The Partition of Real Property Act

    The California legislature has once again changed the laws regarding partitions in California. Effective January 1, 2023, the Partition of Real Property Act ("Act") took effect, adding a twist to any partition action filed on or after that date. 

    The crux of the law is this: A non-partitioning co-tenant can avoid the partition and sale of the property by buying out the partitioning co-tenant. 

    This purchase option is new to California law. This right did not exist at all until the Uniform Partition of Heirs Property Act took effect January 1, 2022, but this only applied only to "heirs properties." The Partition of Real Property Act applies to all partition actions. 

     From a valuation perspective, this gives the partitioning co-tenant a path to liquidity without any "discounts." The rub is that the partitioning co-tenant has no control over whether the property is partitioned or whether the buy-out option is exercised. Furthermore, the Act adds procedural processes which will consume more time that previous partition actions. It may ultimately be that there is no reduction to valuation discounts as a result of this law.

    As a note, all code sections below refer to the California Code of Civil Procedure.

When does the Act not apply?

    The Act applies "to any real property held in tenancy in common where there is no agreement in a record binding the co-tenants which governs the partition of the property" (Section 874.311(b)). 

    In other words, the Act does not apply to properties where the co-tenants have executed a tenancy-in-common agreement that governs partitions. 

What is the purchase price under the option?

    The purchase price for each of the partitioning co-tenant's interest is the value of the entire parcel multiplied by the co-tenant's fractional ownership of the entire parcel (874.317). 

    As for the value of the "entire parcel," the co-tenants may agree upon the value of the property or a method to determine it. If they cannot, the court shall appoint a real estate appraisal to determine the fair market value of the property assuming sole ownership of the fee simple estate (874.316(d)). In some instances, the court may determine the property's fair market value itself.

    Once the court has determined the fair market value of the property - be it through an appraisal or on its own initiative - notice of such value will be sent to the parties. A party may object to the value under the appraisal within thirty days after the notice is sent (874.316(e)).

     Thus, the option price is the pro rata value of the appraised property value. This means that no discounts would apply.

 Does it lower valuation discounts for fractional interests in real properties?

    An now we reach the crux of the matter. 

    The Act makes it possible for the partitioning co-tenant to get cashed-out at a pro rata value (i.e., no valuation discounts). However, the choice rests in the non-partitioning co-tenant(s), so that is far from guaranteed. 

    Ultimately we can expect to see this: If ten years from now one compiled data on discounts for sales of undivided interests in California, it is likely one would observe a reduction in discounts as compared to the discounts before this Act's passage. The reason for this is that some partition actions will undoubtedly result in the non-partitioning parties exercising their buy-out options.

    However, the difference may not be very substantial. Although this provides a discount free path to liquidity, it does increase the issues involved in litigation, i.e., now there will be an appraisal process that is likely to be contested. This could add a substantial amount of time to the litigation.

How do we calculate the valuation of undivided interests under the Act?

    We must somehow consider the possibility that a pro rata buy-out occurs. That becomes difficult, however, because we cannot look to the particulars of the would be buyers since the Fair Market Value standard deals with "hypothetical" parties. 

    The best approach is to include a new method: the present value of the pro rata value weighted against the present value of the partition value. The exact weighting ratio is a discretionary call to be made by the analyst. Nonetheless, it is this authors opinion that a higher weight should be giving to the partitioning proceeds. If nothing else, this accounts for the fact that the appraisal process and option process adds a new level of litigation to the partition process.

Example of a partition valuation considering the Act.

    Hypothetical facts are as follows:

  • Appraised fair market value of the residential property is $1,000,000 and it is debt free.
  • There are two co-tenants and they are 50/50 owners.

    Under a traditional partition method, if we assumed a three year partition process, $15,000 in litigation expenses (equally distributed over the period), $60,000 in brokerage fees, and a 10% discount rate, we arrive at a present value of $340,700 (rounded). That's a discount of about 32%. 

    On a pro rata basis, the value would be $500,000 without regard to time value of money. If we assume it takes one year to move through the appraisal process, that's a present value of $454,545 assuming a 10% present value discount rate.

    If we apply a 70% weighting to the partition method and 30% to the pro rata buyout, the value of the interest comes to $374,900 (rounded). This weighting attempts to give some weight, by proxy, to the net asset value method, which is not shown here but usually results in a value similar to the partition method. 

     That value implies a discount of about 25%, which is still a healthy discount. Ultimately the Act may not lower discounts for undivided interests substantially.

What can attorneys do to ensure valuation discounts for their clients?

    The Act only applies to properties with no agreement governing partition actions binding the co-tenants (Section 874.311(b)). Drafting a tenancy-in-common agreement that waives partition will avoid the terms of the Act and provide for higher valuation discounts.

 

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