Real Estate Appraiser Specializing in Commercial Industrial Residential Income Land & Single Family Residential Properties Existing or Proposed Construction Estate & Gift Tax Conservation Easements Partial Values Fractional Interests Former Senior Appraiser United States Treasury Department IRS Large Business and International Division California General Certified Real Estate Appraiser FHA Approved

Michael F. Ford #AG002512

 

MARKET VALUE & FAIR MARKET VALUE

 

No value opinion can have meaning without first being defined.

The intended use of an appraisal dictates which definition of market (or other) value is applicable to a specific assignment.

Example: Market Value and fair market value are not the same thing.  IRS internal documents tend to suggest that these values are ‘very similar’ or ‘nearly the same’ when they are not remotely close. In the case of IRS interpretations, even fair market value has several different fair market value definitions depending on which section of the tax code they are used with.

The first step in hiring an appraiser is to make sure that he or she fully understands the specific value definition applicable to your problem.

Preparing an appraisal for a multi million dollar property based on market value only to find fair market value was required is ‘not easily corrected’. Usually the problem is only discovered after the fact, and after deadlines have passed. By that time it is too late to avoid potentially negative repercussions.

The following is a partial list of common values and their definitions,  for which appraisals are obtained: It is generally conceded under most widely accepted definitions of market value that the definition incorporates the concept that market value “reflects the collective perceptions and actions of a market,” not the “preconceived view or vested interest of a particular individual.”

Market Value is described in the Uniform Standards of Professional Appraisal Practices (USPAP) as “a type of value, stated as an opinion, that presumes the transfer of a property (i.e., a right of ownership, or a bundle of such rights), as of a certain date, under specific conditions set forth in the definition of the term identified by the appraiser as applicable in an appraisal.”

Market Value is defined by The Appraisal Institute in their basic text; The Appraisal of Real Estate, 13th Ed., p.23 as: “The most probable price, as of a specified date, in cash, or in terms equivalent to cash, or in other precisely revealed terms, for which the specified property rights should sell after reasonable exposure in a competitive market under all conditions requisite to a fair sale, with the buyer and seller each acting prudently, knowledgeably, and for self-interest, and assuming that neither is under undue duress.”

Fair market value definitions follow the discussion below.

The International Valuation Standards market value basis of valuation is consistent with other discussions of market value in professional standards.

USPAP itself does not contain a citable definition of market value. It describes market value instead. USPAP does require certain items to be included in every appraisal report. These are:

  1. Identification of the specific property rights to be appraised.
  2. Statement of the effective date of the value opinion.
  3. Specification as to whether cash, terms equivalent to cash, or other precisely described financing terms are assumed as the basis of the appraisal.
  4. If the appraisal is conditioned upon financing or other terms, specification as to whether the financing or terms are at, below, or above market interest rates and / or contain unusual conditions or incentives.  The terms of above- or below- market interest rates and / or other special incentives must be clearly set forth; their contribution to, or negative influence on, value must be described and estimated; and the market data supporting the opinion of value must be described and explained.

While above requirements include non-cash equivalent financing terms within the scope of the market value of appraised property rights, such rights are valued in relation to cash. Increments or diminutions in market value attributable to financing terms are measured against an all cash standard, and the dollar amount of variance from the cash standard must be reported.

State and Federal Law contain varied market value definitions.  The following definition is used by agencies that regulate federally insured financial institutions in the United States:

“ The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently, knowledgeably and assuming the price is not affected by undue stimulus.  Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby:

  1. buyer and seller are both typically motivated;
  2. both parties are well informed or well advised, and each acting in what he or she considers his or her own best interest;
  3. a reasonable time is allowed for exposure in the open market;
  4. payment is made in terms of cash in U.S. dollars or in terms of financial arrangements comparable thereto; and
  5. the price represents the normal consideration for the property unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.”

The definition of market value used by Fannie Mae and Freddie Mac includes additional discussion of financing and sales concessions:

Adjustments to the comparable must be made for special financing or sales concessions. No adjustments are necessary for those costs which are normally paid by sellers as a result of tradition or law in a market area; these costs of readily identifiable since the seller pays these costs in virtually all sales transactions. Adjustments for special or creative financing can be made by comparing the financing terms of the comparable property to the financing terms offered by third-party institutional lender that is not already involved in the property or transaction.   Any adjustment should not be calculated based on a mechanical dollar- for -dollar comparison of the cost of the financing or concessions; rather, the dollar amount of any adjustment should approximate the market’s reaction to the financing or concessions based on the appraisers judgment . See Uniform Residential Appraisal Report Freddie Mac Form 70/Fannie Mae Form 1004, p.4 (March 2005); also Fannie Mae Single Family 2007 Selling Guide, Part XI: Property and Appraisal Guidelines, 205: Definition of Market Value.

The Fannie Mae / Freddie Mac definition require that the effect of property value of any special or creative financing or sales concessions be determined and that the opinion of value reflect cash-equivalent terms. Special financing or sales concessions often characterize transactions in depressed markets.

NOTE: The market value definition most familiar to the majority of American real estate appraisers is the Fannie Mae definition. This definition has become so imbedded due to it’s predominance in the profession, that it is ‘assumed’ to be the sought after value in almost all instances, absent specific precautions to the contrary.

While appraisals of the market value are the most common, appraisal clients needs regularly require appraisers to develop value opinions of other types of value.

Fair Value: Traditionally the accounting profession has used the depreciated purchase price for reporting the value of corporate assets for tax purposes and for use in financial statements. Due to significant accounting scandals of the late 1990’s that gave rise to the Sarbanes-Oxley Act of 2002, the International Accounting Standards Board (IASB) and the U. S. Financial Accounting Principles Board (FASB) changed the generally accepted accounting principles (GAAP) to recognize that the value in exchange is a more accurate measurement. In 2007, FASB defined fair value as:

“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.” (Financial accounting standard 157 (FAS 157).

Market participants are buyers and sellers in the principal (or most advantageous) market for the asset or liability that are:

  1. Independent of the reporting entity (they are not related parties).
  2. Knowledgeable, having a reasonable understanding about the asset or liability and the transaction based on all available information, including information that might be obtained through due diligence efforts that are usual and customary.
  3. Able to transact for the asset or liability.
  4. Willing to transact for the asset or liability (meaning that they are motivated but not forced or otherwise compelled to do so).

The fair value of the asset or liability should be determined based on the assumptions that market participants would use in pricing the asset or liability.

A fair value measurement assumes the highest and best use of the asset by market participants, considering the use of the asset that is physically possible, legally permissible, and financially feasible at the measurement date.  The highest and best use of the asset establishes the valuation premise used to measure the fair value of the asset, specifically:

  1. In-Use Value. The highest and best use of the asset in use would provide maximum value to market participants principally through its use in combination with other assets as a group.
  2. In-Exchange Value. The highest and best use of the asset is in exchange if the asset would provide maximum value to market participants principally on a stand-alone basis.

Appraisers may have to report both values so that the user of the report can make an informed decision.  This should be addressed within the Scope of Work decision, and appropriate section of the appraisal report.

The International Valuation Standards point out that fair value and market value are not necessarily synonymous in the International Financial Reporting Standards, where market value is used in differing contexts.

Use Value is the value a specific property has for a specific use. In estimating use value, the appraiser’s focus is the value the real estate contributes to the enterprise of which it is a part, without regard to the highest and best use of the property or the monetary amount that might be realized from its sale.  Real property has both a use value and a market value, which may or may not be the same or different depending on the property and the market.

Section 2032A of the Internal Revenue Code (IRC) permits the taxpayer to elect to value certain farm and closely held business real property at its farm or business use value rather than its fair market value (FMV).

Investment Value is the value of a specific property to a particular investor. As used in appraisal assignments, investment value is the value to a particular investor based on that person’s (or entity’s) investment requirements. The primary difference between market value and investment value is that for investment value, the value is to a specific individual and not necessarily that found in the marketplace.

Business Value or Going-Concern Value applies to an an established and operating business with an indefinite future life.  For certain types of properties such as hotels, motels, restaurants, bowling alleys, manufacturing enterprises, athletic clubs, land fills, hospitals and skilled nursing or other special care facilities, the physical real estate assets are an integral part of an ongoing business.

The market value of such properties including all tangible and intangible assets of the going concern is commonly referred to by laymen as business value or business enterprise value.  This is incorrect. It is the market value of the going concern including real property, personal property, and the intangible assets of the business.

The going concern includes tangible property in the form of real property and personal property interests, and intangible property such as reputation; work force in place, contracts, copyrights, patents, trademarks, other assets, residual income, and goodwill.

It is often difficult, or not even possible to separate the market value of the land and physical improvements from the total value of the business. When it is not feasible to separate the market value of the real estate from the business value it is considered appropriate that a statement to that effect be made, and a statement that the reported opinion of value includes both market value and business value, and that the appraiser has not been able to distinguish between them.

Special expertise is required to perform these types of assignment. 

The appraiser-sponsor of this web site has such expertise and experience

Public Interest Value is a general term covering a variety of value concepts that relate the perceived highest and best use of a property to non economic uses.

Public interest value is driven by social, political, and public policy goals.

It is not based on economic principles. Public interest is based on non economic highest and best use. Public interest value is also referred to as natural value, intrinsic value, aesthetic value, scenic value, preservation value, and similar non economic based terms.

The concept of public interest value has important potential application when it is defined and applied in public benefit terms. A cited example is a case in which a highway department pays 100% of their opinion of market value for property needed for a new highway. They then may add an additional 25% to avoid litigation costs that would otherwise arise from condemnation procedures. This formula demonstrates that the first 100% was paid as a perception of market value, held by the highway department. The second 25% was paid “in the public interest” rather than directly resulting from market forces. In this specific example the public interest value was 125% of market value.

This value is among one of the currently hotly debated topics in appraisal circles and legislative efforts by those supporters who contend that redefining highest and best use to include non economic benefits to recognize conservation and preservation. 

Opponents contend that because non economic uses are not responsive to market forces, such uses cannot give rise to market value, the basis of which can only be economic highest and best use.

A perceived characteristic of public use is that it will always be higher than market value (or fair market value), not constrained to follow market economic rules.

This last perception gives rise to many, if not most of the conservation easement donations contested by the IRS.  These “issues”  as IRS designates them, account for hundreds of millions of dollars in potential “adjustments” against the taxpayer, or donor of the easement.

A current audit underway (as of April, 2011) involves a large (anonymous) Southern California land developer who donated hundreds of acres for preservation of open space. The disputed amount if the deduction is disallowed approximates half a billion dollars! With penalties, this could amount to nearly three quarters of a billion dollars. This is just one of many such cases across the country.

It behooves donors of non cash charitable donations or conservation / facade easements, to very carefully shop their appraisals before committing themselves to such easements or donation deductions. Shopping only for a specific designation, or reputation for ‘intensity of highest and best use’ can be exceptionally costly. A point to consider; When designated appraisers face off against each other in court, fully half of them are going to to lose! Are you betting hundreds of millions of dollars with only a 50/50 chance of success?

Better to shop for appraisers that know and understand the approaches and techniques the IRS will take in contesting (nearly all) similar donations.

The issue of conservation easements is a national priority among Senior IRS Territory Managers, and senior executives.

Highly competent appraisal services in this category are not inexpensive. Neither are the penalties and interest assessed to the taxpayers arising from faulty valuations.

Expect to pay from $50,000 up to $250,000 (plus direct costs) for these type of conservation easement appraisals.

Assessed Value applies in ad valorem (at value) taxation and refers to the value of the property according to the tax rolls.  Assessed value may not conform to market value, though it is usually calculated in relation to a market value base. Some locales estimate both an assessed value and a market value.

In California, “Prop-13”, now passed and incorporated as Article XIII of the State Constitution stipulates that property will be assessed at no more than 1% of it’s most recent sale price, plus any locally voter-approved assessments and bonds. The relationship to market value at date of sale is coincidental, Assuming the sale itself was at market value, then the assessed value would also be at or near market value. If the property were a foreclosed property having suffered a decline in value, then assessed value would likely be very much higher than market value.

Assessed valuation should never be used as a value indicator for California properties by non real estate professionals in California. Even trained professionals that deal with this regularly, need to exercise caution.

California’s Definition of Fair Market Value (FMV) is contained in the Code of Civil Procedure:

“CAL. CCP. CODE § 1263.320 : California Code - Section 1263.320

Search CAL. CCP. CODE § 1263.320 : California Code - Section 1263.320

(a)The fair market value of the property taken is the highest price on the date of valuation that would be agreed to by a seller, being willing to sell but under no particular or urgent necessity for so doing, nor obliged to sell, and a buyer, being ready, willing, and able to buy but under no particular necessity for so doing, each dealing with the other with full knowledge of all the uses and purposes for which the property is reasonably adaptable and available.

 

(b)The fair market value of property taken for which there is no relevant, comparable market is its value on the date of valuation as determined by any method of valuation that is just and equitable.

Compensatory FMV (Where the appraisal report is to be used as a basis or guideline for establishing the just compensation to which the owner(s) is entitled for the property.)

Fair Market Value provides for an assessment at the price that the property would bring to its owner if it were offered for sale on an open market under conditions which neither buyer nor seller could take advantage of the need of the other.  It is a measure of desirability translated into money amount and might be called the Market Value of the property in its condition based on the date of value (Section 1 of article XIII of the California Constitution) Revenue & Taxation Code Section 110 and Property Tax Rule 2 likewise define “full cash value” or “fair market value” as “the amount of cash or its equivalent that the property would bring if exposed for sale in the open market under conditions in which neither buyer nor seller could take advantage of the need of the other, and both buyer and the seller have knowledge of all of the uses and purposes to which the property is adapted and for which it is capable of being used, and the restrictions upon those uses and purposes.” 

Implicit in these definitions is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions where by:

1) Buyer and seller are typically motivated.

  • 2) Both parties are well informed or well advised and each acting in what is considered their own best interest.
  •             3) A reasonable time is allowed for exposure in the open market.
  •             4) Payment is made in terms of cash in U.S. dollars or in terms of financial            arrangements comparable thereto.

    • 5) The price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.

     

    Sources: The Appraisal of Real Estate; Treasury Regulations, Internal Revenue Code, Internal Revenue Manual, IRS Appraisal Guidelines, Consultations with IRS Managers and other IRS Senior Appraisers, Engineers and Valuators, USPAP, USPAP for Federal Land Acquisition (Yellow Book), State and Federal Appraisal regulations, California Code of Civil Procedure, FIRREA, NACVA, and various miscellaneous trade publications and articles.

    The following is a copy of an internal IRS memorandum from a Senior IRS Appraiser to the Territory Manager. The entire document is copied as received, except that the embedded header IRS, Washington DC & logo has not been copied.

    The following memo continues to be given to new IRS appraisers for use in determining value-standards, or definitions as late as June, 2010.  Mr. Cerruti is a Group-West Territory Manager now.  LMSB has morphed into the  Large Business and International Division (LB&I). 

     

    Note that the phrase "...Nor is the fair market value [of] an item of property the sale price 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..." appears in numerous definitions. 

    There are numerous (if not a preponderance) of cases in which unrelated surrogate markets are used by IRS for both general market data, and specific  rate derivations; usually discounts.  Although the courts have held that surrogates may be used where  interests traded or sold are sufficiently similar to the property being valued as to be relevant.  A fine point that is routinely ignored in IRS fair market value reviews and alternative value positions (audit adjustments).

     As of June 2010, the following memorandum copy was still being used in the Western Region as the basis for determining which value definition was to be applied to IRS issues. Appraisers were ‘urged’ to simply copy and paste the ‘appropriate’ value definition into their own reports.

    "April 22, 2005

     MEMORANDUM FOR    Ron Cerruti, Territory 1850 Manager

                                                 San Francisco, California  94102

     THROUGH:                     

                                                Valuation Manager, Team 1856

     FROM:                                 Joan M Gaar

                                                 Appraiser, Team 1856 SUBJECT:                             Standard Fair Market Value Definitions                                                and Law.

     

    Standard Fair Market Value Definitions:

    Gift tax:  Treas. Reg. §25.2512-1.

    “The value of the property is the price at which such 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.  The value of a particular item of property is not the price that a forced sale of the property would produce.  Nor is the fair market value an item of property the sale price 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.”

     

    Estate Tax:  Treas. Reg. §20.2031-1(b).

     “The fair market value 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 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 the sale price 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.”

     

    Estate Tax:  Treas. Reg. §20.2031-4.

    Valuation of interests in businesses:

    (a)  “The fair market value of any interest of a decedent in a business, whether a partnership or a proprietorship, is the net amount which a willing purchaser, whether an individual or a corporation, would pay for the interest to a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. 

     

     Estate Tax:  Treas. Reg. §20.2031-4.

     Valuation of notes:

     The fair market value of note, secured or unsecured, is presumed to be the amount of unpaid principal, plus interest accrued to the date of death, unless the executor establishes that the value is lower or that the notes are worthless.”

     

     Charitable contributions / Easements : 

     Treas. Reg. §1.170A-1(c) (2).

     

    “The fair market value 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 sell and both having reasonable knowledge of relevant facts.  If the contribution is made in property of a type which the taxpayer sells in the course of his business, the fair market value is the price which the taxpayer would have received if he had sold the contributed property in the usual market in which he customarily sells, at the time and place of the contribution and, in the case of a contribution of goods in quantity, in the quantity contributed.”

      

    Subchapter Corporation:  Treas. Reg. §1.1372-7.

     Inventory:

     “The fair market value of the inventory of an S corporation on the first day of the recognition period equals the amount that a willing buyer would pay a willing seller for the inventory in a purchase of all the S corporation’s assets by a buyer that expects to continue to operate the S corporation’s business.  For purposes of the preceding sentence, the buyer and seller are not presumed to be under any compulsion to buy or sell and to have reasonable knowledge of all relevant facts.”

      

    Business Valuation:  Rev. Rul. 59-60, 1959-1 C.B. 237.

     “The fair market value is the price at which the property would change hands between a willing buyer and a 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.  The buyer and seller are hypothetical and assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.”

      

    Income Tax:  Federal Register, vol. 55, no. 163, August 22, 1990, pages 34228 and 34229.

    "The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus.  Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby:

     1.  Buyer and seller are typically motivated;

     2.  Both parties are well informed or well advised, and acting in what          they consider their own best interests;

     3.  A reasonable time is allowed for exposure in the open market;

     4.  Payment is made in terms of cash in U.S. dollars or in terms of             financial arrangements comparable thereto; and

     5.  The price represents the normal consideration for the property sold       unaffected by special or creative financing or sales concessions             granted by anyone associated with the sale."

     

    Appraisal Institute:  American Institute of Real Estate Appraisers.  The Dictionary of Real Estate Appraisal, Chicago; American Institute of Real Estate Appraisers, 1984, page 194-195.

    "The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus.  Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby:

     a.  Buyer and seller are typically motivated;

     b.  Both parties are well informed or well advised, and acting in what          they consider their own best interests;

     c.  A reasonable time is allowed for exposure in the open market;

     d.  Payment is made in terms of cash in U.S. dollars or in terms of             financial arrangements comparable thereto; and

     e.  The price represents the normal consideration for the property sold       unaffected by special or creative financing or sales concessions             granted by anyone associated with the sale."

     [1] Price and Change Hands.

    As can be seen in the definition above, there are several qualifying characteristics that define "the price at which the property would change hands." Note that the definition references the price, and not the proceeds, of the sale of a property."

     

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