“Whether you are the planner or the valuation expert, it is prudent to have a firm understanding of this new law, the protections it affords to your clients and the potential impact on value, and therefore planning opportunities,” according to Eric Bardwell of Jeffer Mangels Butler & Mitchell and Carsten Hoffmann of Stout.
By Eric Bardwell and Carsten Hoffmann | February 28, 2023 at 08:00 PM
A recent California bill, AB 2245, is effective for actions for the partition of real property filed on or after Jan.1, 2023. The bill could potentially impact the rights of an undivided interest holder in California, thereby impacting the fair market value of an interest. This change is significant for understanding the rights of the undivided interest holder as well its implications for potential estate planning.
Carsten Hoffmann, a managing director at investment bank and advisory firm Stout, and Eric Bardwell, an estate planning partner at Jeffer Mangels Butler & Mitchell, discuss the key aspects of this legislation.
What does AB 2245 address?
Hoffmann: AB 2245 alters the statutory rights of cotenants as they relate to real property, specifically in the context of a partition by sale.
Is this a new law or an expansion of an existing law?
Bardwell: It is a little bit of both, actually. In 2021, AB 633 was approved, thereby enacting the Uniform Partition of Heirs Property Act (UPHPA). The UPHPA modified existing legal procedures for the partition of real property held as tenants in common by multiple owners if it satisfied the requirement of “heirs property.”
Essentially, heirs property is property where 20% of the interests is held by relatives or by an individual who acquired their interest from a relative, or where 20% or more of the cotenants are relatives. If a cotenant requests partition by sale for heirs property, the cotenants who did not request the partition now have the option to buy all of the interests of the cotenants that requested partition by sale.
There are also new safeguards for heirs property regarding how the fair market value of the property is determined. AB 2245 extends these protections previously applicable to heirs property to all real property interests held as tenants in common, regardless of how the property was acquired or the relation of the cotenants.
How was fair market value determined for an undivided interest under previous law, and are there additional considerations under the new law?
Hoffmann: This new law does not change the definition of fair market value for a fractional undivided interest and therefore should also not change the methodology. Fair market value continues to be the price that a willing buyer would pay to a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of the relevant facts.
Despite the existing definition of the hypothetical willing buyer and willing seller, this new law does present some relevant facts that those buyers and sellers will be aware of. Namely, the additional protection afforded to certain existing owners that may make the attainment of liquidity more challenging.
From a legal perspective, what does this law modify from prior language?
Bardwell: The new law makes it more difficult for a single cotenant to force a partition by sale, especially at auction, where property often transacts below fair market value. Now, unless all cotenants agree on a value or method of valuation, or the court finds the evidentiary value of the appraisal is outweighed by its costs, an independent appraisal is required. The cotenants who did not request the partition by sale have an opportunity to acquire the interests from the cotenants who requested the sale, and if they cannot acquire these interests, there is a strong preference for a partition by kind unless it would cause great prejudice.
If partition by sale is ultimately determined to be the only option, an open market sale conducted by a licensed real estate broker must occur, and the sales price must be no lower than the previously agreed-upon fair market value.
The bill also provides that the new law applies in cases where there is no agreement that governs the partition of the property binding all of the cotenants. It is now more important than ever to consider a tenant in common or similar agreement in the context of family estate planning.
What is the appropriate methodology for determining the fair market value?
Hoffmann: The methodology will generally start with a net asset value approach and then apply the discounts for control and marketability. Most appraisers will rely upon actual undivided interest transaction data (this is very challenging to collect and analyze, as the data is not readily available) as one approach.
A second approach is often built around partnership data for real estate entities that are more readily available. Adjustments to this data will be necessary to distinguish an undivided interest from a partnership interest.
The last approach will revolve around the cost to partition and the time required, if the partition has not been waived in a cotenancy agreement.
Why was there a need for this new law?
Bardwell: It appears that the focus of the bill is to prevent the abuse of the prior law, which enabled cotenants with even a 1% interest in real property to force partition by sale. Comments from the Senate Judiciary Committee state that “Opportunistic speculators have exploited this vulnerability to acquire a single family member’s interest in inherited property and forcing the sale of the whole thing, often at below market value.”
In order to determine if a partition would cause “great prejudice,” the court will look to all of the facts and circumstances present, including how long the property has been held by the cotenant and prior owners, as well as a cotenant’s specific attachment to the property. Given the subjective nature of the determination of great prejudice, practitioners must be cognizant of these new rules and how they may impact existing planning.
Notably, the new act removes the references to “heirs property,” which has important ramifications. The goal of the bill is to facilitate retention of real property wealth, both during a cotenant’s lifetime and intergenerationally, by preventing other cotenants from being able to force the sale of the real property to a third party or the cotenant who requested partition by sale. By removing the reference to heirs property, the law now applies to all tenancy in common ownership, regardless of how it was acquired.
Generally, what is the magnitude of the discounts, and what factors impact the magnitude of the discounts?
Hoffmann: The magnitude of the discounts for lack of control and lack of marketability for an undivided interest are generally driven by such factors as property type, property performance as measured by cash flows, debt level of property as it relates to risk, size of the interest compared to appraised value, and the existence of any agreements governing ownership. The range of discounts concluded can vary greatly, but an approximation of the average range points to discounts between 30% and 40%. This is also supported by looking at the various court cases in this area, even though the Service will generally start with a 15% first resolution offer in an audit.
What are the implications of the new law with regard to determining the magnitude of the discounts and in turn the fair market value?
Hoffmann: Although the difference might be subtle, the new law has given certain rights and privileges to the existing owners of the property that could complicate a forced partition process and therefore could complicate attaining liquidity. All else being equal, this will have upward pressure on the magnitude of the discount. It might also lengthen the period in which a partition process would be completed.
Whether you are the planner or the valuation expert, it is prudent to have a firm understanding of this new law, the protections it affords to your clients and the potential impact on value, and therefore planning opportunities.
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About the Author:
Eric Bardwell is a tax and estate planning attorney in Orange County. His practice focuses on all aspects of wealth transfer planning, including estate planning, charitable planning, business succession planning and post-death administration. Eric routinely assists individuals and families in efficiently minimizing estate, gift and generation-skipping transfer taxes through the creation of wills, trusts, business entities and charitable organizations and the use of gifts, sales and other wealth-transfer strategies. He works closely with each client’s team of advisors, including accountants, investment advisors and insurance agents, to ensure the client’s personal planning and wealth preservation goals are accomplished in a coordinated manner. Eric is designated as a Certified Specialist in Estate Planning, Trust & Probate law by the State Bar of California, Board of Legal Specialization. Contact him at 949.623.7234 or EBardwell@jmbm.com.