Judicial Opinions Regarding Fractional Interests in Real Estate
This article presents an overview of several recent judicial opinions regarding appropriate discounts for fractional interests in real estate. Fractional interests in real estate result from a property owner's ownership of less than 100% of a given property. Generally, the owner of a fractional interest has the right to partition, the right to a pro rata share of income, and veto power over decisions concerning the use or disposition of the property. Ultimately, state laws determine the bundle of rights available to the owner of a fractional interest. Common sense and numerous judicial opinions tell us that a fractional interest in real property is worth less than the interest's pro rata portion of the total property value. For property owners, their advisors, and appraisers, the issue is determining what discount to the interest's pro rata portion of the fee simple property value is appropriate.
To support an appropriate discount for a fractional interest, two appraisals will likely be required. The first step is to obtain a credible real estate appraisal for the underlying property.
Because most real estate appraisers are not experienced in valuing fractional interests, the next step is hiring a valuation professional who understands valuation methodologies and how they apply to fractional interests.
IRS Position. In issuing deficiency notices, the IRS frequently attempts to limit the amount of the fractional interest discount to the cost to partition the property; however, the IRS Training Manual for Appeals Officers Coursebook recognizes several factors that could influence the size of the discount. The following factors are listed in the Coursebook:
- The size of the fractional interest;
- The number of owners;
- The size of the tract;
- The use of the land;
- Availability of financing for undivided interests; and,
- The costs of dividing the land (partition).