What Is Fair Market Value?
Anyone who has ever tried to purchase or sell a home will be familiar with the significance of a property's fair market value, or FMV. FMV is the price that a property would sell for on the open market under usual conditions. Thus, the FMV is significant to those who own a property, as well as those who must pay taxes on that property. Taking a property-based deduction requires determining the FMV. The term is also widely used in the real estate investment market.
Unfortunately, there is no easy or universal way to determine market value for real estate. However, nearly every market valuation comes down to two factors: real estate appraisals and recent comparable sales.
- The fair market value is the price a home would sell for on the open market under normal conditions.
- Fair market value (FMV) is often different than actual market value or the appraised value and is used in some property tax evaluations.
- Guidelines on how to fairly evaluate a property's value are spelled out by the IRS.
The Economics of Market Value
The value of every good in a market economy is based on price discovery process. Producers and resellers propose hypothetical values and hope to find buyers with similar valuations. In contrast, consumers bid up or push down prices based on their changing interpretations of the value of goods. This process is imperfect and ever-changing.
For the real estate market, a buyer must value a property higher than the amount they are willing to trade for that property. At the same time, the seller must value the property at a price below the money offered. Of course, the supply and demand for a home in a given region will play into these economic evaluations, as well as the state of the broader economy in terms of GDP growth, unemployment, and inflation.
Appraisals and Comparable Sales
An appraisal is a professional opinion of value. During a home sale, the bank that offers the home loan will typically select an appraiser to render an opinion about the value of real estate as of a specific date.
Comparable sales, also known as the "market data" approach, is the most common way to arrive at market value. Here, the recent sales of properties of similar stature are reviewed to inform judgment. If prices of recently sold homes that generally match the same criteria as your own (e.g., in terms of size, number of rooms, amenities, etc.) are high, you are likely to also get a more favorable appraised value. Note that the appraised value may end up being quite different from the actual sale price in the market.
IRS Publication 561
The governing tax code publication for the fair market value of real estate is IRS Publication 561. This publication addresses all types of property valuations including cars, boats, collections, used clothing, securities, patents, annuities, and many others. But it does not set aside a section for determining real estate market value.
Publication 561 explicitly states "a detailed appraisal by a professional appraiser is necessary" for proper valuation. Three approaches are considered acceptable by the appraiser: the comparable sales approach, capitalization of income approach, or the replacement cost new method.
Comparable Sales Approach
The comparable sales approach compares a property to other properties with similar characteristics that have sold recently. This method takes into account all the features of the property, for example, its size, the number of bedrooms, and the effect that individual features have on the overall property value.
Capitalization of Income Approach
The capitalization of income approach values an investment based on the expectation of future benefits. This method relates the property's value to the market rent that it can be expected to earn and to the resale value.
Replacement Cost New Value Approach
The replacement cost new value method determines the current cost of constructing a property with the same utility using the current construction materials and adhering to current design standards and layouts.
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The Bottom Line
Regardless of how you value a property, at the end of the day, the amount of money received for a home will be negotiated between a buyer and a seller. Each party may use valuation techniques to help argue their case, but a deal is typically reached with some compromise and some personal back-and-forth.