The business world is filled with many guidelines, laws, practices, and tactics that make business transactions possible and beneficial to both parties – buyers and sellers.
One of the legal business practices protecting buyers and sellers during their business transactions is the Fair market value (FMV).
The fair market value (FMV) ensures that buyers and sellers during a business transaction act and make decisions out of free will and careful consideration of their interests and benefits.
Mostly used in real estate, taxation, insurance, and other business fields, FMV creates a market environment where buyers and sellers can transact without pressure from either party and ensures a high level of satisfaction.
In this article, we share valuable insights on fair market value, why it’s important, and how to calculate it.
What to expect
- What is Fair market value?
- Conditions for Fair market value
- Why is fair market value important?
- Fair market value vs. market value
- Where does fair market value apply?
- Ways to calculate the fair market value
What is Fair market value?
The fair market value according to the internal revenue service (IRS) is defined as
“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 have reasonable knowledge or relevant facts.”
In simple terms, fair market value is the price of a certain property, business, or asset that is agreed upon and set by both parties in an open market.
It is the situation when a buyer who has the intention to buy, is knowledgeable and is unpressured is willing to pay to a seller who has the intention to sell, is well-informed about market value, and is unpressured.
It specifically considers the willingness of the buyer and sellers and the knowledge base of both parties on the market values of the property or asset. Check out the guide about customer lifetime value.
What to consider when determining the fair market value
Fair market value differentiates from fair value based on some discounts. Creating a fair market value in an open and unrestricted market requires real estate agents, and business professionals to consider the following discounts:
Marketability: This discount looks at the inability to rapidly transform an ownership stake into cash.
Lack of control: This discount takes into account the lack of control that one of the two parties – buyer or seller – has before or after the sale transaction. It specifically considers the lack of total control a seller has in selling a business or asset and the lack of control a buyer will have after purchasing the business.
Conditions for determining Fair market value
Under fair market value, the price of goods or services has to be agreed upon independently by the buyers and sellers.
Existing studies suggest that to get an accurate fair market value of the goods or services being exchanged, certain conditions must be met. The conditions are as follows:
1. There shall be no asymmetries of information
This term suggests unequal, disproportionate, or lopsided information, where one party has more detailed information than the other party. This condition clearly states that both parties must be equally and reasonably informed and knowledgeable about the real estate, business, or goods being transacted.
2. Both parties must be perfect logisticians and economic agents
This condition states that both parties – seller and buyer – must be able to make decisions about their goods or service purchase, use, and logistics. Both parties must behave and decide based on their personal interest.
3. Absence of pressure from any of the parties involved
This condition states that both parties – buyer and seller – must be free of any undue pressure by either of them to complete the transaction. This means that to determine fair market value, the seller and buyer must not be pressured to complete the transaction.
4. Give a reasonable amount of time to complete the transaction
This condition states that the buyer and seller must be given enough time to execute the transaction. None of the parties must be hurried to close the deal.
The above conditions are economic principles that show the degree of freedom and openness in a competitive market.
Why is fair market value important?
Calculating fair market value can help achieve the following:
Enhance purchase decision
By determining the fair market value of an asset, property, or product, a buyer, seller, or investor can decide whether or not to buy or sell the asset or property. They have to compare the fair market value of the product with the current market price to make a decision.
Essentially, if the fair market value is higher than the current market price, the buyer would be willing to buy but the seller won’t want to sell, and vice versa. A fair market value is achieved where the FMV is proportionate to the current market price. Explore the guide about marketing qualified lead.
To determine taxation
To achieve taxation, tax authorities around the world ensure that transactions are made at fair market value and that both long-term and short-term capital gains are determined fairly.
When determining the inheritance of a property or an asset, and calculating tax deductions on donations to avoid complications or claims of fraud from tax authorities. Calculating fair market value for taxation ensures that you are tax compliant
Improve financial statements
Understanding the fair market value of a property or asset can increase the company’s asset value listed on the balance sheets. Calculating the fair market value can show the true wealth a company has created over the years.
Showing a company’s asset increase can improve its financial ratios and provide business owners with information about their company’s long-term solvency.
Fair market value vs. market value
Market value also known as open market valuation (OMV) is the price a property, asset, or good is set for in an open market or refers to the price an investment community gives particular equity or business.
According to the international association of assessing officials for tax assessment, market value is defined as
“The most probable price (in terms of money) 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”.
In simple terms, it is the highest price that an interested buyer is willing to pay for a property, asset, or product, and the lowest price a seller is willing to sell its product.
Whereas, fair market value is defined by a legal or regulatory authority, where a buyer and seller under no compulsion or pressure decide to buy or sell a property, asset, or product for an agreed price that is favorable for both parties.
Unlike market value where prices are set by market forces, both the buyer and seller agree on the price that is beneficial for both of them. Check out some sales-related guides, B2B sales, SaaS sales and tech sales.
Where does fair market value apply?
Fair market value is a term that can be used across various industries. It can be used in the following industries:
1. Real estate
Firm market value works for the buying and selling of real estate properties. In real estate, FMV is the price a willing buyer would pay a willing seller in an open market.
Homeowners have to be well-informed and knowledgeable about the fair market value of their houses, to determine their net worth and the value of the investment property. A real estate agent calculates the fair market value of a property to determine the price range that a home will sell for to create a property listing.
2. Insurance claims
Fair market value can influence homeowners’ insurance claims when a property is damaged. Real estate agents determine the appraised value of a home to calculate the fair market value of the property by calculating the insurance cost per month.
Usually, an insurance company considers every liability included in a home to determine the coverage and cost of the insurance.
The fair market value of a property or asset is used to calculate the property tax of a property or asset. Aside from property tax, FMV can also affect other taxes like the estate tax, gift tax, and inheritance tax.
4. Legal Disputes
FMV is essential when solving legal disputes like a divorce settlement, when private property is damaged, or when two people are given property, and one of them wants to sell the property.
Legal advisors calculate fair market value to determine the value of an asset and share this information with all parties involved in a dispute to prevent one party from taking advantage of the other.
Ways to calculate the fair market value
Several factors have to be considered when calculating the FMV. You can use the following ways or methods to determine the fair market value of a property, asset, or business.
Use the selling price: This is one of the most acceptable approaches used for measuring the FMV of properties or assets that have just been bought or sold. The selling price of a property or asset clearly indicates its FMV.
Comparative analysis: This involves conducting a comparative market analysis to compare the property to other similar properties. It works for real estate properties, assets like cars, jewelry, or rare collectible and products by checking the price of a similar product or asset that was recently sold to determine their own pricing.
Averaging: This involves calculating FMV by averaging the highest and lowest selling prices of the day. If the highest selling price of the day is $15 and the lowest price is 5, the fair market value for that day would be $10.
Professional appraisal report: This involves getting a professional or expert’s opinion on the property or asset, using their knowledge and expertise to appraise the property to determine its fair market value. Find the guide about sales analysis reports.
The fair market value (FMV) is a legal ruling that can impact the selling price, and everything related to a property, business, asset taxes, property, inheritance, or insurance claims.
When calculating the FMV of an asset, property, or business like your home’s fair market, consider working with a financial advisor who can help you achieve your financial goals by determining a fair market price. Alternatively, you can also use a property tax calculator to assess the estimated value of your property or asset and calculate your personal finance – how much you’re owing the government.