The most recent California bill, AB 2245, is effective for real estate property division actions filed on or after January 1, 2023. The bill has the potential to affect a stakeholder’s undivided rights in California, thus impacting the fair market value of the property. an interest. This change is important for understanding the stakeholder’s undivided rights as well as its implications for potential estate planning.
Carsten Hoffmann, managing director at investment bank and advisory firm Stout, and Eric Bardwell, estate planning partner at Jeff Mangles Butler & Mitchell, discuss key aspects of this legislation.
What does AB 2245 cover?
Hoffman: AB 2245 changes the statutory rights of subscribers as they relate to real property, specifically in the context of division by sale.
Is this a new law or an expansion of an existing law?
Bardwell: It’s a little bit of both, in fact. In 2021, AB 633 was approved, thus enacting the Uniform Partition of Heirs’ Property Act (UPHPA). The UPHPA has modified existing legal procedures for dividing real property owned as joint tenants by multiple owners if it meets the “heir ownership” requirements.
Basically, heirs’ estate is an estate where 20% of the interests are held by relatives or an individual who received their interest from a relative, or where 20% or more of the co-contractors are relatives. If a covenant required division by sale of the heirs’ property, the covenants who did not require division now had the option of purchasing all the interests of the contracting parties who required division by sale.
There are also new safeguards for the estate of the heirs regarding how the fair market value of the property is determined. AB 2245 extends these protections previously applied to estates of estates to include all real property interests held as joint tenants, regardless of how the property was acquired or the relationship between the tenants.
How was the fair market value of an undivided interest determined under the previous law, and are there additional considerations under the new law?
Hoffman: This new law does not change the definition of fair market value for a partial undivided interest, and therefore should not change the methodology. Fair market value remains the price paid by a willing buyer to a willing seller, without being under any compulsion to buy or sell, both of which have reasonable knowledge of the relevant facts.
Despite the current definition of a hypothetical buyer and a willing seller, this new law introduces some relevant facts that these buyers and sellers will be aware of. It is the additional protection afforded to some existing owners that may make achieving liquidity more difficult.
Legally, what does this law amend from the previous language?
Bardwell: The new law makes it more difficult for a single tenant to enforce a subdivision by sale, especially at auction, where it often deals for less than fair market value. Now, unless all the contracting parties agree on a value or method of valuation, or the court finds that the evidentiary value of the valuation outweighs its costs, an independent valuation is required. The contracting parties who did not ask for division by sale have an opportunity to obtain the benefits from the contracting parties who asked for the sale, and if they cannot obtain such interests, there is a strong preference for division by kind unless it would cause great harm.
If foreclosure is ultimately determined to be the only option, the sale must be made on the open market by a licensed real estate broker, and the sale price must not be less than the pre-agreed fair market value.
The bill also states that the new law applies in cases where there is no agreement governing the division of property and binds all contracting parties. It is now more important than ever to consider the tenant in a joint venture or similar agreement in the context of family estate planning.
What is the appropriate methodology for determining the fair market value?
Hoffman: The methodology will generally start with an NAV approach and then apply discounts for control and marketability. Most valuers will rely on unpartitioned effective interest transaction data (this is very difficult to collect and analyze, as the data is not readily available) as one approach.
The second approach often relies on partnership data for real estate entities that are more readily available. It will be necessary to make adjustments to these particulars to distinguish between an undivided interest and a partnership interest.
The latter approach would center around the cost of the partition and the time required, if the partition was not waived in the partnership agreement.
Why was this new law needed?
Bardwell: The focus of the bill appears to be to prevent abuse of the previous law, which enabled contractors with even 1% of real estate ownership to force a division by sale. Comments from the Senate Judiciary Committee suggest that “opportunistic speculators exploited this vulnerability to obtain a family member’s interest in the inherited property and force them to sell everything, often at below market value.”
In order to determine whether a partition would result in “significant bias”, the court will consider all current facts and circumstances, including how long the tenant and previous owners have held the property, as well as the specific tenant’s association with the property. Due to the subjective nature of significant bias determination, practitioners should be aware of these new rules and how they may affect existing planning.
Notably, the new law removes references to “heirs’ property,” which has important implications. The goal of the bill is to facilitate the retention of real estate wealth, whether during the life of the tenant or between generations, by preventing other contractors from being able to force the sale of real property to a third party or a tenant who has requested division by sale. By removing the reference to heirs’ property, the law now applies to all tenancies in joint ownership, regardless of how they were acquired.
In general, what is the size of the discounts, and what are the factors affecting the size of the discounts?
Hoffman: The magnitude of deductions due to the lack of control and the inability to market undivided interest is generally driven by factors such as the type of property, the performance of the property as measured by cash flows, the level of debt of the property as it relates to risk, the size of the interest compared to the assessed value, and the existence of any agreements governing ownership. The range of discounts can vary widely, but a rounding of the average range indicates discounts of between 30% and 40%. This is also supported by the consideration of various court cases in this area, although the service will generally start out by offering the first solution at 15% in the audit process.
What are the implications of the new law with regard to determining the size of the discounts and thus the fair market value?
Hoffman: Although the difference may be subtle, the new law gave certain rights and privileges to the current owners of the property, which could complicate the forced partition process and thus may complicate the process of obtaining liquidity. All other things being equal, this will have an upward pressure on the size of the discount. It may also lengthen the period in which the partitioning process will be completed.
Whether you are the planner or the valuation expert, it is wise to have a solid understanding of this new law, the protections it offers your clients and the potential impact on value, and therefore planning opportunities.