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Estate strategies: A case of contending appraisals
Steven Henry
6 November 2006
Appraisal methods should reflect the attitudes and actions of the market. Steven Henry is a manager with the valuation and financial advisory services firm FMV Opinions's real estate valuation division.
Overview
If I had a nickel for every time I've heard "we need a low value; the IRS is just going to split the difference anyway," I might not be a wealthy man -- nickels don't go as far as they used to -- but I'd have more than a few dollars to show for it. Estate of F. Wallace Langer et al v. Commissioner; T.C. Memo. 2006-232 turns this little truism on its head, suggesting that the days of "splitting the difference" are coming to an end.
In this matter, the court considers the methodology and merit of two appraisals to determine fair market value.
The facts
The Langer family owned and operated farmland in Sherwood, Ore., a city approximately 15 miles southwest of Portland. During the 1990s, Sherwood's population increased dramatically, resulting in increased commercial development close to the subject properties. In 1995, the family created an eight-phase planned unit development for commercial development consistent with the city's general plan. Phases 2 and 5 of the PUD are the focus of this case, both of which were zoned for retail commercial uses.
In 1998, the family formed the Langer Family Limited Liability Company , and the ownership of the PUD land was contributed to the newly formed LLC. F. Wallace Langer died on February 29, 2000, at which time an estate tax return was filed. Six months after the date of death, LFLLC entered into sale negotiations with Target Corporation on Phase 5 of the PUD.
The City of Sherwood approved an application for the development in October 2001. In 2002, at the behest of Sherwood's mayor, LFLLC voluntarily redesigned and reconfigured the PUD. The amendment was approved in November 2002. In September 2003, Target entered into a purchase agreement with LFLLC for a portion of Phase 5. An additional portion of Phase 5 was sold to Gramor Langer Farms.
On 2 April 2004, the Internal Revenue Service issued a notice of deficiency on the estate's tax return in the amount of $1,769,700 with regard to Phases 2 and 5 of the PUD. Both parties retained valuation experts to determine the fair market value of the subject properties. The estate retained Brian Kelley; the IRS retained Stephen Pio. The values concluded by the appraisers are summarized in the table below.
Contention and resolution: Rival appraisals
Phase 2 value
Phase 5 value
Kelley
$525,000
$2,075,000
Pio
$620,000
$3,420,000
Court's conclusion
$620,000
$2,813,279 Kelley used a discounted cash flow analysis in his appraisal, arguing that extended marketing times due to a stale market would have prevented a sale of the properties for several years. To determine the demand for retail space, Kelley performed a retail expenditure analysis by looking at household retail spending within a 1.5 mile radius of a major intersection close to the subject properties. Kelley concluded that there was an oversupply of commercial space in Sherwood based on his analysis, which supported his assumption that the subject properties were not marketable as of the date of death. Additionally, Kelley suggested in his analysis that extraordinary offsite costs resulting from traffic mitigation requirements further detracted from the marketability of the site.
Kelley estimated the value of the site as if the property were marketable as of the date of death using the direct sales comparison approach. He then adjusted his concluded property values upwards by 3% a year for three years to reflect an inflationary value increase in the properties over the three-year period that the properties would not be marketable. |image1| He then deducted sales and marketing costs from the future value. Finally, he discounted the remaining proceeds back to the date of death at a 12% discount rate to arrive at a "net-present 'as-is' land value".
The court rejected Kelley's discounted cash flow methodology, in part because it was based on the assumption that the subject properties would not sell until three years after the date of death, the effective valuation date. The definition of fair market value assumes that a sale of the subject property takes place on the effective valuation date. Instead, the court maintained that the risk of incurring the extraordinary offsite costs referred to in Kelley's report should be reflected in the sale prices of the comparable properties near the subject properties.
The court also disagreed with Kelley's retail expenditure analysis, noting that the presence of community users such as movie theaters and restaurants would be likely to attract consumers from greater distances than 1.5 miles. This would have an impact on the perceived demand for and marketability of the subject properties.
The only valuation approach employed by Pio was a direct sales comparison. This is typically employed by appraisers when valuing this type of land. Pio tells me he used this approach because the properties were entitled for development as of the date of death, and negotiations with Target began approximately six months after the effective valuation date. The fact that the properties did not actually sell may have been due, in part, to the estate's voluntary reconfiguration of the PUD.
The court went on to perform a detailed analysis of the comparable sales used in each of the appraisals. As a result, the court accepted and rejected comparable sales from each of the appraisers' analyses on the basis of location and date of sale. Sales that the Court deemed too far, physically, from the subject properties were rejected, as were sales that occurred too long before or after the effective valuation date.
Conclusion
The fact that the court rejected the use of discounted cash flow analysis in this case is not to say it should never be used. In valuing office buildings and retail centers, for instance, the use of a discounted cash flow methodology is often relied upon by the market, by appraisers and by courts. Even land valuation sometimes calls for discounted cash flow analysis. This is particularly true of residential subdivisions, where developers look at revenues and expenses over time to determine the net present value of a site.
In the end, the court concluded values of $620,000 and $2,813,279 for phases 2 and 5, respectively. The court adopted Pio's value conclusion for Phase 2. The court's conclusion of value for Phase 5 fell between the values concluded by Kelley and Pio, but -- had the court agreed with the data and methodology used -- either appraiser's concluded value could have been adopted.
It is important to note the depth to which the court analyzed both experts' reports to arrive at its conclusions. This case demonstrates that appraisals of real estate assets are being scrutinized to a higher degree than they have been historically. We cannot underestimate the importance of having a competent appraiser whose work truly reflects the actions and attitudes of the market. -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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