Barge v. Commissioner Confirms VSI Valuation Approach for Tenant in Common Interests

In a previous issue of Eye on Value (Issue No. 3, Summer 1997) we discussed the risks associated with owning real estate through tenant in common interests. In that article, we touched on, but did not fully describe the Valuation Services, Inc. ("VSI") methodology for valuing tenant in common ("TIC") interests. VSI developed its own approach to TIC valuations several years ago. The validity of our valuation methodology was recently confirmed in a Tax Court case, Barge v. Commissioner T.C. Memo. 1997-188.

Background - In valuing an undivided interest in real estate, valuation analysts traditionally determine the fair market value of the real estate and compute the proportionate share owned by the interest being valued. Next, a discount is taken from the pro rata value to determine the value of the fractional interest. This discount is meant to incorporate and quantify the risks inherent in owning such an interest.

The Internal Revenue Service has stated in Private Letter Ruling 9336002 that the discount for TIC interests should be limited to the costs of partitioning the real estate. Their theory has been that since the owner of a TIC interest has the right to go to court and seek a partitioning of the asset, that the owner will eventually have access to his/her pro rata value of the underlying real estate.

The "New" Approach - In the Barge case, a new approach to determining the value of a TIC interest was introduced by the court. The "new" approach takes into account not only the costs related to partitioning, but also addresses other issues such as the degree of risk, likelihood of success, anticipated cash flow, and the time value of money.

In the Barge case, at issue was the value of a gift of a 25% undivided interest in a large parcel of timberland. Based on an income capitalization approach, the taxpayer’s expert argued that a 50% discount from the pro rata value of the real estate was appropriate. The expert for the IRS argued for much less of a discount.

The court, while using some of the facts derived from the testimony of the experts, ultimately rejected both experts’ testimony and determined the value of the 25% interest on its own. The court used a discounted cash flow ("DCF") model. The court projected the net cash flow stream to be received by the owner of the interest over a four year time period. The four year period was the court’s estimate of the length of a hypothetical partition process. The court determined the estimated costs of the partition process, the ultimate sale price of the real estate in four years, and the share of the sale proceeds to be received by the owner of the interest at the end of the four year period as a result of the partition. The court then took this projected cash flow stream and discounted it at an internal rate of return ("IRR") of 10% to determine the net present value of the income stream to the owner of the 25% interest. The court concluded that this net present value was the value of the interest. This value represented an approximate 26% discount from the pro rata value of the real estate.

"New" Approach Not New to VSI - The conclusions reached in the Barge case verify the valuation approach used by VSI in many of its valuations. For years VSI has valued TIC interests in exactly the same way as the court did in Barge. The DCF method, in our opinion, takes into account the same factors and contains the same investment criteria (projected cash flow, risk, holding period, and the time value of money) considered by buyers and sellers of fractional real estate interests. Purchasers and sellers of fractional real estate interests do not buy and sell based on a perceived "discount" from the fee simple value. Instead, they make their decision based on risk versus reward and concern themselves with the question "what are the risks and likely outcome of my investment and how much will I earn on my investment"? The DCF model addresses these concerns. As a result, we applaud Judge Halpern from the Barge case for his insight and business acumen in analyzing the value of the fractional interest.

Valuation Risks (Choose the right expert) - The Barge case highlights some real risks to the valuation community related to the credibility of expert testimony. Expert testimony in the case suggested that the appropriate IRR for the fractional interest ranged from 10% to 14%. The taxpayer argued that a 14% IRR should apply to the interest. Judge Halpern felt, however, that the taxpayer did not adequately support the 14% IRR and due to the lack of credible evidence in support of this, the court used a 10% rate in arriving at its value for the interest. The discount rate has a very material impact on value when using the DCF model. Based on the facts presented in the case, the resulting discount based on a 14% IRR would have been almost 36%, for an additional tax savings to the taxpayer of over $482,000! If the taxpayer’s expert could have been more persuasive in support of the discount rate used, significant additional tax savings could have been achieved.

The Barge case represents another example of the need for credible expert witness testimony. One of the roles of the valuation expert is to educate the courts. The determination of investment strategies and investment risk is best left to valuation experts, not the courts. The court looks to the expert for guidance on these types of investment and valuation matters. If the expert can not educate and persuade the courts as to the credibility of his/her valuation assumptions and methodology, too much will be left to the discretion of the courts.