                        T.C. Memo. 2011-94



                      UNITED STATES TAX COURT



 ESTATE OF JAMES J. MITCHELL, DECEASED, WHITTIER TRUST COMPANY,
               EXECUTOR AND TRUSTEE, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 17351-09.              Filed April 28, 2011.



     John F. Ramsbacher, John W. Prokey, and Dennis I. Leonard,

for petitioner.

     Trent D. Usitalo and Nathan H. Hall, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     KROUPA, Judge:   Respondent determined a $10,177,566

deficiency in the Federal estate and gift taxes of the Estate of

James J. Mitchell (the Estate).   The deficiency related to the

valuation of interests in five real properties, 10 paintings and
                                  -2-

other various assets held by the Estate.   The parties have

resolved all the issues except the valuation of two real

properties and two paintings.   The values of the two real

properties consist of the 95-percent interest in each property

owned by the James. J. Mitchell Trust (Mitchell Trust) and the 5-

percent interests James J. Mitchell (decedent) gifted to his

sons’ trust six days before his death.   We are asked to determine

the fair market values of 95-percent interests owned by the

Mitchell Trust as of January 31, 2005 (valuation date)1 and the

5-percent interests gifted to decedent’s children as of January

24, 2005 (transfer date).2   We are also asked to determine the

fair market values of two paintings owned by the Mitchell Trust

as of the valuation date.

                        FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.

The stipulation of facts and the accompanying exhibits are

incorporated by this reference.    Decedent died as a resident of

Los Olivos, California on January 31, 2005.   Whittier Trust

Company (Whittier Trust), the executor and trustee of the Estate,




     1
      The parties agree that the valuation date for decedent’s
property interests is Jan. 31, 2005, the date of decedent’s
death.
     2
      The parties agree that the valuation date for the 5-percent
interests gifted to decedent’s children is Jan. 24, 2005, the
date of transfer from the Mitchell Trust to a trust for
decedent’s children.
                                 -3-

had its principal place of business in South Pasadena, California

at the time it filed the petition.

The Mitchell Family and the Mitchell Trust

     Decedent was born into a prosperous California family in

1944.   His father was a co-founder of United Airlines and married

to Lolita Armand, heiress to a famed Chicago meat packing family.

Decedent’s parents accumulated a sizeable fortune and bequeathed

a great deal to him, including American Western art by such

famous artists as John Gamble, Frederic Remington (Remington) and

Charles Marion Russell (Russell).      It is unknown when or from

whom his father acquired the paintings.      Decedent’s father crated

the paintings at a general storage facility where they remained

for over 30 years.   The paintings were not discovered until after

decedent’s death.    It is unclear whether decedent ever knew the

paintings were in storage.   It is further unclear whether

decedent ever thought they were of any value.      The paintings are

currently being professionally stored at Art Pack, Inc., a

securely monitored and climate-controlled fine arts storage

facility.

     Decedent also inherited several real properties, including

an oceanfront property at 1695 Fernald Point Lane in Santa

Barbara, California (the Beachfront Property) and a 4,065-acre

ranch along Refugio Road in Santa Ynez, California (the Ranch).

As an adult, decedent spent little time at either the Beachfront
                                 -4-

Property or the Ranch.   He lived in the San Francisco Bay area,

which was more than a 5-hour drive from the properties.      Decedent

did, however, have a great appreciation for both properties.

Decedent grew up on the Beachfront Property, and had many fond

childhood memories of the property.    Decedent prized the Ranch

not only for its size, but also for its rich history.    In the

1930s decedent’s father started a famous riding group called the

Rancheros Vistadores.    The group’s purpose was to revive the old

California Western way of life by having a week-long horse ride

through the Ranch.   Many famous individuals have been members of

the Rancheros Vistadores, including President Ronald Reagan and

Walt Disney.    The ride continues to attract 500 to 700 Rancheros

Vistadores every year.   Decedent inherited the Beachfront

Property and the Ranch subject to leases executed by his father,

and decedent determined to continue the leases to keep ownership

of the real properties in the Mitchell family.

     Decedent had a successful life in his own right.    He was

well-educated and worked as the business editor of the San Jose

Mercury News.   He married Susan Sutton, a prominent bankruptcy

attorney, and they adopted two sons.    As a result of his

inherited and self-made wealth, decedent accumulated many

valuable assets.   He determined it would be in his family’s best

interest if he placed his assets in a revocable living trust.      He
                                -5-

transferred all of his property interests to the Mitchell Trust

and named himself as trustee.

     Decedent’s wife unexpectedly passed away in 2002, and in

2004 he learned that he had cancer.   He thereafter amended the

Mitchell Trust and named Whittier Trust as trustee.    Decedent

wanted to pass both real properties to his sons but wanted to

ensure that his sons kept the properties in the family.

Accordingly, he included provisions in the Mitchell Trust to keep

his sons from receiving outright ownership of the real property

until the youngest son attained the age of 45.   Decedent gifted a

5-percent interest in both the Beachfront Property and the Ranch

to a trust for his sons’ benefit (children’s trust).     The

Mitchell Trust retained a 95-percent interest in both real

properties.   Decedent passed away shortly thereafter.    His two

teenage sons were orphaned at his death.

     The Estate consists of oil and gas interests, jewelry,

interests in five real properties and 12 paintings.    At issue

here are the Estate’s interests in the Beachfront Property, the

Ranch, “Casuals on the Range” by Remington (Remington’s Casuals)

and “Creased” by Russell (Russell’s Creased) (collectively, the

property at issue).

The Beachfront Property

     The Beachfront Property is a single-family, oceanfront

property located in the exclusive community of Montecito,
                                  -6-

California, near Santa Barbara.    The property is a gated

residence that consists of approximately 1.78 acres and a huge

backyard with 167 feet of ocean frontage.    The property includes

a 4,000 square foot house, a 600 square foot guest house and a

930 square foot carport.   The estimated annual property tax was

only $7,522 in 2005 because the house had not been sold for

several decades.3

     Decedent began leasing the Beachfront Property shortly after

his father’s death in 1987.   Leasing the property accomplished

decedent’s goal of keeping the property in the Mitchell family.

It also transferred the cost of upkeep to the property’s tenants

and provided income to decedent and his family.    Many different

tenants lived in the property over the 15-year span from the time

decedent inherited the property until he learned of his cancer.

In 2002 decedent leased the Beachfront Property to Mark and Lynda

Schwartz.   The Schwartzes lived in Los Angeles at the time and

wanted a weekend and summer home in the more tranquil Santa

Barbara area.   The Schwartzes quickly developed a strong

emotional connection to the Beachfront Property and decided to

make it their permanent home.




     3
      California Proposition 13 generally limits annual increases
in base year value of real property to no more than two percent,
except when property changes ownership or undergoes new
construction.
                                 -7-

     The Schwartzes tried to purchase the Beachfront Property

from decedent on several occasions.    Decedent rebuffed their

offers, but agreed to a long-term lease shortly before he died.

The Schwartzes and decedent negotiated a 5-year lease, with three

optional 5-year extensions exercisable unilaterally by the

Schwartzes for a total of 20 years (Schwartz lease).    They agreed

to $15,000 monthly rent for the first six months of the lease,

which would increase to $16,750 per month in July 2005 and then

increase 3.5 percent annually.   Annual rent for the first year

was approximately $190,000.   All rent was prepaid in an annual

lump-sum installment every January 1.

     The Schwartzes and decedent shared responsibility for

property expenses.   The Schwartzes negotiated the right to

renovate the main house on the Beachfront Property, subject to

decedent’s approval.   The house had not been renovated in over 30

years, so the Schwartzes desired to, and eventually did, spend

approximately $200,000 to renovate the house.    The Schwartzes

also negotiated the right to sublet the property.    They hoped

that either decedent would eventually agree to sell to them or

they could sublet the property for a profit.

The Ranch

     The Ranch encompasses 4,065 acres, making it one of the

largest ranches in the Santa Ynez Valley of Santa Barbara County,

California.   The Ranch’s diverse terrain makes much of the land
                                  -8-

difficult to work.   The ranch is the steepest ranch in Santa Ynez

Valley, and much of the property is covered with trees and brush.

Only half of the land is useable for agriculture or livestock

grazing.   There are two houses on the Ranch property.   The

primary house is 1,760 square feet with three bedrooms, and the

other house is 1,150 square feet with two bedrooms.   The houses

are approximately 70 years old and in fair to poor condition.

     Don and Sue Hanson (the Hansons) began leasing the Ranch

from decedent’s father in 1980.    The Hansons, both graduates of

Stanford University, have been life-long ranchers and used the

property both for living and business purposes.   Mr. Hanson

raised cattle on the Ranch during the winter months and then

transported them to the Hansons’ ranch in Wyoming during the

summer months.   He would then sell all his cattle in the fall.

     The Hansons signed a 5-year lease with decedent’s father in

1980 with a right to renew the lease at the end of the term.    The

Hansons found the property very useful for their cattle business

and continued to renew the lease for 5-year terms with decedent’s

father and then with decedent.    In 2004 the Hansons and decedent

negotiated a 5-year lease, with four optional 5-year extensions

exercisable unilaterally by the Hansons for a total of 24 years

and nine months (Hanson lease).    The Hansons’ rent was $32,000 a

year beginning in 2005, increasing $1,000 per year.   The Hansons

bore responsibility for any property expenses, except decedent
                                 -9-

paid the property taxes.    The Hanson lease satisfied the Hansons’

desire to retire on the Ranch and decedent’s goal of keeping the

property leased and maintained until it would be distributed to

his sons outright.

Remington’s Casuals

     Remington painted Remington’s Casuals in 1909.    Remington is

regarded as one of the greatest artists and sculptors of the

American West, having created approximately 3,000 drawings and

paintings and 22 sculptures during his career.    He developed an

impressionist style later in his life, which can be seen in

Remington’s Casuals.   His later works are considered his most

refined for their great attention to detail and convincing

depictions of western gear.

     Remington’s Casuals is an 18- by 26-inch oil on canvas

depicting a cowboy and an Indian talking on horseback in a

pastel-colored landscape.   An expansive mesa forms the backdrop

and marks the horizon line.   The figures in the painting are

fixed in their poses, rigid and staid.   Remington signed and

dated the lower right corner of the painting.    The painting is

thought to have been commissioned by a Chicago art dealer for a

private purchaser.    It is unknown how or when decedent’s father

received the painting.
                                 -10-

Russell’s Creased

     Russell painted Russell’s Creased in 1911.   Russell was

known as “the cowboy artist” because he developed inspiration for

his paintings from his work as a cowboy, trapper and wrangler.

His paintings often depicted the difficulties of surviving and

taming the American West.   He completed approximately 4,000

works, including paintings, watercolors and sculptures.

     Russell’s Creased is a 28- by 23-inch watercolor

illustrating a cowboy, two horses and a dying elk.   The painting

depicts a wounded elk struggling to survive after being shot by

the cowboy.   Snow-topped mountains provide the background for the

action scene.   Russell signed and dated the lower left corner of

the painting.   No one purchased Russell’s Creased when it was

completed.    It is unknown how or when decedent’s father received

the painting.

The Estate’s Estate Tax Return

     The Estate timely filed a Federal estate tax return.    The

Estate reported a $17,016,944 gross estate with a $6,916,919

total transfer tax.   The Estate valued the separate interests in

the Beachfront Property at $5,881,450 for the 95-percent interest

owned by the Mitchell Trust and $241,600 for the 5-percent

interest gifted to the children’s trust.   The Estate valued the

separate interests in the Ranch at $2,570,000 for the 95-percent

interest owned by the Mitchell Trust and $123,750 for the 5-
                                -11-

percent interest gifted to the children’s trust.    The Estate also

valued Remington’s Casuals at $400,000 and Russell’s Creased at

$300,000.

Respondent’s Examination and Tax Court Proceedings

     Respondent examined the Estate’s Federal estate tax return

and determined that the Estate underreported the fair market

values of several real properties and several paintings.

Respondent timely issued the Estate a deficiency notice that

assigned higher values to the properties, including the

properties at issue.   Respondent determined that the fair market

value of the 95-percent interest in the Beachfront Property was

$12,918,578 and the 5-percent interest gifted to the children’s

trust was $435,153.    Respondent determined that the fair market

value of the 95-percent interest in the Ranch was $10,950,371 and

the 5-percent interest gifted to the children’s trust was

$432,251.   Respondent valued Remington’s Casuals at $2 million

and Russell’s Creased at $2.6 million.

     Whittier Trust, as executor of the Estate, filed the

petition with this Court contesting the entire deficiency.    The

parties have been able to resolve all the valuation issues and

other estate tax issues, but still dispute the fair market value

of the two paintings and two real properties.   The parties

stipulated that 19-percent and 32-percent fractional discounts

should be applied to the 95-percent and 5-percent leased-fee
                                 -12-

interests in the Beachfront Property, respectively.     The parties

also stipulated that 35-percent and 40-percent fractional

discounts should be applied to the 95-percent and 5-percent

leased-fee interests in the Ranch, respectively.

                                OPINION

     We are asked to determine the fair market value of two

pieces of real estate and two pieces of art.      We appreciate that

valuing real property and art can be an ambitious task.      Both

real property and art are unique and infrequently exchange hands.

Moreover, the value of art, like beauty, often lies in the

proverbial “eye of the beholder.”

     This estate and gift tax valuation case illustrates the

difficulty in ascertaining fair market value, the quintessential

fact question.   The parties have abandoned their valuations

reported on the Federal estate tax return and determined in the

deficiency notice.     Both parties advanced at trial different

valuations of the property at issue.      We shall consider each

party’s valuation in turn.     We begin by considering the burden of

proof.

I.   Burden of Proof

     In general, the Commissioner’s determinations in the

deficiency notice are presumed correct, and the taxpayer has the

burden of proving that the Commissioner’s determinations are in
                                -13-

error.    See Rule 142(a);4 Welch v. Helvering, 290 U.S. 111, 115

(1933).    The burden of proof may shift to the Commissioner with

respect to a factual issue relevant to a taxpayer’s tax

liability, however, if the taxpayer introduces credible evidence

and establishes that he or she substantiated items, maintained

required records and fully cooperated with the Commissioner’s

reasonable requests.    Sec. 7491(a)(1) and (2)(A) and (B).

      The Estate filed a motion to shift the burden of proof to

respondent.    After reviewing all of the evidence presented, we

have found that resolving this case does not depend on which

party bears the burden of proof.    The parties adduced testimony

and offered exhibits supporting their respective positions.

Accordingly, we base our conclusions upon the preponderance of

the evidence rather than an allocation of the burden of proof.

See Estate of Jorgensen v. Commissioner, T.C. Memo. 2009-66;

Estate of Harper v. Commissioner, T.C. Memo. 2002-121.    We next

consider the valuations of the property at issue beginning with a

brief summary of the estate tax.

II.   Estate Tax Valuations Generally

      The value of a decedent’s gross estate includes the fair

market value of the property owned by the decedent on the date of



      4
      All Rule references are to the Tax Court Rules of Practice
and Procedure, and all section references are to the Internal
Revenue Code in effect for the date of decedent’s death, unless
otherwise indicated.
                               -14-

death.   Sec. 2031(a); sec. 20.2031-1(b), Estate Tax Regs.    Fair

market value is the price that a willing buyer would pay a

willing seller, both persons having reasonable knowledge of all

relevant facts and neither person being under compulsion to buy

or to sell.   See sec. 20.2031-1(b), Estate Tax Regs.    Morever,

the value must reflect the highest and best use of the property

on the valuation date.   Estate of Kahn v. Commissioner, 125 T.C.

227 (2005).

     Both parties relied extensively on expert opinions to

support their differing views on the fair market values of the

subject properties.   We evaluate the expert valuation opinions in

light of the expert’s qualifications and all other evidence.

Estate of Christ v. Commissioner, 480 F.2d 171, 174 (9th Cir.

1973), affg. 54 T.C. 493 (1970); Parker v. Commissioner, 86 T.C.

547, 561 (1986).   We may adopt all or none of the expert’s

methodology or value conclusions.     See Helvering v. Natl. Grocery

Co., 304 U.S. 282 (1938); Chiu v. Commissioner, 84 T.C. 722, 734-

735 (1985).   We must carefully consider all the facts, weigh all

relevant evidence and draw appropriate inferences and conclusions

in determining fair market value.

III. Real Property Interests at Issue

     We now consider the value of the 95-percent and 5-percent

interests in the Beachfront Property and the Ranch.     The parties

agree that the real property interests at issue are leased-fee
                               -15-

interests in contrast to a fee simple interest.    A leased-fee

interest describes the landlord’s rights in leased property,

including the right to receive lease payments and the

reversionary interest when the lease expires.     Marks v.

Commissioner, T.C. Memo. 1985-179; Appraisal Institute, The

Appraisal of Real Estate 114 (13th ed. 2008).   An appraiser

values a leased-fee interest subject to the actual lease and the

actual tenant, rather than on hypotheticals.    See Estate of

Proctor v. Commissioner, T.C. Memo. 1994-208.

     The parties’ experts used different valuation methods for

approximating the fair market values of the leased-fee interests

of the real properties at issue.   The Estate’s experts calculated

the leased-fee interests using the income capitalization method,

whereas respondent’s expert applied a novel leased buyout method.

The income capitalization method values income-producing property

by estimating the present value of anticipated future cash flows,

that is, lease payments and the reversionary interest.       Shepherd

v. Commissioner, 115 T.C. 376, 390 n.13 (2000), affd. 283 F.3d

1258 (11th Cir. 2002).   The appraiser selects an appropriate

lease period for the property, forecasts future cash flows and

chooses an appropriate discount rate to convert the future cash

flows into a present value.   The applicable discount rate takes

into account the inherent risks of real estate ownership and

competitive alternative investments.   An increment is added to a
                                -16-

base rate to adjust for risk by compensating for the extent of

evaluated risk.    Appraisal Institute, supra at 114.

     Respondent’s experts stated that a leased-fee interest under

the lease buyout method equals the real property’s fee simple

absolute value less the amount a landlord would have to pay to

buy out a tenant (buyout amount).      The buyout amount includes,

among other things, a return of advance payments and deposits as

well as the tenant’s costs to terminate the lease and find

another similar property to rent.      We will consider both methods

in determining the fair market values of the leased-fee interests

of the real properties at issue.

     Moreover, the Estate’s expert reports submitted at trial

valued the real properties at lower values than the Estate

reported on the Estate tax return.      We lack jurisdiction,

however, to find that the values were lower than that reported on

the Estate tax return.   See LTV Corp. v. Commissioner, 64 T.C.

589, 595 (1975).   The only issue before us is whether there is a

deficiency.   We will consider each expert’s report in determining

whether the values of the real properties at issue are equal to

or higher than the amounts reported on the Estate tax return.

     The parties stipulated that the fair market values of the

95-percent and 5-percent leased-fee interests in the real

property at issue should be based on each property’s 100-percent

leased-fee interest discounted by stipulated fractional amounts.
                                -17-

Accordingly, we must first determine the 100-percent leased-fee

interest value of the real properties at issue to determine the

value of the 95-percent interests owned by the Mitchell Trust and

the 5-percent interests gifted to the children’s trust.     We will

then apply the parties’ stipulated fractional amounts to

determine the values of the properties for Estate tax purposes.

     A.     The Beachfront Property

     We begin by considering the 100-percent leased-fee interest

value of the Beachfront Property.      Both parties submitted expert

reports providing valuations of the 100-percent leased-fee

interest.   The Estate presented expert reports and testimony from

James Hammock (Mr. Hammock) and John Thomson (Mr. Thomson).     Mr.

Hammock and Mr. Thomson are California-certified general

appraisers and members of the Appraisal Institute, which has the

highest credential level for an appraiser.     Both experts have

experience valuing residential and commercial property in the

Santa Barbara area.   Respondent offered expert reports and

testimony from Keith Andersen (Mr. Andersen), a real estate

appraiser and member of the Appraisal Institute with experience

valuing property in the Santa Barbara area.

     The Estate’s experts valued the 100-percent leased-fee

interest value of the Beachfront Property at $6 million to $8

million.    Respondent’s expert valued the 100-percent leased-fee

interest value of the property at $12.5 million.     The prime cause
                                    -18-

for the experts’ different valuations was the method applied for

valuing the property.

            1.   Valuation Method

       We now consider the proper method for valuing the 100-

percent leased fee interest of the Beachfront Property.        The

Estate’s experts applied the income capitalization method, which

is the general method for valuing leased-fee interests.        See,

e.g., Shepherd v. Commissioner, supra; Estate of Hinz v.

Commissioner, T.C. Memo. 2000-6; Kloppenberg & Co. v.

Commissioner, T.C. Memo. 1986-325; Marks v. Commissioner, supra.

Respondent’s expert Mr. Andersen contends that appraisers

generally use the income capitalization method only with respect

to commercial property leases, not residential leases.      Moreover,

he claims the income capitalization method does not yield a value

that would make economic sense because the Beachfront Property’s

property expenses far exceeded the rental value.      He asserts that

his lease buyout method should be used to value the Beachfront

Property.    We disagree.

       Any property that generates income can be valued using the

income capitalization approach.       Appraisal Institute, supra at

472.    Decedent treated the Beachfront Property as an investment

and profited from leasing the property.      Decedent never intended

to live on the property or use it as his residence.      The

Beachfront Property had been leased to third-party caretakers for
                                -19-

decedent’s entire adult life, and he intended to continue leasing

the property to caretakers until his sons could manage the

property.   Moreover, the long-term leases served decedent’s

legitimate property management and maintenance goals and produced

stable income.   Decedent not only received income but also

financially benefitted from having third-party caretakers

maintain the property.    The Schwartz lease relieved decedent from

having to pay a property manager to live on the property as well

as giving him someone to share all property expenses.

     Respondent’s expert Mr. Andersen claims that the Beachfront

Property’s property expenses exceeded the income generated from

leasing the property.    This assertion is unfounded.   Mr. Andersen

bases his argument on the first year’s lease payments of $190,500

and his projected expenses of $150,500 for property taxes,

maintenance, management and reserves.    His expense calculation

largely depends, however, on a reassessment of the property that

would lead to a steep increase in property tax.    Reassessment

occurs only upon completion of new construction or sale, neither

of which occurred here.    Moreover, he failed to show the Court

that new construction or sale would put the land to its best use.

The Mitchell Trust’s Federal income tax returns for 2003, 2004

and 2005 show an average of $73,200 in expenses associated with

the Beachfront Property compared to approximately $190,500 in

income generated under the first year of the Schwartz lease.      We
                               -20-

find that leasing the Beachfront Property was an income-producing

activity that put the land to its best use.

     Mr. Andersen also argues that the income capitalization

method generally is used to value commercial rather than

residential property and therefore should not be used in this

case.   We recognize that residences are typically owner-occupied,

not leased, so the income capitalization method generally does

not provide the best indication of value.    Here, however,

decedent treated the property as an income-producing property

rather than a personal residence.     Mr. Schwartz frequently sought

to buy it, but decedent rebuffed each offer.    Decedent, however,

wished to continue leasing the Beachfront Property to generate

income.   Decedent also saw a benefit in having the Schwartzes

maintain the property and preserve it for his sons’ benefit and

enjoyment.   We see no reason to deviate from the accepted use of

the income capitalization method for valuing income-producing

property like the Beachfront Property.

     We further find Mr. Andersen’s lease buyout analysis

speculative at best.   Expert testimony must be the product of

reliable principles and methods.    Fed. R. Evid. 702.   Mr.

Andersen’s lease buyout method has not been accepted by any court

or generally recognized by real property appraisers.     In applying

his lease buyout method, he estimated that the Schwartzes’

advance rent payment, security deposit and moving expenses would
                               -21-

total between $250,000 and $2 million, which is far from an exact

amount.   Moreover, he had no basis for assuming that the

Schwartzes would be willing to take a lease buyout.   We reject

the application of this method in this case.   Accordingly, we

find that the income capitalization method is the best method for

determining the value of the 100-percent leased-fee interest of

the Beachfront Property.

     The Estate’s experts were the only experts to submit

valuations based on the income capitalization method.    We

therefore look to the Estate’s expert reports for valuing the

leased-fee interest using the income capitalization method.     The

Estate’s experts determined that the Estate’s future cash flows

consisted of the lease payments from the Schwartz lease and the

reversionary interest of clear title to the property when the

lease expired after the 20-year term.   We first consider the

appropriate lease term for determining the value of the lease

payments and reversionary interest.

          2.   Term of the Schwartz Lease for Valuation Purposes

     An appraiser may be justified in concluding that a tenant

will exercise options to renew a lease when the renewal terms

favor the tenant.   Appraisal Institute, supra at 114.   Here, the

lease terms patently favored the Schwartzes, who had the option

to renew the lease three times, and not decedent, who was at the

mercy of the Schwartzes’ renewal decision and could not terminate
                                 -22-

the lease.    Moreover, the Schwartzes lived in the house for

several years, spent approximately $200,000 to renovate the house

and had not expressed any desire to move as of the valuation

date.   Accordingly, we conclude that a 20-year lease term is the

best estimate of length for the Schwartz lease.

            3.   Present Value of the Lease Payments and
                 Reversionary Interest

     We next consider the proper calculation for determining the

present value of the lease payments and the reversionary

interest.    Although both of the Estate’s expert analyses were

appropriate, we tend to favor Mr. Thomson’s methodology for

estimating the present value of the anticipated future lease

payments and the reversionary interest.    Mr. Thomson averaged the

actual expenses reported on the Mitchell Trust’s income tax

returns for 2003, 2004 and 2005 and annually adjusted the

expenses for inflation.    We find this to be the best expense

estimate.    We also find that Mr. Thomson’s 9.5-percent discount

rate, the average discount rate for residential property in the

Santa Barbara area, is a better discount rate than Mr. Hammock’s

use of the average discount rate for commercial property in the

Santa Barbara area.    We therefore find Mr. Thomson’s conclusion

that the present value of the lease payments would be $1,329,996

for a 20-year lease term to be the most accurate.

     We next consider the present value of the reversionary

interest.    We begin by determining the value of the property in
                               -23-

fee simple absolute.   Mr. Thomson did not value the property in

fee simple absolute but rather used the fee simple absolute

valuation prepared by respondent’s expert Mr. Andersen.      Mr.

Hammock and Mr. Andersen used the comparable sales method to

value the Beachfront Property in fee simple absolute.      The

comparable sales method determines value by analyzing and

comparing sales of property similar to the subject property and

weighing the information to reach a likely value for the land

being appraised.   Estate of Fawcett v. Commissioner, 64 T.C. 889,

898-899 (1975); Estate of Langer v. Commissioner, T.C. Memo.

2006-232.   Mr. Hammock and Mr. Andersen valued the Beachfront

Property in fee simple absolute at roughly the same amount using

the comparable sales method, $14 million versus $14.5 million,

and both experts selected a reasonable number of comparables.

Both experts considered lot size, home improvements and ocean

frontage price per foot as important comparable factors.     The

primary difference between the sales comparisons is that Mr.

Andersen selected properties sold in 2004 and 2005, while Mr.

Hammock selected properties sold in 2003 and 2004.   Mr.

Andersen’s sales were closer in time to the valuation date.        Both

experts acknowledged that the property in Santa Barbara

appreciated rapidly from 2002 to 2005.   We find Mr. Andersen’s

valuation more appropriate as it included comparables sold closer
                                -24-

to the valuation date.   We therefore use a $14.5 million fee

simple absolute valuation to calculate the reversionary interest.

     Mr. Thomson calculated the present value of the reversionary

interest using Mr. Andersen’s $14.5 million fee simple absolute

valuation.    He increased the fee simple absolute value by a 3.5-

percent annual growth rate and reduced it by a 9.5-percent annual

discount rate.   He noted that the reversionary interest value was

inversely related to the length of the lease term, with the

reversion amount decreasing as the lease term lengthened.   He

concluded that the reversionary interest amount would be

$4,697,779 for a 20-year lease term.   Mr. Thomson then added the

present value of the lease payments to the present value of the

reversionary interest and determined that the 100-percent leased-

fee interest value would be approximately $6 million.   Applying

the stipulated discounts to Mr. Thomson’s determination, the 95-

percent interest the Mitchell Trust owned had a fair market value

of $4,617,000 as of the valuation date, and the 5-percent

interest gifted to the children’s trust had a fair market value

of $204,000 as of the transfer date.

     We find Mr. Thomson’s estimation of the value of the

Beachfront Property most persuasive.   Accordingly, we find that

the Estate properly valued the Beachfront Property on the Estate

tax return.
                                  -25-

     B. The Ranch

     We now consider the 100-percent leased-fee interest value of

the Ranch.   The parties stipulated that a 35-percent and 40-

percent fractional discount should be applied to the 95-percent

and the 5-percent leased-fee interests, respectively.   The Estate

offered the valuation reports and testimonies of Mr. Hammock and

Mr. Thomson.   Respondent offered the valuation reports and

testimony of Donald Bratt (Mr. Bratt), a self-employed real

estate appraiser and a member of the Appraisal Institute.     Mr.

Bratt has experience valuing property in the Santa Ynez Valley.

     The Estate’s experts valued the 100-percent leased-fee

interest of the property at approximately $3.5 million.

Respondent’s expert valued the 100-percent leased-fee interest at

$20 million.   Like the Beachfront Property, this sizeable

valuation difference is primarily a result of the valuation

methods applied.

          1.   Valuation Method

     The Estate’s experts assert that the income capitalization

method is the best indicator of value for us to determine the

100-percent leased-fee interest value of the Ranch.   Respondent’s

expert Mr. Bratt advocates, however, that the lease buyout method

provides the best indicator.   We disagree with Mr. Bratt for the

same reasons we rejected respondent’s expert lease buyout method

to determine the value of the Beachfront Property.    The Ranch had
                                 -26-

been leased to the Hansons for 25 years.    This provided decedent

with annual income and also reallocated the regular maintenance

cost to third-party caretakers.    It was also consistent with

keeping the Ranch in the Mitchell family.    We find that the

income capitalization method should be used to determine the

Ranch’s 100-percent leased-fee interest value.

            2.   Term of the Hanson Lease for Valuation Purposes

     We now consider the appropriate lease term for determining

the present value of the lease payments and the reversionary

interest.   The Estate’s experts analyzed the 100-percent leased-

fee interest using different lease terms depending on the number

of options exercised.    The lease terms patently favored the

Hansons, who had the option to renew the lease four times.

Moreover, the Hansons lived on the property for 25 years and had

not expressed any desire to move as of the valuation date.      We

understand that Mr. Hanson’s age may be a factor in determining

the total lease term.    We were not, however, provided any data on

his life expectancy.    Cf. Estate of Proctor v. Commissioner, T.C.

Memo. 1994-208.    Accordingly, we calculate the 100-percent

leased-fee interest value based on all options being exercised

for a total lease of 24 years and nine months.
                                 -27-

            3.   Present Value of the Lease Payments and
                 Reversionary Interest

     We next consider the proper calculation for determining the

present value of the lease payments and the reversionary

interest.   For determining the present value of the future lease

payments, we accept the annual lease payments, expenses and

discount rate used by Mr. Thomson.      Mr. Thomson considered

decedent’s previous tax returns and determined $15,000 as a base

for expenses in 2005, which he annually adjusted for inflation.

We find that Mr. Thomson’s use of the 9.5-percent national

discount rate on leased residential property best reflects the

risks associated with investing in the Ranch and more accurately

estimates the rate of return investors expect when investing in

property like the Ranch.    We agree with Mr. Thomson’s conclusion

that the present value of all lease payments would be $150,713 if

all lease options are exercised.

     We must also consider the proper fee simple absolute

valuation for determining the value of the reversionary interest.

Mr. Thomson used Mr. Bratt’s comparable sales for his analysis.

Mr. Hammock and Mr. Bratt valued the property using the

comparable sales method, and all experts selected a reasonable

number of comparable sales.    The primary difference is that most

of Mr. Bratt’s comparable sales are located in the Santa Ynez

Valley, while eight of the nine comparables Mr. Hammock selected
                               -28-

were located outside the Santa Ynez Valley.   Both experts agreed

that property located in Santa Ynez Valley was priced much higher

than other property in the area.   We find Mr. Bratt’s comparable

sales better indicate the fee simple absolute value of the Ranch

because they were located in the Santa Ynez Valley.   Location,

location, location is paramount in real estate valuation.

     We do not, however, accept in toto Mr. Bratt’s comparable

sales methodology.   We are especially troubled by his applied

appreciation rate.   Mr. Bratt determined that the property most

similar to the Ranch was a 4,674-acre ranch that sold for $2,353

per acre in 1999 (Brinkerhoff Ranch).   He increased the sale

price of the Brinkerhoff Ranch by two percent per month for 61

months for passage of time, for a present value of $5,224 per

acre.   Mr. Bratt’s valuation appreciates the Brinkerhoff Ranch by

more than 100 percent in just over five years.   The Brinkerhoff

Ranch had appreciated at only 4.5 percent per year the previous

20 years.   While the property value in the Santa Ynez Valley may

have been appreciating rapidly between 1999 and 2005, we find no

support for such extreme growth.   We also are uncomfortable with

Mr. Bratt’s $24 million valuation being nearly double his most

comparable sale.

     We find Mr. Thomson’s fee simple absolute valuation using

Mr. Bratt’s comparable sales much more appropriate.   Mr. Thomson
                               -29-

recognized that there was significant growth from 2000 to 2005.

He applied an average 15-percent annual growth rate to the value

of the property based on the median home price appreciation in

Santa Barbara County during this period.   He determined the

proper price per acre should be between $2,600 and $3,500, for an

estimated $13 million fee simple absolute valuation.   We agree

with Mr. Thomson’s conclusion that the fair market value of the

Ranch in fee simple absolute is $13 million.

     Mr. Thomson applied a 3.5-percent annual appreciation rate

and a 9.5-percent discount rate to determine the present value of

the reversionary interest.   He concluded that the reversionary

interest value would be $3.2 million if all lease options were

exercised.   He then added the present value of the lease

payments, $150,713, to the current value of the reversionary

interest, $3.2 million, to determine the 100-percent leased-fee

interest amount to be approximately $3.37 million.   Applying the

stipulated discounts to Mr. Thomson’s determination, the fair

market value of the 95-percent interest in the Ranch owned by the

Mitchell Trust is $2,080,975 on the valuation date, and the 5-

percent interest in the Ranch owned by the children’s trust is

$101,100 as of the transfer date.
                                -30-

      We find Mr. Thomson’s estimation of the value of the Ranch

most persuasive.   Accordingly, we find that petitioner properly

valued the Ranch on its Estate tax return.




IV.   Paintings at Issue

      We must now determine the fair market value of the American

Western paintings Remington’s Casuals and Russell’s Creased on

the valuation date.   Experts consider several different criteria

in valuing art that are not typically used in general property

valuations.   These include thematic appeal, period of work,

style, overall quality, provenance,5 condition of artwork and

market conditions (collectively, the art valuation factors).

      Respondent contends that the fair market value of

Remington’s Casuals is approximately $2.3 million and of

Russell’s Creased is approximately $2 million.   The Estate

asserts that the fair market value of Remington’s Casuals is

approximately $1.2 million and of Russell’s Creased is

approximately $750,000.    Both parties offered expert reports and

testimony to aid the Court in making its determination.    The



      5
      “Provenance” means the origin or history of ownership of
the painting. Documented evidence of provenance for a painting
can help to establish that it has not been altered and is not a
forgery, a reproduction or stolen art.
                               -31-

parties jointly offered an expert report prepared by Virginia

Blyth Hill (Ms. Hill) on the condition issues specific to

Russell’s Creased.   Ms. Hill has over 30 years of experience as a

paper conservation expert.   The Estate offered the expert reports

and testimonies of Nancy Escher (Ms. Escher), Catherine Gellert

(Ms. Gellert) and Richard Alasko (Mr. Alasko) to support its

valuations of the paintings at issue.   The Estate’s experts are

members or candidate members of the American Society of

Appraisers (ASA), certified by the Uniform Standards of

Professional Appraisal Practice (USPAP) and have extensive

experience valuing American Western artwork.   Respondent offered

the expert reports and testimonies of Peter Fairbanks (Mr.

Fairbanks) and Gretchen Wolf (Ms. Wolf).   Mr. Fairbanks is a

member of the Appraisers Association of America and has been an

art appraiser for almost 25 years, specializing in 19-century

American and European paintings and traveling antiques.   Ms. Wolf

is an Internal Revenue Service (IRS) art appraiser, a member of

the ASA and certified by the USPAP.   Neither Mr. Fairbanks nor

Ms. Wolf has an expertise or extensive background in American

Western art.

     We also received appraisals for both paintings from the IRS

Art Advisory Panel (Art Panel).   The Art Panel comprises 25 art

experts who volunteer to assist the IRS in evaluating taxpayers’
                                  -32-

fair market value appraisals of works of art.    The IRS does not

tell the Art Panel whether an item is being valued for charitable

contribution purposes or estate tax purposes to ensure

objectivity.    The Art Panel submits its valuation to the IRS

Appraisal Office, which then makes the ultimate determination of

value.     The Art Panel’s valuation generally becomes the position

of the IRS.    Here, the Art Panel determined the value of

Remington’s Casuals to be between $600,000 and $850,000 and

Russell’s Creased to be between $300,000 and $1 million.     The Art

Panel submitted its appraisals to Ms. Wolf, the IRS staff

appraiser assigned to value the paintings at issue.    Ms. Wolf was

concerned by the Art Panel’s disparate and wide-ranging

valuations, which she attributed to its inexperience in American

Western art.    She believed that a much higher value was

warranted, which led her to prepare her own valuation report.

Respondent used Ms. Wolf’s valuation for purposes of the

deficiency notice.

     A.     Remington’s Casuals

     The parties submitted three appraisals of Remington’s

Casuals in addition to the Art Panel’s appraisal.    All of the

experts used the comparable sales approach to valuing Remington’s

Casuals.    The Estate’s expert Ms. Escher compared Remington’s

Casuals to 54 auction sales of Remington paintings between 1997
                               -33-

and 2005 in valuing the painting at $1.2 million.   Respondent’s

examination expert Ms. Wolf relied on a smaller pool of

comparable paintings to reach a $2.3 million valuation.

Respondent’s trial expert Mr. Fairbanks considered not only

public auctions but also private sales in valuing the painting at

$2.2 million.

     The experts agree that the positive valuation factors for

Remington’s Casuals include the period during which it was

painted, its condition, its impressionist style, the signature on

the painting and the market conditions on the valuation date.

The experts disagree, however, on the proper comparable paintings

and sales as well as whether the subject matter of the painting

should be viewed as a positive or negative factor in the

valuation.

     We begin by analyzing the comparables used by the experts.

Ms. Escher and the Art Panel relied only on public sales as

comparables, in contrast to Mr. Fairbanks, who considered private

sales.   The parties dispute whether private sales should be

considered.   This Court generally finds auction prices more

probative of value than poorly documented private sales.       See

Estate of Scull v. Commissioner, T.C. Memo. 1994-211.     We

generally look at private sales when they are well-documented.

See Williford v. Commissioner, T.C. Memo. 1992-450.   Here, Mr.
                               -34-

Fairbanks failed to provide the exact sale prices, exact sale

dates, identities of buyers or sellers, information on the

condition of the paintings or discussions on provenance.     He even

acknowledged that he did not put great weight on the private

sales.   Accordingly, we focus on comparable paintings that have

been publicly auctioned for purposes of valuing Remington’s

Casuals.

     We find the value conclusions of Mr. Fairbanks and Ms. Wolf

to be unreasonably high.   Their $2.2 million to $2.3 million

range is more than twice that of the Art Panel.   Ms. Wolf

expressed suspicions about the Art Panel report because the

panelists were not experts in American Western art.   If this were

the only criterion, then the Court would only rely upon Ms.

Escher as no trial or examination expert for respondent has

expertise in valuing American Western art.   Ms. Escher looked at

all auctioned Remingtons over a 6-year period to determine the

best comparables.   Three of the four paintings she selected were

selected by the other experts as comparables.   We find that the

Estate’s expert’s report is a better indicator of value as she

exhaustively researched all sales, had expertise in American

Western art and provided the most understandable report.

Accordingly, we find the fair market value of Remington’s Casuals

to be $1.2 million.
                                -35-

     B.     Russell’s Creased

     The parties submitted three appraisals of Russell’s Creased

in addition to the Art Panel’s appraisal.     All of the experts

used the comparable sales approach to value the painting and

considered Russell’s 1908 painting “A Disputed Trail” as a

comparable.    “A Disputed Trail,” a large watercolor widely

recognized as one of Russell’s finest works, sold at auction in

2001 for $2.31 million, which was the highest selling price of

any Russell before the valuation date.     The Estate’s expert Ms.

Escher compared Russell’s Creased to nine other Russell

paintings, including “A Disputed Trail,” in valuing the painting

at $750,000.    She considered “A Disputed Trail” far superior to

and more valuable than Russell’s Creased.     Respondent’s trial

expert Mr. Fairbanks and respondent’s examination expert Ms. Wolf

viewed Russell’s Creased as very similar to “A Disputed Trail,”

though they both viewed “A Disputed Trail” as an overall better

painting.   Mr. Fairbanks valued Russell’s Creased at $1.8 million

and Ms. Wolf valued Russell’s Creased at $2 million.

     Both parties’ experts agree that positive valuation factors

for Russell’s Creased include the period during which it was

painted, Russell’s signature on the painting and the market

conditions on the valuation date.      The experts disagree, however,

on the proper comparable paintings and sales as well as whether
                                 -36-

the subject matter of the painting should be viewed as a positive

or negative factor.

     We have fully considered all of the experts’ reports and

testimony.   All of the experts agreed that “A Disputed Trail” was

one of Russell’s greatest works, and no expert claims that

Russell’s Creased should be considered a great work.      The

Estate’s expert Mr. Alasko pointed out that the painting’s

provenance leaves much to be desired.      No one purchased Russell’s

Creased when it was completed.    Ms. Hill determined that the

watercolor image of the painting was in good condition.      In

contrast, the paper and back boarding were irremediably poor

because of weak ground wood and acidic paper pulp.      The Estate’s

expert Ms. Gellert testified as to the condition of Russell’s

Creased and determined that the surface of the painting has

yellow stains because of the poor paper quality.      We place less

weight on the reports of respondent’s experts as they failed to

adjust their valuation of Russell’s Creased for its inferior

status and for its poor paper quality and back boarding.

     The Estate’s expert Ms. Escher’s appraisal contains a

reasonably detailed description of nine comparables, including

comments about the condition of each piece.      Moreover, she fully

considers the painting’s provenance and poor paper and back

boarding in making her valuation.       Ms. Escher’s valuation rests
                                 -37-

squarely within the Art Panel value range of $300,000 to $1

million.   We find the Estate’s expert valuation the most

reasonable and well-supported.    Accordingly, we determine the

fair market value of Russell’s Creased to be $750,000.

V.   Conclusion

     This Court applies the stipulated fractional percentages in

finding that the fair market value of the Mitchell Trust’s 95-

percent interest in the Beachfront Property was $4,617,000 and in

the Ranch was $2,080,975 as of the valuation date.      We hold that

the fair market value of the children’s trust’s 5-percent

interest in the Beachfront Property was $204,000 and in the Ranch

was $101,100 on the transfer date.      We also hold that the fair

market value of Remington’s Casuals was $1.2 million and of

Russell’s Creased was $750,000 as of the valuation date.

     We have considered all arguments made in reaching our

decision, and, to the extent not mentioned, we conclude that they

are moot, irrelevant, or without merit.

     To reflect the foregoing,


                                             An appropriate order will

                                        be issued denying petitioner’s

                                        motion to shift the burden of

                                        proof, and decision will be

                                        entered under Rule 155.
