Taking Advantage of Real Estate Valuations During COVID-19
2020 provides an excellent opportunity for gifting interests in family limited partnerships (FLP) or limited liability companies (LLC) for two reasons:
- The COVID-19 pandemic has led to depressed asset valuations.
- Should the November elections result in changes in Congress, the current $11.58 million exemption for individuals ($23.16 million for couples) could be reduced dramatically in 2021.
Valuing a noncontrolling interest in an FLP or LLC owning real estate versus one that owns marketable securities is a similar exercise:
- The entity’s assets are “marked to market,” usually to fair market value
- The market value of liabilities is deducted from the fair market value of assets, resulting in net asset value (NAV)
- A discount for lack of control (DLOC) is applied to the pro rata NAV allocable to the subject interest, resulting in the interest’s marketable, minority interest value (MMIV)
- A discount for lack of marketability (DLOM) is applied to the MMIV, resulting in the fair market value of the interest
Discount for Lack of Control
The secondary market for real estate limited partnerships provides data points on DLOCs observed in trades across entities owning a wide variety of property types, including shopping centers/strip malls, commercial office buildings, hotel/lodging properties, office parks, and multifamily residences, among others. The catch: DLOCs observed in the secondary market reflect a DLOM component. The business appraiser must use professional judgment when reducing the DLOC by a certain percentage1 to arrive at a purer DLOC to be applied to the subject interest’s NAV.
Discount for Lack of Marketability
Business appraisers have numerous methods at their disposal to estimate a DLOM. Most appraisers use restricted stock studies to estimate the DLOM.2When determining the appropriate DLOM, business appraisers consider the transfer restrictions of the interest, the entity’s cash flow generating ability, distribution policy, and the riskiness of assets owned. The various restricted stock studies estimate DLOMs ranging from approximately 13 percent to 50 percent.
The following is a simple example of the application of the DLOC and DLOM when valuing a noncontrolling interest in a real estate holding company. Discounts shown below are for illustrative purposes only and may not be applicable in every valuation.
While no two gifting situations are identical, thoughtful consideration should be given to gifting noncontrolling interests in real estate FLPs and LLCs considering the uncertainty of the current political landscape and the effect COVID-19 has had on certain real estate investment classes. The role of valuation discounts in wealth transfer programs, while always important, takes on additional significance in situations where potential changes in legislation may have a negative effect on the taxpayer.
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1 The estimated portion of the DLOM is less than 10 percent of the overall DLOC; see Comprehensive Guide for the Valuation of Family Limited Partnerships, fifth edition.