Family Office
Estate strategies: Experts' testimony leaves holes

Land-value case highlights need for experts to illuminate their
contentions. Leslee Hippert is a senior manager of FMV
Opinions, a valuation and financial advisory services
firm.
Overview
Faced with dueling experts opining on the value of a land parcel
in Terrene Investments, Ltd. et al. v. Commissioner (T.C.
Memo. 2007-218) earlier this month, Judge Holmes became his own
expert and determined that the value of the parcel was $1,303,616
for purposes of a charitable contribution.
Background
This single-issue case was to extract the value of a 31.41-acre
parcel with sand and gravel deposits, which was gifted as a
charitable donation. The property's former owner estimated the
value at $1,801,618, while the IRS set the value considerably
lower at $301,000.
The taxpayers originally bought a larger 74-acre tract, of which
this parcel was part, at a tax foreclosure sale. The taxpayers
had noticed valuable white pines on the property, and thought
they might be up against bidders who didn't recognize the
parcel's true value. They bought the entire property for a little
over $50,000. Then they cut the timber and sold it for $45,000.
Noticing an adjacent parcel being mined for sand and gravel, they
had core samples drilled and had their suspicions confirmed: the
parcel possessed such deposits.
In 1998, they donated 31.41 acres to a religious foundation and
took a charitable deduction on the basis of its appraised value.
The IRS disputed their valuation and the case was tried solely on
this issue.
The vacant parcel was on a sand-and-gravel filled floodplain in
Houston, Texas, that was filled with. Thus, the land was not just
a location: it contained a valuable commodity. The Tax Court
wryly summed up the issue at hand as an inquiry into the "effect
the four holes drilled into the 31.41-acre parcel" had on its
value.
Although the market for sand and gravel in Houston is large, the
court noted that "neither production nor consumption is highly
concentrated, and prices are set on a wide variety of terms." It
is sold by the cubic yard or by the ton; and prices vary
depending upon coarseness, length of contract and distance to a
buyer's worksite. The decision
The court noted that only two of the three accepted methods of
estimating fair market value for any property would be
appropriate: comparable sales and income capitalization (also
known as "discounted cash flow"). Both parties agreed with the
court that the replacement-cost method was inappropriate.
The Taxpayers' proposed value of $1,801,618 was based on the
discounted cash flow analysis by its expert EBanks. The
commissioner's expert (Moritz) proposed value of $301,000 was
based on the direct sales comparison method (66%) and the
discounted cash flow analysis (34%).
The court noted that in only one of the five comparable
sales that the commissioner's expert used, were the parties even
aware that the land contained valuable sand and gravel deposits.
As a result, these sales were not considered comparable as
neither buyer nor seller had reasonable knowledge of the relevant
facts, a requirement for fair market value. (And in the one sale
where the parties negotiated the sales price on the basis of the
sand and gravel deposits, the land was burdened with oil-pipe
easements and leases in addition to oil contamination.)
After discarding the direct sales method, the court determined that discounted-cash-flow method was most appropriate for estimating the value of the land. This method calculates a cash flow from a property and then discounts it to the present. The court noted the number of variables involved in the discounted-cash-flow method and the fact that the experts disagreed with each factor. In turn, the court disagreed with the experts on several of the factors.
Volume of material: The volume of material is based upon estimating the following items:
Setbacks: Ttrips of un-mined land between pit walls and property
lines. They vary in size depending upon whether the pit adjoins a
public road (25' legally mandated); private road or other parcel.
Other than public roads, the setbacks are up to the operator and
property owner, varying between 5' to 50', depending upon soil
type (the more compact the soil in a pit wall, the less likely to
collapse) and the operator's risk preference. The experts'
setbacks varied between 5' and 50' feet. The Tax Court chose two
25' setbacks and two 10' setbacks.
Work area: The need for some land to be set aside for a
work-plant to sort the excavated material. The experts' work
areas varied between 0 and 7 acres. The Tax Court chose 4
acres.
Pit slope: The pit wall's angle or repose, the closest to
vertical is preferred to maximize the mined material versus a
more gentle slope to create stability and prevent the walls from
collapsing. The Tax Court sided with the Taxpayer's expert and an
angle of 75�. NNN iv. Waste: The waste of the material, the
waste inevitably occurs during extraction and processing. The
experts' waste estimates varied between 0% and 10%. The Tax Court
chose 10%, siding with the IRS.
Rate of Extraction: How long will the mining take and how much
can the mine produce annually. The Tax Court noted that
absorption of the material was not an issue given the area's
strong demand. The experts' rates of extraction varied between
200,000 and 360,000 tons annually. The Tax Court sided with the
Taxpayer's expert and an extraction rate of 360,000 tons.
Royalties: The royalty rates for sand and gravel are not uniform,
varying from $0.25 to $1.00 per ton. The Tax Court estimated
$0.71 per ton.
Discount Rate: The single largest source of dispute was applying
the appropriate discount rate. The rates varied between 9% and
28%. The Tax Court rejected both rates and noted that the highest
rate was erroneously associated with the operations of the pit,
rather than passively receiving royalty rates from the land. The
court started with a risk-free rate of 4.5%, based upon the
average of 3-year and 5-year Treasury notes. A risk premium of 3%
was added to create an implied rate of return for buyers of
comparable properties. It noted an illiquid 8-year stream of
royalty payments. This percentage was the spread between Treasury
notes and Baa corporate bonds. In addition, the court noted
additional risks associated with interruptions of operations from
flooding, malfunctioning equipment, etc. and added another 4%.
The resultant discount rate was 11.5%, which (as a reality check)
is reasonably close to discount rates in other cases involving
royalty interests.
Other Factors: Moritz raised a parade of improbable specters that
might diminish value: wetland regulation, social pressure and
other regulatory risks. The court found these factors
wanting.
After applying all these factors, the court held that the value
of the property was $1,303,616.
Summary and conclusion
Although the court found that the experts were credible, it
substituted its value estimate of the land by choosing bits and
pieces from the assumptions used by the three experts. The court
noted that the experts' lack of transparency in determining their
estimated value doomed fully following either expert's
opinion.
As the court disagreed with elements of the assumptions of all of
the experts, without transparency, the computations could not be
adjusted using information from the record to obtain a final
amount that the court found reasonable. Thus, it is extremely
important that an expert testifying supply sufficient information
and fully illuminate its conclusions, so that if the court
disagrees with a small portion of its analysis; it may still
concur with the expert's final opinion -- or something quite
close to it. -FWR
This is not intended or written to be used by any taxpayer or
advisor to a taxpayer for the purpose of avoiding penalties that
may be imposed upon the taxpayer or advisor by the IRS. This
writing is not legal advice, nor should it be construed as
such.
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