Fair Market Value in Real Estate for Tax Purposes

Real estate agent showing a house to a couple

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Fair market value (FMV) is an important concept in the valuation and exchange of real property and other property. The Internal Revenue Service (IRS) uses fair market value to determine the dollar value of charitable donations, of assets that are converted to business use, and in various other tax-related matters.

What Is Fair Market Value?

According to the IRS, fair market value is established when five criteria are met:

  • The property would likely sell for this price on the open market.
  • Both the buyer and the seller are willing to enter into the transaction at this price.
  • The seller isn't being forced to sell the property, and the buyer isn't being forced to buy. Neither party is under duress to consummate the transaction.
  • They both have full knowledge of the property, its condition, and all relevant facts pertaining to it.
  • No restrictions have been placed on how the property can be used.

As an example, Fred is selling his home to Freida for $125,000. The house's basement floods with every hard rain, so nobody would be willing to pay much more than that price. The property has met the open market criteria.

Freida wants the property as badly as Fred wants to sell it, so the "willing" criteria is met. Fred isn't desperate to sell, Freida isn't desperate to buy, and Freida is fully aware of the basement problem, so the remaining criteria are met. The property's fair market value is therefore $125,000.

The last rule for restrictions as to the property's use doesn't apply if the home is being sold rather than given to charity.

FMV is an estimate of the market value of a property based on what an educated, willing, and unpressured buyer and seller could agree on, each behaving in their own best interest.

The concept of fair market value exists within a specific period of time for the transaction to occur. The FMV can change if the time period for the transaction changes. The fair market value of the property is then a fair valuation, or an assessment of its worth.

An Example of FMV: Gift Taxes

Now let's say Fred gives the house to his daughter, Mary. He would owe a gift tax if he doesn't receive compensation from her that's equal to or more than the home's fair market value.

The question of fair market value becomes moot if Mary gives Fred nothing in return—the house is a gift and he owes a gift tax. But let's say she pays him $50,000 for the property. The house is still a gift if its fair market value is $125,000. It's value from $50,000 to $125,000—or $75,000—is subject to the gift tax.

So how does the IRS determine the home's fair market value? First, what could Fred have sold the property for in the current market, assuming it's not a fire sale? He's not desperate to sell because of some pressing circumstance. He's not required to act and dispose of the property.

Nor is the buyer desperate to purchase the home for any reason. He's not required to act, either. Both buyer and seller are aware that the basement leaks and the buyer's offer is based on this information: $125,000. Both have a reasonable knowledge of relevant facts.

The IRS says that $125,000 is the fair market value of the property under these circumstances. Fred has therefore made Mary a gift of $75,000 if he accepts just $50,000 for the property.

The gift tax rate can be as high as 40% as of 2020, but this depends on the total value of all property a donor gives away over the course of their lifetime. As a practical matter, however, up to $11.58 million can be given as of 2020 without incurring a gift tax, but this exemption is shared with the estate tax. It must cover both.

Another Example: Charitable Donations

The same basic concept applies to donated property a person gives to charitable organizations. What would someone be willing to pay you in today's economy for that used television in its current condition? That's its fair market value.

Luckily, most qualified charities publish lists online as to how much-donated items of clothing and other personal property are worth for tax purposes, always assuming that your gift is in good condition. The IRS generally won't let you take a tax deduction for items that aren't in "good used condition," although exceptions exist for antiques and if you can provide an appraisal.

Fair Market Value vs. Intrinsic Value

An estimate of fair market value can be based on either precedent or extrapolation. FMV differs from the intrinsic value, which is the actual value of a property or asset based on analytical techniques and underlying perceptions of its tangible and intangible factors.

Intrinsic value might or might not be the same as the fair market value. For example, investors analyze securities in the hope of finding investments where the true or intrinsic value of the investment exceeds its current fair market value.

Fair Market Value vs. Imposed Value

Place, time, comparable precedents, and the personal evaluation of each person involved in the transaction all play into the formation of FMV. It's the subjective interpretation of the facts and information available at the time of assessment. It's different from imposed value, in which a legal authority, such as an existing tax regulation or a court, sets an absolute value for the property.

What Fair Market Value Is Not

There are some circumstances where fair market transactions don't apply. They include eminent domain, where a property is taken in lieu of sale. The seller is under duress in this case, so the IRS criteria for fair market value hasn't been met.

Fair market value doesn't apply to liquidation sales, deeds in lieu of foreclosure, or other distressed sales.

Other Uses of Fair Market Value

The concept of fair market value is used widely in business and life. FMV is used to determine how much you can write off for the donations of property you make to charities such as Good Will. It determines if a gift tax is due to the federal government, as well as the value of an estate for estate tax purposes.

Municipal property taxes are often based on FMV. It's used when you're filing an insurance claim, perhaps as the result of an automobile accident where the insurance company will cover damages up to the fair market value of your vehicle. But in most cases, the fair market value equation set by the IRS is used for determination.