Land-value case highlights need for experts to illuminate their contentions. Leslee Hippert is a senior manager of FMV Opinions, a valuation and financial advisory services firm.

Overview

Faced with dueling experts opining on the value of a land parcel in Terrene Investments, Ltd. et al. v. Commissioner (T.C. Memo. 2007-218) earlier this month, Judge Holmes became his own expert and determined that the value of the parcel was $1,303,616 for purposes of a charitable contribution.

Background

This single-issue case was to extract the value of a 31.41-acre parcel with sand and gravel deposits, which was gifted as a charitable donation. The property's former owner estimated the value at $1,801,618, while the IRS set the value considerably lower at $301,000.

The taxpayers originally bought a larger 74-acre tract, of which this parcel was part, at a tax foreclosure sale. The taxpayers had noticed valuable white pines on the property, and thought they might be up against bidders who didn't recognize the parcel's true value. They bought the entire property for a little over $50,000. Then they cut the timber and sold it for $45,000. Noticing an adjacent parcel being mined for sand and gravel, they had core samples drilled and had their suspicions confirmed: the parcel possessed such deposits.

In 1998, they donated 31.41 acres to a religious foundation and took a charitable deduction on the basis of its appraised value. The IRS disputed their valuation and the case was tried solely on this issue.

The vacant parcel was on a sand-and-gravel filled floodplain in Houston, Texas, that was filled with. Thus, the land was not just a location: it contained a valuable commodity. The Tax Court wryly summed up the issue at hand as an inquiry into the "effect the four holes drilled into the 31.41-acre parcel" had on its value.

Although the market for sand and gravel in Houston is large, the court noted that "neither production nor consumption is highly concentrated, and prices are set on a wide variety of terms." It is sold by the cubic yard or by the ton; and prices vary depending upon coarseness, length of contract and distance to a buyer's worksite. The decision

The court noted that only two of the three accepted methods of estimating fair market value for any property would be appropriate: comparable sales and income capitalization (also known as "discounted cash flow"). Both parties agreed with the court that the replacement-cost method was inappropriate.

The Taxpayers' proposed value of $1,801,618 was based on the discounted cash flow analysis by its expert EBanks. The commissioner's expert (Moritz) proposed value of $301,000 was based on the direct sales comparison method (66%) and the discounted cash flow analysis (34%).

The court noted that in only one of the five comparable sales that the commissioner's expert used, were the parties even aware that the land contained valuable sand and gravel deposits. As a result, these sales were not considered comparable as neither buyer nor seller had reasonable knowledge of the relevant facts, a requirement for fair market value. (And in the one sale where the parties negotiated the sales price on the basis of the sand and gravel deposits, the land was burdened with oil-pipe easements and leases in addition to oil contamination.)

After discarding the direct sales method, the court determined that discounted-cash-flow method was most appropriate for estimating the value of the land. This method calculates a cash flow from a property and then discounts it to the present. The court noted the number of variables involved in the discounted-cash-flow method and the fact that the experts disagreed with each factor. In turn, the court disagreed with the experts on several of the factors.

Volume of material: The volume of material is based upon estimating the following items:  Setbacks: Ttrips of un-mined land between pit walls and property lines. They vary in size depending upon whether the pit adjoins a public road (25' legally mandated); private road or other parcel. Other than public roads, the setbacks are up to the operator and property owner, varying between 5' to 50', depending upon soil type (the more compact the soil in a pit wall, the less likely to collapse) and the operator's risk preference. The experts' setbacks varied between 5' and 50' feet. The Tax Court chose two 25' setbacks and two 10' setbacks. Work area: The need for some land to be set aside for a work-plant to sort the excavated material. The experts' work areas varied between 0 and 7 acres. The Tax Court chose 4 acres. Pit slope: The pit wall's angle or repose, the closest to vertical is preferred to maximize the mined material versus a more gentle slope to create stability and prevent the walls from collapsing. The Tax Court sided with the Taxpayer's expert and an angle of 75�. NNN iv. Waste: The waste of the material, the waste inevitably occurs during extraction and processing. The experts' waste estimates varied between 0% and 10%. The Tax Court chose 10%, siding with the IRS. Rate of Extraction: How long will the mining take and how much can the mine produce annually. The Tax Court noted that absorption of the material was not an issue given the area's strong demand. The experts' rates of extraction varied between 200,000 and 360,000 tons annually. The Tax Court sided with the Taxpayer's expert and an extraction rate of 360,000 tons. Royalties: The royalty rates for sand and gravel are not uniform, varying from $0.25 to $1.00 per ton. The Tax Court estimated $0.71 per ton. Discount Rate: The single largest source of dispute was applying the appropriate discount rate. The rates varied between 9% and 28%. The Tax Court rejected both rates and noted that the highest rate was erroneously associated with the operations of the pit, rather than passively receiving royalty rates from the land. The court started with a risk-free rate of 4.5%, based upon the average of 3-year and 5-year Treasury notes. A risk premium of 3% was added to create an implied rate of return for buyers of comparable properties. It noted an illiquid 8-year stream of royalty payments. This percentage was the spread between Treasury notes and Baa corporate bonds. In addition, the court noted additional risks associated with interruptions of operations from flooding, malfunctioning equipment, etc. and added another 4%. The resultant discount rate was 11.5%, which (as a reality check) is reasonably close to discount rates in other cases involving royalty interests. Other Factors: Moritz raised a parade of improbable specters that might diminish value: wetland regulation, social pressure and other regulatory risks. The court found these factors wanting.

After applying all these factors, the court held that the value of the property was $1,303,616.

Summary and conclusion

Although the court found that the experts were credible, it substituted its value estimate of the land by choosing bits and pieces from the assumptions used by the three experts. The court noted that the experts' lack of transparency in determining their estimated value doomed fully following either expert's opinion.

As the court disagreed with elements of the assumptions of all of the experts, without transparency, the computations could not be adjusted using information from the record to obtain a final amount that the court found reasonable. Thus, it is extremely important that an expert testifying supply sufficient information and fully illuminate its conclusions, so that if the court disagrees with a small portion of its analysis; it may still concur with the expert's final opinion -- or something quite close to it. -FWR

This is not intended or written to be used by any taxpayer or advisor to a taxpayer for the purpose of avoiding penalties that may be imposed upon the taxpayer or advisor by the IRS. This writing is not legal advice, nor should it be construed as such.

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