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How Do Partial Interests Impact Value?

October 17, 2023 - Ricky Sommers

My brother and I own land that has been in our direct family lineage for 150 years, and I am proud of this legacy. There is a general admiration for farm operations that have been in a family for several generations. However, there can be surprises in the event of a death or marriage dissolution that a family may be unaware of when there are multiple owners with varying fractions of ownership, resulting in minority ownership.

Property rights are inherent in all real estate and are commonly thought of as the "bundle of rights." When an individual has all the rights and complete ownership, it is known as fee simple title. This provides the owner the following rights, subject to government and public restrictions: the right to use it, the right to sell it, the right to lease it, the right to mortgage it, the right to enter upon it, the right to give it away, and the right to refuse to exercise any of these rights.

Fee simple title can be divided into several ways: by lease, by easement, by deed restrictions, and by life estate. With these divisions, the fee simple title gives up a part of the rights of owning the property but, except for the specific right(s) given up by the owner, still retains general control of the property.

Fee simple title can also be divided by co-ownership. Co-ownership of real estate differs from the other division types in that each co-owner has the same rights as each of the other co-owners.

If a co-owner is not satisfied with the ownership interest, there are options available to dispose of the interest. The co-owner may sell the undivided interest, seek to have the property partitioned voluntarily, or have the property partitioned by the courts. The lack of total ownership control of any real estate property presents risks to financial return in the short term and risks to the market value of the property in the long term. Some of the risks include not having complete control over the selection of a tenant, agreement to leases and terms, managing the property, managing the property, expenditure of funds for maintenance and capital improvements, selling the real estate interest, and mortgaging one’s interests.

A fractional owner could request legal intervention, by way of a partition suit, to force the division or sale of the real estate. While this offers some protection to a fractional interest owner by allowing them to sell their interest, it places the other owners of the property at risk. One of these risks is that a property division approved by the court may not be best suited to all the landowners. Of greater concern is that if an equitable land division cannot be made, the courts may force the sale of the entire property. If this were to occur, the owner of a fractional interest may have to decide to purchase the remaining interests or sell their interest.

Selling an undivided interest in a property is generally difficult. Most buyers prefer fee simple title, which gives them full control of the real estate.

Because of the nature and undesirability of undivided interests, they very rarely occur or are involved in transactions except within families where they are created by division of real estate by inheritance. The transactions between family members are not considered bona fide transactions because they typically involve other considerations such as reunification of the title to a property and not the market value of the undivided interest itself.

The sale of fractional interests on the open market would be the best determination of the value of a fractional interest, as the price paid for the interest could be compared to its estimated market value to determine the discount applied by the buyer. The primary reason that a discount is warranted is that the owner of a fractional interest would not have control of the property rights typical to full ownership. The lack of full ownership rights reduces the interest of any prospective purchaser, resulting in a reduction in the market value of the affected property. Market data of non-related owners indicates that most minority interests are at 20 to 50% discount.

Most family farming operations continue until a death or divorce shatters the trust between the owners. It’s important to know if you have an undivided interest or not. And if so, at what percent? It’s better to know this and have a defined exit strategy for a minority interest that wants out, rather than a court decision. It’s also important to consider that even if a spouse is not named on the deed, he or she will have a legal interest if marital funds were used for the purchase of the property.

A family farm that has passed assets to the next generation has created dynamic generational wealth. This same wealth can result in heartache when a family farm is forced to sell to settle an estate or divorce.  Be aware of the details of your operation. Having a transitional plan in place is key to keeping the family farm intact for the next generation.