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 property a would sell for on the open market. Thus, FMV is significant to those who own a property and 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 Economics of Market Value
The value of every good in a market economy is based on a 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.
Appraisals and Comparable Sales
An appraisal is simply a professional opinion of value. During a home sale, the bank that makes the home loan normally selects 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.
IRS Publication 561
The governing tax code publication for 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 bedroom, 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.
Replace Cost New Value Approach
The replace 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.