Fair Market Value

(This is the 3rd of a 3-part article | Part 1 | Part 2)

(by David Maloney) Fair market value is often confused with market value. The stumbling block is normally in regards to the issue of title transfer. While a market value appraisal assumes the transfer of sold property to the new owner as of a specified date, fair market value assumes that the item is not sold, but rather that ownership is retained. Fair market value is used, as an example, by the IRS to substantiate tax deductions for noncash charitable contributions, or as a basis on which to levy estate taxes on property in the decedent’s estate that is bequeathed and not sold.

Fair market value is defined by a legal or regulatory jurisdiction and may vary with individual jurisdictions, i.e., from state to state. For the purposes of this book, we will make use of fair market value as defined by IRS Regulation §1.170A-1(c)(2) and as expanded on by the Treasury Regulation state §20.2031-1(b).

Definition of Fair Market Value

Treasury Regulation §1.170A-1(c)(2) defines FMV for noncash charitable contribution purposes as:

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 sell and both having reasonable knowledge of relevant facts.

Treasury Estate Tax Regulations expands on the above definition. Estate Tax Regulation §20.2031-1(b) defines FMV as:

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. The fair market value of a particular item of property includible in the decedent’s gross estate is not to be determined by a forced sale price. Nor is the fair market value of an item of property to be determined by the sale price of the item in a market other than that in which such item is most commonly sold to the public, taking into account the location of the item wherever appropriate. Thus, in the case of an item of property includible in the decedent’s gross estate, which is generally obtained by the public in the retail market, the fair market value of such an item of property is the price at which the item or a comparable item would be sold at retail…

Fair market value was originally devised by the federal government as a method by which to form a basis for the taxation for property within a decedent’s gross estate which was not sold upon the taxpayer’s death, such as property bequeathed to heirs. Decedent’s property that is sold can be taxed based on proceeds generated from the sale, but in order to form a basis on which to tax property that was not sold, it was necessary to define and assign fair market value.

Fair market value of the subject property is based on what the appraiser concludes that property’s probable sales price would be if the property were to be hypothetically sold between hypothetical parties. (The appraiser bases this value opinion on past sales within the “appropriate market” of comparable properties.) In other words, the subject property is assumed not to have actually been sold, rather, it is assumed (at least as of the effective date of the appraisal for purposes of the analysis) that title is retained. Title will eventually transfer (e.g., to the heirs, giftee or donee), but for purposes of the assignment, title is assumed to have been retained.

An actual sale price would be the best evidence of value, but often the subject property is not sold, such as that property that is bequeathed, gifted or donated. If the subject property is not sold, the appraiser must make a reasonable estimate of what the hypothetical gross sale price would be if the subject property were to be sold. (The gross sale price does not subtract for expenses normally associated with a sale such as auctioneer’s commissions, transportation, advertisement, color catalog photographs, insurance, etc.). Generally, the hypothetical sale is considered to be a sale for cash, as opposed to a financed sale, or an exchange for some other property. The below section entitled “Fair Market Value is a Hypothetical Value: A Case Study” will explore this issue further.

All federal tax liability uses for appraisals (such as estate tax, gift tax, noncash charitable contributions, casualty loss) require the assignment of fair market value. In Anselmo v. Commissioner the Tax Court, in applying this definition of fair market value in a noncash charitable contribution case, held that there should be no distinction between the measure of fair market value for estate and gift tax purposes and noncash charitable contributions under the income tax law. In other words, whenever doing an appraisal for federal purposes, make use of fair market value and no other type of value.

To substantiate a determination of fair market value presented in the appraisal report, the appraiser must base such an opinion on past comparable sales which exhibit the market characteristics as stipulated in the above definition of fair market value.

But if …

Those comparable sales are not between a willing buyer and a willing seller, or
If buyer or seller are under compulsion to act, or
If buyer or seller are not reasonably knowledgeable of relevant facts, or
If the comparable sale was not “to the public” (i.e., at retail to the end consumer), or
If the comparable sale was not in terms of cash or cash equivalent, or
If the comparable sales being considered did not occur within the “most common market”

… then those comparable sales must be excluded from the appraiser’s analysis as they do not conform to the required definition of fair market value. Let’s look at these requirements of fair market value in greater detail.

Willing Buyer and Willing Seller

The concept of “willing buyer and willing seller” is a state of mind which considers a hypothetical sales scenario in which someone wants to buy the item and someone wants to sell the item. This is of critical importance. If buyer or seller were not willing, either there would not be a sale in the first place, or the sale that did occur would not be representative of a fair market value.

For instance, I am not an acceptable “willing seller” if I have an oak sideboard that I do not want to sell. Instead, I want to keep it for my own use. If I were to sell it, I would ask an astronomical amount for it (see Endowment effect.) Otherwise, I would keep it. If that astronomical price were paid, it would be an anomaly and would not be indicative of fair market value. Comparable sales found to have been conducted with an unwilling buyer or unwilling seller must be discarded and not used as a basis for determining fair market value.

Neither Buyer nor Seller under Compulsion

The difference between “willing buyer and willing seller” and “neither being under compulsion to buy or sell” is purely one of degree. One may be willing to sell in an orderly sale scenario where the highest price would be realized but not be willing to sell in a forced sale scenario where the sale price would be less.

A sale under which one party or the other would be compelled to act would not be representative of a fair market value so could not be used as a comparable sale.

If the buyer is forced to buy (such as might be the case with a limited offering for goods or an immediate need of the buyer), the price paid could be artificially high. As such, it would be an anomaly and not be representative of fair market value. Such sales must be discarded and not used in the appraiser’s analysis.
Conversely, it would be considered a compulsion to sell if I was under bankruptcy court order to liquidate certain property in order to satisfy creditors by a certain deadline. In such a case, the property would necessarily be sold within a short amount of time and with little exposure to the most appropriate marketplace. Consequently, it might be sold for merely pennies on the dollar. This, too, would be an anomaly and it would not be indicative of fair market value either.

Reasonable Knowledge

Fair market value also assumes that both buyer and seller have a reasonable knowledge of all the relevant facts regarding the subject property. It should also be assumed that buyer and seller are equally knowledgeable of those facts so that both parties have similar bargaining power. Without reasonable and equal knowledge, one side has the advantage over the other, and the sale will not be representative of fair market value.

Example: A buyer is informed of the fact that the property for sale is genuine, while the seller is under the mistaken impression that it is a later, albeit high-quality, reproduction. The property will probably sell for a much lower price than its true worth due to the seller’s lack of knowledge regarding the property’s authenticity. Such a sale could not be used by the appraiser to support his or her opinion of fair market value because the buyer and seller were not reasonably and equally knowledgeable.

To the Public

IRS Estate Tax Regulation §20.2031-1(b) states:

…nor is the fair market value of an item of property to be determined by the sale price of the item in a market other than that in which such item is most commonly sold to the public…

“Public” refers to the end user, the end consumer—not to a wholesaler who is one who buys with the intent of reselling. A sale “…to the public…” refers to a retail customer who is the ultimate consumer of the property—at least of the property in its current form. The “public” for an antique clock is the collector who intends on keeping and not reselling the item. A dealer is not considered to be the “public” since a dealer typically buys for resale.

Here are some additional examples of the appropriate end consumer, i.e., “the public”:

The ultimate consumer for a wrecked car is a salvage yard. The salvage yard does not intend to resell the item “in its current form.” Instead, the salvage yard intends to disassemble the car and then sell the salvaged parts.
The ultimate consumer for a costume once worn by Marilyn Monroe is the collector of Hollywood memorabilia, and not a costume store.
The ultimate consumer for a large collection of used, out-of-date medical books is a book dealer who (while not intending to resell the large collection as a single lot) disassembles the collection and sells the books piecemeal.
At issue in Anselmo v. Commissioner was the valuation of a large quantity of loose, low-quality, un-mounted gemstones. The taxpayer claimed a deduction based on the value of loose gemstones as if they had been set into jewelry and sold in jewelry stores at retail. In objecting, the Tax Court ruled that the ultimate consumer of a large quantity of loose, low-quality gemstones was jewelry manufacturers, who would pay considerably less for the loose gems than what the gems would sell for once mounted and sold through jewelry stores.

Most Common Market

To be indicative of fair market value, the comparable sale the appraiser wishes to make use of as a basis for fair market value must have taken place “somewhere,” and that somewhere is defined by the above Treasury Regulation as the marketplace in which that type of item is most commonly sold to the public.

Estate Tax Regulation §20.2031-1(b) states:

…nor is the fair market value of an item of property to be determined by the sale price of the item in a market other than that in which such item is most commonly sold to the public…

It is the appraiser’s responsibility to determine the most common market for each item being appraised. For used household goods the most common market might be a yard sale or local auction. For a fine work of art the most common market might be a regional, national or an international auction house.

The most common market could also be a retail gallery. For instance, assume that collectors most often obtain American folk art paintings by a noted Southern African American artist not through auction but most frequently through specialized art galleries in the South. That retail market, then, is the most common market, and gallery sales of comparable properties can be used as a basis for determining the fair market value for similar properties. In addition, certain living artists sell their works only through a designated gallery. These specific retail markets would be the most common market for the artist and so should be used.

On a related matter, with some types of property where the issue of genuineness is of paramount concern (for example with pre-Columbian art) purchases from galleries which offer connoisseurship, firm guarantees of authenticity, return policies and good title may be the most common market as opposed to auctions which might not offer such advantages.

Fair Market Value is a Hypothetical Value: a Case Study

Fair market value is a hypothetical value in that it assumes that title does not transfer from the hypothetical seller to the hypothetical buyer, but rather that the property and any rights inherent to ownership (i.e., the bundle of rights) are retained by the owner, and that those rights and benefits of ownership will continue.

Fair market value is rooted in the federal estate tax concepts—contents of an estate which are sold during the closing of an estate are taxed at the amount netted by the estate. (The IRS considers the sale price of property as good and sufficient proof of fair market value.) But estate property which is left unsold (for instance property that is bequeathed) is taxed not on what it might have netted if sold, but rather on what would have been paid by a buyer if the property had been (hypothetically speaking) sold.

It is for these reasons that fair market value is called a hypothetical concept. It is hypothetical in the sense that the unsold estate property is being valued as though it had been sold, but that its rights of ownership and title were not transferred.

Since the property is assumed to be retained, there would be no expenses associated with a sale; therefore, fair market value is, in effect, the gross proceeds (not the net proceeds) that one would expect to be realized if the item had been sold.

In other words, fair market value is a measure of the amount which would be obtained (e.g., an auction hammer price plus buyer’s premium) and not the amount that would be retained (selling price less sales commissions and other expenses).

In their Technical Advice Memorandum (Priv. Ltr. Rul. 9235005) based on Publicker v. Commissioner the IRS ruled that a buyer’s premium paid at auction is a component of the purchase price and, as such, is additive to the sale price when calculating fair market value. This ruling may have little effect on some estates, since under certain circumstances the buyer’s premium may be deductible as an administration expense. Those “circumstances” generally revolve around whether or not the sale was made out of necessity in order to pay estate taxes or just for convenience in order to facilitate the division of property among heir. Regardless, it is a topic best explained by an experienced accountant or estate lawyer.

Consider a fine painting in the decedent’s estate which will be inherited by a descendent. The painting must be valued for estate taxation purposes at fair market value because it is not going to be sold. Rather, it has been bequeathed to a descendent. An appraiser is retained to develop an opinion of the painting’s fair market value. To determine fair market value of this unsold subject property, the appraiser conducts market research to locate past sales of comparable properties on which to base an opinion of value.

The appraiser locates two comparable paintings which recently sold at a regional auction which the appraiser deems to be the most common market in which such items are sold to collectors (i.e., end consumers). One painting sold for $12,000 while the second sold for $15,500. Basing an opinion of value on an analysis of both comparable sales, the appraiser averages the selling prices and comes to the opinion that, if sold, the subject painting would sell for $13,750.

$13,750 represents the amount for which the subject painting would most probably sell at a regional auction, if it were offered for sale. Granted, the comparable properties netted their consignors considerably less than the auction hammer price when considering the expenses associated with the sale (not the least of which was the auctioneer’s commission). But fair market value does not allow for consideration of those expenses, rather it considers only the potential selling price to the exclusion of any potential expenses, i.e., it considers the amount that would be obtained (the gross) as opposed to the amount that would be retained (the net).

Here is a comparison of the amount that would be retained by the seller following an actual sale of a $13,750 painting to the amount that would be obtained if it were hypothetically sold — absent expenses but including the buyer’s premium (when charged):

1. Amount retained if actually sold:

Hammer price: $13,750
Insurance: -$100
Shipping: -$250
Photography: -$400
10% Selling Commission: -$1,375
Amount retained by seller: $11,625

2. Amount obtained if hypothetically sold:

Hypothetical hammer price: $13,750
10% Buyer’s Premium: +$1,375
Hypothetical amount obtained: $15,125 (fair market value)

In the above example, the painting’s fair market value would not be $11,625 (the amount retained by the seller) but rather $15,125 (the hypothetical amount obtained).