In preparing for a recent trial in US Tax Court, I was reviewing a valuation we had performed several years ago. The valuation was of a 40% undivided interest in real estate, a tenant-in-common (TIC) interest. There was no formal entity into which the real estate or the interest had been contributed.
Our valuation approach was that this interest was a security and is a passive investment because investors do not have any decision-making power. When it comes to real estate joint ventures, like TIC interests, a non-managing, non-control, undivided interest is likely to meet the definition of a security established by the Investment Advisors Act and various cases law. Therefore, our approach focused on the rate of return that would be required by investors to buy the interest, given an assumed holding period and related risks. Conceptually, we viewed this as no different from valuing a non-control interest of an entity that holds the same real estate.
The IRS disagrees with our analysis. According to the IRS in this tax court case, this TIC interest is merely a real estate interest. In this particular case, the underlying real estate had been appraised by a qualified real estate appraiser as being worth $4MM. Therefore, the value of the 40% interest, without consideration of its non-controlling and non-marketable nature, would be $1.6MM. The reason for the IRS challenge was that our valuation approach produced a materially lower value.
There are a number of theories about how these interests should be considered, and many of them have some logical and intuitive appeal. For instance, some practitioners believe that because an owner of these interests have rights to partition the underlying asset (the real estate), the proper “discount” from its pro-rata value should be no more than the costs associated with exercising these rights. Without addressing this idea fully, I believe that the underlying premise is incorrect because the standard of value, FMV, assumes a transaction between a hypothetical willing buyer and a hypothetical willing seller. In my experience, there is no likely pool of buyers looking for interests for which they would have to bring a partition law suit in order to receive their required rate of return.
Interestingly, because of the IRS’ view of valuing the real estate interest, part of the IRS challenge was that we did not have the appropriate qualifications to testify. The IRS viewpoint was that the only expert qualified to provide valuation expertise in this case is a qualified real estate appraiser. Valuation theories aside, it is the nature of the interest in question that should drive the choice of experts to value the interest. Although I was accepted as an expert by the Court for the purpose of valuing the undivided interest in real estate in question, it was based upon my experience and not because of our approach or any recognition of the nature of the interest as a security.
The conflict continues. While the Court has accepted me as an expert in valuing these interests, there still remains the essence of the disagreement – Real Estate versus a Security. We are anxiously awaiting the ruling…fingers crossed!
Read Part 2 and Part 3 of the discussion here: