Value of decedent's unfinished residence, not completed value, was includible in gross estate.

In October 1991, B'S house was completely destroyed in a fire in California. Under her insurance policy with C, she was entitled to receive replacement cost, limited to 50% of the policy's coverage limits. After its adjusters examined the property, C paid B the maximum amount under the policy (almost $500,000).

Within six months after the fire, the California insurance industry (including C) unilaterally agreed, in connection with this fire, to disregard the 50% charges and pay the actual cost of replacement, even if that cost exceeded the policy limits.

B then invited bids for construction of a replacement residence. Ultimately, C agreed to pay her $1.3 million for this work. C also paid B for living expenses while the residence was being rebuilt.

B died in 1994. After her death, the co-executors of her estate decided to complete the reconstruction of the residence. B'S estate tax return reflected the value of the partially (57%) finished home as its fair market value (FMV). Also included was an amount that the estate estimated would be due from C for future reimbursement on completion of the restoration; excluded was the amount that would be due the contractor. In effect, this resulted in a net reduction in B's gross estate.

The IRS determined that the completed value of the residence should be included, thereby increasing B's gross estate. The estate challenged this increase. In a memorandum opinion, the Tax Court holds for B's estate. No amount representing any possible future payment from C is includible in B's estate; at the same time, the estate is not entitled to deduct the possibility of future payments to the contractor.

For Federal estate tax purposes, assets are includible in a decedent's gross estate at FMV determined at the date of death. FMV is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts. FMV is tested on an objective basis, using a hypothetical buyer and seller, and not on the basis of the particular entities or individuals involved.

First, the asset in question was incomplete and under construction at the time of death. More significantly, the residence was to be restored to its prefire specifications. The cost of restoring the destroyed residence to its original vintage condition was substantially greater than the per-square-foot cost of constructing a contemporary home. In other words, there was no compulsion for the costs to be within boundaries that related in any way to resale value. That anomaly resulted in circumstances in which more was being expended for construction and restoration than could possibly be realized if the structure were sold on completion. The FMV of the finished residence was substantially less than the cost of restoration. Finally, although the insurance company's obligation was contractually and legally limited to the payment of up to half of the stated policy limit if the residence were rebuilt, the insurance company unilaterally agreed to bear the cost of replacement of the vintage structure and to pay B's living expenses during the interim. The insurance company's agreement to pay, however, was contingent on B's pursuit and completion of restoration, and was unique to B.

Conventional approaches to valuation, inclusion of assets and reduction of the estate for B's obligations do not accurately address these peculiar circumstances. The estate's approach of estimating the cost to complete and the reimbursement of part of that cost have no meaningful relationship to B'S asset--the partially completed residence. At the date of death, the estate had no right to receive insurance reimbursement and no obligation to pay for the completion of the residence.

From the Service's perspective, B had a contract right that was worth, at very least, the difference between the incomplete structure and its ultimate selling value. The estate reported the value of the incomplete structure at the value set forth in the appraisal attached to the estate's return.

The IRS, however, contends that the value should be increased to reflect the completed value of the residence, because the insurance company agreed to reimburse B for rebuilding the residence. The estate argues that B did not own any asset or contract right that would enhance the value of the incomplete residence at the time of her death. We agree with the estate.

The concept of FMV, in the context of Federal taxation, has remained unchanged for more than 80 years. For estate tax purposes, the amount includible in the gross estate is the FMV of a decedent's interest in an asset on the date of death. B owned an incomplete residence (57% completed).

The Service's determination is that B had a right or was entitled to the completion of the residence so that the completed value should have been included in the gross estate. Accordingly, B had a right to the insurance reimbursement, and the value of that right was includible as an asset in her estate.

Under the agreement between C and B, C had unilaterally agreed to pay for restoration of the residence, but only if restoration were pursued and completed. To the extent that C had an obligation to B at the time of her death, it could only be to reimburse for any portion of the residence that had been restored. In addition, C's exposure under the agreement was to be reduced if the cost of construction was less than estimated.

At the time of B's death, it appears that neither B nor her heirs had any enforceable right to payments from C. Additionally, because the construction contract ran between B and the contractors, at the time of death there was no assurance the contractor would complete the project. Under these circumstances, C's obligation to pay for improvements after B's death was subject to a condition precedent.

The practical reality was that, after B's death, there existed a 57%-complete residence with no enforceable right to insurance reimbursement and no contractual obligation between the estate or heirs and the contractor for the completion of construction. Under these circumstances, no amount was includible in B's gross estate to represent any possible future payment from C.

Conceptually, the purpose of the estate tax is to tax the transmission of wealth at death. Sec. 2031 is intended to provide for inclusion of a decedent's interests transferred at death. Likewise, Sec. 2053(a) was intended to ensure that only the net estate (i.e., that which is available for distribution to the beneficiaries) is taxed.

In this case, the asset available for distribution to the beneficiaries was the 57%-completed residence. The beneficiaries had the option to complete the residence and thereby incur the benefits and burdens of such action. The FMV of the asset received by the beneficiaries, however, was no more or less than the FMV of the incomplete residence.

ESTATE OF M.B. BULL, TC MEMO 2001-92