskoph, for petitioners.

Andrew R. Moore, for respondent.

MEMORANDUM OPINION

HALPERN, Judge: Respondent determined deficiencies in

Federal gift tax for 2005 for Andrew K. Ludwick and Worth Z.

Ludwick of $86,529 and $88,785, respectively. Petitioners owned

a vacation home as tenants in common, and the only issue for
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decision is the value of the interests therein that they

separately transferred in trust to a so-called qualified personal

residence trust.

Unless otherwise stated, all section references are to the

Internal Revenue Code in effect for 2005, and all Rule references

are to the Tax Court Rules of Practice and Procedure.

We round all dollar amounts to the nearest dollar.

Background

Some facts have been stipulated and are so found. The

stipulation of facts and accompanying exhibits are incorporated

herein by this reference.

Petitioners are husband and wife, and they resided in

California when they filed the petition.

In 2000, petitioners purchased unimproved real property on a

bluff on the north shore of Hawaii’s Big Island. By the end of

2003, they had improved the property by constructing a vacation

home. In 2004, they owned the improved property (the property)

as tenants in common, each having an undivided one-half interest

therein.

In December 2004, petitioners executed agreements

establishing separate qualified personal residence trust

arrangements. In February 2005, petitioners transferred their

undivided interests in the property pursuant to those trust

agreements. At the time of the transfers, the property had a
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fair market value of $7.25 million and an annual operating cost

of approximately $350,000.

On their separate 2005 Federal gift tax returns, petitioners

each reported a gift resulting from the transfers in trust. They

valued their separate one-half interests in the transferred

property at a discount of 30 percent; viz, $2,537,500 (0.70 x

0.50 x $7,250,000). In determining the deficiencies in gift tax,

respondent allowed a discount of only 15 percent, so that he

computed $3,081,250 to be the value of each undivided one-half

interest that petitioners transferred. On brief, respondent

argues for a discount of no more than 11 percent, which results

in a value for each transfer of $3,226,250.

Discussion

I. Introduction

As stated, we must determine the fair market value of each

petitioner’s undivided one-half interest in the property.

The standard for determining fair market value for purposes

of the gift tax is the price at which the property would change

hands between a willing buyer and a willing seller, neither being

under any compulsion to buy or to sell and both having knowledge

of the relevant facts. Sec. 25.2512-1, Gift Tax Regs.

Petitioners bear the burden of proof and do not argue otherwise.
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See Rule 142(a).1 We find that, at the time of the transfer, the

fair market value of each undivided one-half interest in the

property was $3,000,089, for a discount of approximately 17

percent. We will explain the process by which we reach that

result.

II. Valuation of the Gifts

To support their respective valuations, the parties have in

part relied on the testimony of experts. We have considered that

testimony and have in part relied on it in reaching our

conclusion.

A. Method of Valuation

1. The Expert Reports

Petitioners request that we value each undivided interest by

discounting half the fair market value of the property

($3,625,000) by 30 percent to reflect the disadvantages of owning

an undivided fractional interest in property. Respondent

requests a broadly similar approach, although he reaches a

different conclusion regarding the size of the proper discount.

Petitioners’ expert, Carsten Hoffman, an expert in the

valuation of fractional interests in property, relied on analyses

of sales of undivided interests and partnership interests.

1
Petitioners have not raised the issue of sec. 7491(a),
which shifts the burden of proof to the Commissioner in certain
situations. We conclude that sec. 7491(a) does not apply here
because petitioners have not produced any evidence that they have
satisfied the preconditions for its application.
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Respondent’s expert, Stephen Bethel, also an expert in the

valuation of fractional interests in property, relied on analyses

of sales of undivided interests, various surveys of brokers, a

review of tender offers for majority interests in public

companies, and lawyers’ estimations of the cost of partition. We

do not find the analysis of either expert convincing.

Mr. Hoffman, in his direct testimony, compared the discounts

from 69 “undivided interest transactions” between 1961 and 2006.

He calculated the mean and median discounts for the set of all

the transactions and for three subsets: 16 income-producing

properties, 26 parcels of raw land, and 22 transactions involving

undivided 50-percent interests. He also provided the range of

discounts for all the transactions and for each of those three

subsets. He provided no way for us to evaluate his analysis,

however. He failed not only to explain how the discounts were

calculated (i.e., how did he calculate the underlying fair market

value?) but also to provide any measure of the variability or

dispersion of his data points (e.g., their standard deviations).

Most importantly, he did not provide any of the data; we do not

know the specifics of any of the “undivided interest

transactions”. We have no way to know how comparable those

properties were to the one here in issue.

Mr. Hoffman also compared petitioners’ property to 10 real

property limited partnerships. Yet petitioners’ property was
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never intended to produce income; it was a private vacation home,

not a source of revenue. The cashflow statements of the 10

limited partnerships (which held, for instance, apartment

buildings and mobile homes) are not relevant.

Mr. Bethel, in his direct testimony, in part relied on four

sales of undivided interests between 2002 and 2007. Yet all the

sales involved commercial property in the eastern United States.

We are not convinced that such data tells us much about the

appropriate discount for a multimillion dollar vacation home in

Hawaii.

Mr. Bethel also relied on three surveys of California

brokers that his firm conducted in 1999, 2005, and 2008. The

survey questions involved the discounts associated with

fractional interests in property. About 10 brokers responded to

each survey by providing a range of discounts and a brief

explanation.2 Yet we have no way of evaluating or of reconciling

the brokers’ responses because we have no information about the

transactions on which the brokers based their opinions.

Moreover, the brief explanations are often so cryptic as to

2
We ignore some responses. For example, one broker opined
that the discount associated with the sale of a fractional
interest would be 15 percent (he did not give a range), yet the
comment beside his estimate stated: “He has never sold a
minority position in a tenancy in common, but in his opinion
there must be a discount for the position.”
 - 7 -

reveal almost nothing about the reasons behind the discount

ranges. The surveys provide little guidance.

Mr. Bethel also relied on two surveys with brokers regarding

so-called pooled public tenancy-in-common investments, which are

professionally managed investment properties with multiple

owners. Fractional interests in those investments generally

trade with almost no discount. In his report, Mr. Bethel

conceded that there are “four critical differences” between those

investments and petitioners’ property,3 yet he argued that those

differences would only “slightly” increase the discount proper

here. Mr. Bethel did not explain his conclusion, and, without

any reasoning, we are not convinced.

Finally, Mr. Bethel relied on a professional review of

tender offers for majority interests in public companies.

Specifically, he relied on transactions involving the change of

control of real estate companies. He calculated the discounts as

follows: If the market price were $100 and a buyer tendered

$125, then the premium would be 25 percent and the discount would

be 20 percent. As Mr. Bethel noted, however, the size of a

control premium depends on many factors (e.g., “the buyer’s

desire or need to acquire the company * * * to complement his

3
Pooled public tenancy-in-common investments are
professionally managed, and interests therein are readily
marketable, represent ownership in a diverse set of properties,
and have relatively steady income streams.
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present operation”) that do not seem relevant to the discount

appropriate here. We find the tender offer analysis unhelpful.

2. Partition

At trial, we asked both experts why a buyer of an undivided

interest in the property would consider the interest worth any

less than a proportional share of the fair market value of the

whole property reduced by the cost to the buyer of partition;

i.e., the cost to end joint ownership involuntarily by a

judicially mandated sale (as a single residential property, the

property was unlikely to be divided into separate estates) and to

distribute the proceeds appropriately. Both convinced us that a

buyer would also take into account marketability or liquidity

risk; i.e., “the risk of being unable to sell an asset quickly at

its fair market value.” Downes & Goodman, Dictionary of Finance

and Investment Terms 391 (7th ed. 2006). They disagreed,

however, as to the size of the appropriate discount and as to

whether partition would even be necessary.

Although Mr. Hoffman insisted that a buyer would consider

more than just the cost of partition and the marketability risk,

he failed to convince us. Certainly a tenancy in common is not

the ideal way for two strangers to own a vacation home. That

does not mean, however, that a buyer would discount an undivided

interest by any more than the cost of liquidating his investment
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and an additional amount to reflect the risk occasioned by a less

than immediate sale. Indeed, Mr. Hoffman testified:

And if you have the right to * * * force a partition,
you will certainly consider that. And if an investor
were to come to me and say, well, I demand an 80
percent discount because it’s an undivided interest, I
would say, well, that doesn’t make sense because you
can partition it for significantly less than that, so
why would you demand an 80 percent discount.

The logic of that statement is that a buyer who had a right to

partition could not demand a discount greater than (1) the

discount reflecting the cost and likelihood of partition and (2)

the discount representing the marketability risk because, if he

did, another (rational) buyer would be willing to bid more. That

iterative process would drive the discount down to the discount

reflecting the expected cost of partition and the marketability

risk. Mr. Hoffman failed to convince us otherwise.

Petitioners concede that Hawaii law provides for partition

of real property. See Haw. Rev. Stat. Ann. sec. 668-1 (Lexis

Nexis 2007). A buyer would thus be willing to pay an amount

equal to the present value of (1) the fair market value of 50

percent of the property upon sale less (2) his costs of

maintaining the property and his costs of selling the property

(perhaps including the cost of partition). Accordingly, to

determine the price that a buyer would be willing to pay, we must

figure (1) the length of the partition process, its costs

(including the cost of selling the property), and the likelihood
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partition would be necessary, (2) the rate of return the buyer

would demand, and (3) the value of 50 percent of the property

upon sale. See Estate of Barge v. Commissioner, T.C. Memo. 1997-

188.

B. What a Buyer Would Pay

1. Partition

In partition suits, Hawaii courts may sell real property

where partition in kind would be impracticable or greatly

prejudicial to the interested parties. See Haw. Rev. Stat. Ann.

sec. 668-7(6) (Lexis Nexis 2007). Petitioners do not dispute

that partition would result in a sale of the property. Mr.

Hoffman testified that a contested partition would take 2 to 3

years to resolve and that its costs would include $10,000 of

appraisal costs and $70,000 of litigation expenses. Mr. Bethel

testified that a contested partition could take up to 2 years to

resolve, and he estimated that its costs would include $15,000 to

$20,000 “to proceed with filings”, a brokerage fee of 4 to 6

percent, and a closing fee of 1 percent. Mr. Bethel concluded

that the total cost of partition would range from 6 to 8 percent

of the value of the property. Mr. Bethel testified that, if

partition were not necessary, the property could be sold in less

than a year.

We find that a contested partition would take 2 years to

resolve (including 1 year to sell the property) and that the
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costs made necessary by the litigation would be 1 percent of the

value of the property (that is, $72,500). Petitioners, however,

have failed to convince us that partition will always--indeed,

will often--be necessary. In fact, when respondent’s counsel

suggested that partition was “relatively unlikely”, Mr. Hoffman

seemed to agree.4 Nonetheless, neither party suggested the

likelihood of partition. Bearing heavily on petitioners, who

bear the burden of proof, we find that a buyer would expect

partition to be necessary 10 percent of the time. We find that

the cost of selling the property (which the sellers would bear in

any case) would be 6 percent of the value of the property (that

is, $435,000). Finally, the annual operating cost of the

property was approximately $350,000. We assume that a buyer of a

one-half undivided interest in the property would expect to bear

only half the costs described above; the buyer would expect the

remaining petitioner to bear the other half.

4
Respondent’s argument is as follows. Suppose petitioner
husband had sold his interest. If the buyer then told petitioner
wife that he wanted to sell the property, what are the odds that
she would object? Not only would he have a right to partition
but also a court would ultimately order the property sold (as
opposed to divided). Petitioners have failed to explain what (in
that hypothetical) petitioner wife would stand to gain by
opposing partition. Cf. Estate of Barge v. Commissioner, T.C.
Memo. 1997-188 (finding that, in a case in which the property
would have been divided (not sold), the other owners might resist
partition “to obtain an advantageous partition”). Respondent,
however, concedes that such opposition is possible, and we accept
that concession.
 - 12 -

2. Rate of Return

Mr. Bethel testified that, to account for the marketability

risk, a buyer would demand a return of 10 percent. Mr. Hoffman

testified that a buyer would demand a return of 30 percent.

Nonetheless, he presented no evidence to support that conclusion.

Petitioners have failed to prove that a buyer would demand a

return greater than 10 percent.

3. Value of Interest After Partition

The parties stipulated that in 2005 the property had a fair

market value of $7.25 million. Mr. Hoffman testified that the

“long-term sustainable growth [rate] of real estate” was 3

percent annually. Accordingly, at the end of 1 year (if

partition were not necessary) or 2 years (if it were) the

property would sell for $7,467,500 or $7,691,525, respectively.

III. Fair Market Value

Accordingly, to determine the value of an undivided one-half

interest in the property, we use a 10-percent rate of return

(discount rate), a partition period of 2 years (including a

selling period of 1 year), annual operating costs of $175,000,

(possible) partition costs of $36,250 allocated equally to both

years, the cost of selling the property ($217,500), and a fair

market value of $3,733,750 or $3,845,763 (after a sale in 1 year

or 2 years, respectively). We find that the fair market value of
 - 13 -

the gift that each petitioner made in 2005 was $3,000,089; our

calculations are as follows.

If Partition Is Not Necessary

Operating Selling Sale Present
Year Costs Costs Proceeds Total Value

1 $175,000 $217,500 $3,733,750 $3,341,250 $3,037,500

If Partition Is Necessary

Partition
and
Operating Selling Sale Present
Year Costs Costs Proceeds Total Value

1 $175,000 $18,125 -- ($193,125) ($175,568)
2 175,000 235,625 $3,845,763 3,435,138 2,838,957
Total 2,663,388

We have found that a buyer would expect partition to be

necessary 10 percent of the time. Thus, the buyer of an

undivided one-half interest in the property would have been

willing to pay the weighted average of the two present values

calculated above; that is, $3,000,089.

Decisions will be entered

under Rule 155.