The Tax Court recently ruled that undeveloped real estate included in a decedent’s estate should be valued based on a price offered by a developer, thus reflecting the land’s value as developed rental property.

When Mr. Busch died in February 1993, he owned a ½ interest in more than 90 acres of real estate property that had been used for agricultural purposes. But the adjoining city of Pleasanton had designated the property as residential. Busch’s sister-in-law was the co-owner, and Busch left his ½ interest to his niece.

The land was appraised at $12,700,000. The estate discounted the decedent’s ½ interest by 40% ($3,810,000), but the IRS decided a value of $7,400,000 was more appropriate.

The co-owners of the property entered into an option agreement with a local residential developer in June 1994. The agreement included a base price of $150,000 per acre for 88 acres, divided into two 44-acre portions. The purchase price would increase by $50,000 for each building lot approved over 250.The developer expected approval of the development to take two to three years, and the parties expected the sister-in-law’s portion to close June 30, 1997 and the niece’s portion to close December 30, 2000. The purchase price would increase by 9% annually from the first closing to the second or the year 2000.

In 1997, the developer received approval for a 300-unit plan, but the city council rescinded this plan due to citizen opposition. Because of problems getting development approval, the developer did not close in 1997 as expected, and the parties amended their agreement, delaying the closing until February of 2001. By the end of 1998, no development plan had yet been approved.

Before the Tax Court, the estate’s expert witness initially valued the property at $25,000 per acre based on the problems with development approval. He then discounted by 40% for partial interest to arrive at a value of $680,000.

The IRS expert witness used the initial agreement price of $150,000 per acre, and assuming approval for a total of 360 units, added $50,000 for each unit above 250. He discounted the total by 9% for the delayed closings, to arrive at a value of $15 million without applying any discount for partial interest.

Both parties assumed that residential development was the property’s highest and best use.

The Tax Court disagreed with both experts and determined the value to be $4,190,496—the agreement’s price of $150,000 per acre discounted by 9% and then by 10% for partial interest. The Court reasoned that the agreement’s price of $150,000 per acre was realistic compared to other sales and was close enough to the decedent’s death to be used as a benchmark. The number of approved units was unforeseeable at the time of the decedent’s death, so the addition of $50,000 for each unit above 250 was not reasonable. The Court rejected the IRS argument that no discount should be allowed for ownership of partial interests because it could not be assumed that co-owners would cooperate regarding the property regardless of the cooperation here. The 10% discount rate was based on the cost to partition the property should disagreement between the co-owners arise.