Fair Market Value

What is Fair Market Value and why we need it?

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Estimation of fair market value becomes imperative as market transactions are unpredictable for assets such as privately held business and most personal and real property. Factors such as place, time, existence of comparables and precedents affects the estimation of fair market value due to which it becomes a subjective matter. Fair market value is widely used throughout the business and commerce and is an evaluation of market value of a property.

IRS Revenue Ruling 59-60 characterizes the arm’s length definition of fair market value as follows:

“The amount at which the property would change hands between a willing buyer and willing seller, when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”

In other words, Fair Market Value is the expected price that a buyer would be willing to pay to a seller for the purchase of a given asset, given the following condition:-

  • Both the parties have reasonable knowledge about the condition of the asset.
  • There is no pressure on parties to complete the deal.
  • There is no pressure on parties to buy or sell any asset.
  • Trade serves the best interest of both parties.

Fair market value

Example of Fair market value                       

There are two Parties in the deal John and Harry .John wants to sell the house and Harry wants to buy it. Both the parties have relevant knowledge and are under no pressure to complete the deal. John list the house for $800,000 .Harry wants to buy the house and offers John 750,000.Both negotiate the price and agrees on $775,000. $775,000 is the fair market value of a property as john and harry has agreed on this price.

Importance of Fair Market Value

  • To assess tax on property.
  • To assess the price of an asset in open and unrestricted market.
  • To assess the municipal property tax.
  • To assess how much an insurance company will pay when met with an accident.

 

Determination of Fair market value of shares

For calculating the fair market value of a stock, average of the highest and lowest selling prices of the day are taken into consideration

Determination of Fair Market Value

Fair market value cannot be determined using any fixed formula. It should be determined considering factors such as desirability, use, and scarcity in respect of a property. Following are the list of methods which can be used to determine fair market value:-

1. Selling Price

Actual selling price is the best indicator of a fair market value of a property. However, because market conditions can change, selling price may have less weight if transaction does not take place near to the time when fair market value is needed. For this method to be accurate, Transaction should take place near the time when fair market value is needed.

Selling price is a good indicator of the property’s value if:

  • Date of valuation is close to date of purchase or sale of a property in an open market.
  • Purchase or sale took at “arm’s-length,”
  • Buyer and seller knew all the relevant facts,
  • Buyer and seller did not have to act (time boundation), and
  • There are not changes between date of purchase or sale and the date of valuation in the market.

 

Fair Value

 

2. Sales of Comparable Properties

Fair market value can also be calculated by comparing the property in question to similar properties. The weightage to be given to each sale depends on the following:

  • What is the degree of similarity between the property in question and the similar property?
  • How close is the date of sale to the date of valuation?
  • Whether the sale was an arm’s length or not?
  • Prevailing conditions in the market.

3. Replacement Cost

Replacement cost is the cost that it would cost to replace the property in question on the valuation date. This method is generally used in insurance companies. For example, if we purchased a home for $100000 and it burns down, rebuilding the same home may cost $150000. The $150000 figure is the fair market value using replacement cost.

 

Fair Value vs Fair market valueFair Value vs. Fair Market value

 

 

The fair value is defined in ASC 820 is as follows:-

 

“The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

 

Whereas IRS Revenue Ruling 59-60 defines fair market value as:-

 

“The amount at which the property would change hands between a willing buyer and willing seller, when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”

 

Both these definitions look identical. But, they are different.

 

Fair Market Value Fair Value
It is Internal Revenue Service’s (IRS) measure It is the standard of valuation under GAAP.
It is used for tax purpose It is used for reporting purpose.

In conclusion, the Fair Market Value reflects the true value of an asset:

Fair Market Value is the price agreed upon by the buyer and seller in an open market and is used for assessing tax on property, for ascertaining the amount to be paid by insurance company, for guiding a buyer to determine the amount to be paid for purchasing the asset and for determining stock value.

Author: Shweta S. – Jr. Analyst

2 Replies to “What is Fair Market Value and why we need it?”

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