Is Fair Market Really Fair?

Estate Planner Sept-Oct 1998

Have you made a gift today, one that you did not know you made? If so, you or your estate may be called upon years from now by the Internal Revenue Service (IRS) to account for gift taxes plus interest and penalties. The changes made in the tax law in 1997 affected the safety provided by the statute of limitations. Under current law, there is no statute of limitations for gifts made in connection with transactions that are not adequately disclosed to the IRS.

If you want to avoid making an unintentional gift, be sure you always obtain fair market value in exchange for anything you transfer to a family member (except for transfers to your spouse which qualify for the marital deduction).

Hypothetical Fair Market Value

What is the concept of fair market value, what does it involve and who determines it? The generally accepted definition of fair market value is “the price at which 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.”

For federal tax purposes, the definition remains the same for income tax issues as well as estate, gift and generation-skipping transfer tax issues. The definition applies to transfers to charity as well as to transfers to family members. In order to understand and work within this definition of fair market value, the elements of the definition need to be considered.

The price at which property would change hands — This is the hypothetical sale price. Generally, the sale is presumed to be for cash. The hypothetical would insist that the buyer is able to borrow the requisite cash in order to pay the seller. For example, in a home sale, the seller receives cash because the buyer enters into a mortgage arrangement with a lender. Because the seller is deemed to receive cash, the price received by the seller will not need to be adjusted to reflect assumption of any risk or the time value of money and related interest rate.

Between a willing buyer and a willing seller — For purposes of valuation, it is irrelevant who are the actual seller and buyer since you must look to hypothetical persons. When you are dealing with unique property, this becomes the most difficult part of the hypothetical sale. Is there really a willing buyer for a 5% interest in a closely held family business or in a family limited partnership? And, is there really a willing seller when Dad ordinarily would not sell at any price? Nevertheless, we have to assume the existence of two states of mind, one that an imagined owner of the property is in fact a willing seller and second that an imagined holder of cash is a willing buyer.

Neither being under compulsion to buy nor sell — A foreclosure sale would not be indicative of fair market value as the price would generally be artificially low since the seller is under a compulsion to sell. Accordingly, we have to assume a situation where the seller wants to sell, but not too badly; and, the buyer wants to buy, but he really does not have to.

Both having reasonable knowledge of relevant facts of the applicable valuation date — It is important that you assume that both parties have reasonable knowledge of the property. The appropriate standard of reasonable knowledge is not what is actually known by the seller or by the buyer on the valuation date. Instead, you must consider the facts that are discernible through reasonable investigation on the valuation date.

After all, acquired information is not supposed to count, but hindsight is difficult to ignore. For example, assume that a painting which was being valued for gift purposes could be a forgery. The fact that the painting is later determined to be authentic is not a factor on the valuation date, but the possibility of it being a forgery is knowledge which both buyer and seller are assumed to have.

Know Your Facts

The hypothetical fair market value must take place in the marketplace. This generally will be where the property being valued is most likely to be offered for sale to the public. This usually will be the retail market and not the wholesale market.

Please call us if you need advice on ascertaining the fair market value of property. You need to document the considerations and the hypothetical negotiations that resulted in the final figure, since you may be called upon to justify your valuation.