Rental Real Estate Valuation in Divorce

Valuation of commercial real estate and rental properties is an issue that arises in high-asset divorce proceedings. Real estate appraisal is sometimes performed within a business valuation, if the business owns real estate. In 2011, the U.S. Tax Court issued an opinion addressing real estate valuation in a case where competing experts offered two different methods. Like most Tax Court cases, this opinion involved an owner who had passed away, leaving property that was subject to death taxes. Still, the principles enunciated in this decision resonate in divorce proceedings.

In Estate of Mitchell, T.C. Memo. 2011-94, the owner of a California cattle ranch and oceanfront property passed away, leaving the real estate to his heirs. The estate’s CPA valued the properties by capitalizing their rental income streams, much as a business is valued. The IRS employed an expert who valued the properties by looking at their value in a sale (comparables) and then deducting the sum that a buyer might have to pay to terminate the lease.

Before jumping to a conclusion, consider the following facts: The oceanfront property was a 2 acre parcel with a 4,000 square foot house in a gated community, guesthouse, and nearly 200 feet of private beach on the Pacific Ocean near Santa Barbara. It was rented to tenants under a 20 year lease for $15,000 per month plus annual COLA.  The ranch was a 4,000 acre parcel in Santa Ynez Valley, one of the largest ranches in California. While it was partially used for cattle grazing, it also hosted CEOs and U.S. Presidents for an annual horse-riding event. It was leased to a family that operated the ranch under a twenty-four year lease for $32,000 per year. The estate valued the properties at $6 million and $2.6 million, compared to the IRS valuations of $13 million and $11 million. Thus, the capitalized rents were far less than what the properties could be sold for, in the opinion of the IRS. The IRS argued that selling the property would bring greater value than continuing to rent them, even if the buyer would have to pay the tenant to terminate the leases.

Still, the Tax Court held that the income capitalization method was appropriate and rejected the IRS method for valuing these rental properties. The Tax Court disagreed with the IRS expert, who testified that the income capitalization method should be limited to commercial properties and not residential leases. In its opinion, the Tax Court relied on prior decisions and an Appraisal Institute publication for its decision to reject the method advocated by the IRS expert. The Court also observed that the properties were leased under long-term leases, and the owner treated them as income-producing properties rather than personal residences. The Tax Court refused to accept the assumption that the tenants would agree to be bought out, and found that the expert’s estimate of the buy-out payment was too speculative. The Tax Court noted that this method had never been adopted in any other published decision.