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By Deborah M. Beers, Esq.
Buchanan Ingersoll & Rooney PC, Washington, D.C.
Estate of Adler v. Comr.,T.C. Memo 2011-28, is a Tax Court memorandum decision involving (yet again) the inclusion in the decedent's gross estate of residential property to which the decedent purportedly transferred title during his lifetime, but to which he retained the exclusive right to use and possess until death. In Adler, however, the issue was not so much the inclusion of the transferred property in the decedent's gross estate, but the availability of fractional interest discounts for such property.
Under the facts of the case, the decedent, Axel O. Adler (Adler), died on June 20, 2004. At the time of his death, Adler resided at 26446 Oliver Road, Carmel, California. Before December 8, 1965, Adler owned property on Palo Colorado Road in Carmel, California (the "Rancho Aguila property") consisting of approximately 1,100 acres at the date of his death.
On December 8, 1965, Adler executed a grant deed transferring undivided one-fifth interests in the Rancho Aguila property for no consideration to his five children as tenants in common. The deed, however, expressly stated that Adler "[reserved] unto himself the full use, control, income and possession of … [the Rancho Aguila property] and every part thereof for and during … [his] natural life."
After the transfer, Adler continued to use the Rancho Aguila property. None of his children resided there. On August 16, 1991, one of Adler's daughters (Inna) executed a quitclaim deed transferring her interest back to Adler, but neither she nor Adler recorded the deed. Because Adler and Inna never recorded the 1991 quitclaim deed, litigation over her interest occurred during the probate of Adler's estate. As a result, daughter Inna executed a grant deed transferring her interest in the Rancho Aguila property to the estate in May 2005.
Not only did the children not reside in the Rancho Aguila property, none of them interfered with Adler's use, possession, or enjoyment of the property. Adler paid all expenses associated with the property, including taxes, upkeep, and maintenance. Adler was not required to — and did not — pay rent to the children. Adler was not required to — and did not — seek the children's permission to alter or improve the property.
Adler died on June 20, 2004. The parties stipulated that on that date, the fair market value of a fee simple interest in the entire Rancho Aguila property was $6,390,000. Because of his retention of a life estate, it was clear that the value of the property would be included in the value of Adler's gross estate by reason of §2036.
Section 2036(a)(1) thus includes the value of transferred property in the value of the gross estate if three conditions are met: (i) the decedent transferred an interest in the property during life, (ii) the transfer was not a sale, and (iii) the decedent retained possession or enjoyment of the property for life. [Citing Regs. §20.2036-1(a); Estate of Bongard v. Comr., 124 T.C. 95, 112 (2005).]
At issue in the case, however, was whether the value to include in the gross estate is (i) the undiscounted value of a fee simple interest in the Rancho Aguila property or (ii) the value of several fractional interests in the Rancho Aguila property, which must be valued separately with appropriate fractional-interest discounts.
The Tax Court noted that:The general purpose of section 2036 is to include the value of property in the value of the gross estate where the decedent transfers the property during life and the transfer is essentially testamentary in nature… . A testamentary transfer is a transfer made in a will… . Transfers included under section 2036(a)(1) are essentially testamentary in nature because the transferor controls the disposition of the property at death but possesses and enjoys the property during life. [Citations omitted.]
The owner of a fractional interest in property, on the other hand, often lacks the ability to control the property or to sell the interest freely and - for this reason - fractional interests are often discounted to account for lack of marketability and minority interest.
However, the court observed:[w]hether property should be valued as a whole or as separate fractional interests—with appropriate discounts for split ownership—depends on when the interests are separated. If ownership is split during the decedent's lifetime, the interest the decedent retained is valued separately. If the split occurs only at death, the property is valued as a whole—without a discount for split ownership.
The court cited Propstra v. U.S., 680 F.2d 1248 (9th Cir. 1982), in which, before he died, the husband held a one-half community-property interest in land and his wife held the other one-half interest. The court in that case ruled that the husband's interest at death was valued separately from the wife's interest and was entitled to a fractional interest discount. The IRS has explicitly recognized, in Rev. Rul. 93-12, 1993-1 C.B. 202, that minority interests in a corporation that are transferred by gift to children during life are entitled to a discount, despite the fact that corporate "control" remains within the family, because the property valued for gift tax purposes is the property received by the donee. On the other hand, noted the court, where property is transferred at death, the property valued is not the property received, and thus no discount is made for the fact that the asset will "come to rest in several hands rather than one." Citing Ahmanson Found. v. U.S., 674 F.2d 761 (9th Cir. 1981).
The court ultimately held that, for estate tax purposes, the ownership of the Rancho Aguila property should be considered to have been split up at Adler's death. In 1965, Adler transferred a one-fifth remainder interest to each of his five children. He retained a life estate in the property. Thus, "it was as if Adler had retained the entire interest in the land during his life and transferred the property to his children at death." It is, moreover, "consistent with section 2036 to value the Rancho Aguila property as if the children's interests were transferred only at Adler's death. A property interest transferred to separate owners at death is not valued separately for estate tax purposes." (CompareEstate of Mellinger v. Com., 112 T.C. 26 (1999), in which a wife and husband owned a block of stock as community property. When the husband predeceased his wife, he left his interest to a qualified terminable interest property (QTIP) trust for the lifetime benefit of his wife. When the wife subsequently died, she still owned her one-half interest in the stock, the value of which was included in the value of her gross estate under §2033. The value of the husband's interest was also included in the value of the gross estate under §2044. The court upheld the application of discounts because the wife could not control or dispose of the portion of the stock in the QTIP trust.)
Therefore, the value ($6,390,000) on the date of his death of the entire Rancho Aguila property was determined to be includible in Adler's gross estate.
For more information, in the Tax Management Portfolios, see Hood, 830 T.M., Valuation: General and Real Estate, and in Tax Practice Series, see ¶6290, Valuation—Generally.
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