Using Fair Market Value to Your Advantage

Using Fair Market Value to Your Advantage

The Using Fair Market Value to Your Advantage As you can see, obtaining a stepped-up basis on a property can have a significant effect on your taxes when the property is eventually sold. Just as important as obtaining a stepped-up basis is making sure you get the most favorable stepped-up basis.

From the paragraphs above it should be clear that a stepped-up basis is always tied to, and based on, the fair market value of the asset at a specific time. But what exactly is the fair market value of an asset? Whether you inherited a property ten years ago or if you are inheriting one now, how you establish the fair market
value may determine your future tax liability. To understand the variables here, we need to start by defining fair market value, which, according to IRS Publication 523, is “the price that property would sell for on the open market.

It is the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts.” Thus, it is necessary to determine on what price a willing buyer and willing seller would agree. If you have just inherited a property and are selling it on the open market immediately, the actual sales price in an arms-length transaction will almost always be considered the fair market value. However, if you intend to keep an inherited property for some time before selling, or if you are going back now to file for a stepped-up basis on property you inherited some time ago, you then want to establish a favorable fair market value. The following is the IRS’s published appraisal guidelines for determining the value of real estate (IRS Publication 551):

Because each piece of real estate is unique and its valuation is complicated, a detailed appraisal by a professional appraiser is necessary. The appraiser must be thoroughly trained in the application of appraisal principles and theory. In some instances the opinions of equally qualified appraisers may carry unequal weight, such as when one appraiser has a better knowledge of 26 SELLING REAL ESTATE WITHOUT PAYING TAXES local conditions. The appraisal report must contain a complete description of the property, such as street address, legal description, and lot and block number, as well as physical features, condition, and dimensions. The use to which the property is put, zoning and permitted uses, and its potential use for other higher and better uses are also relevant. In general, there are three main approaches to the valuation of real estate. An appraisal may require the combined use of two or three methods rather than one method only.

1. Comparable Sales. The comparable sales method compares the property with several similar properties that have been sold. The selling prices, after adjustments for
differences in date of sale, size, condition, and location, would then indicate the estimated fair market of the property. If the comparable sales method is used to determine the value of unimproved real property (land without significant buildings, structures, or any other improvements that add to its value), the appraiser should consider the following factors when comparing the potential comparable property and the property:

a. Location, size, and zoning or use restrictions,
b. Accessibility and road frontage, and available utilities and water rights,
c. Riparian rights (right of access to and use of the water by owners of land on the bank of a river) and existing easements, rights-of-way, leases, etc.,
d. Soil characteristics, vegetative cover, and status of mineral rights, and
e. Other factors affecting value.

For each comparable sale, the appraisal must include the names of the buyer and seller, the deed book and page number, the date of sale and selling price, a property
description, the amount and terms of mortgages, property surveys, the assessed value, the tax rate, and the assessor’s appraised fair market value. The comparable
selling prices must be adjusted to account for differences between the sale property and the property. Because differences of opinion may arise between appraisers as to the degree of comparability and the amount of the adjustment considered necessary for comparison purposes, an appraiser should document each item of adjustment.
Only comparable sales having the least adjustments in terms of items and/or total dollar adjustments should be considered as comparable to the property.

2. Capitalization of Income. This method capitalizes the net income from the property at a rate that represents a fair return on the particular investment at the particular time, considering the risks involved. The key elements are the determination of the income to be capitalized and the rate of capitalization.

3. Replacement Cost New or Reproduction Cost Minus Observed Depreciation. This method, used alone, usually does not result in a determination of fair market value.
Instead, it generally tends to set the upper limit of value, particularly in periods of rising costs, because it is reasonable to assume that an informed buyer will not pay more for the real estate than it would cost to reproduce a similar property. Of course, this reasoning does not apply if a similar property cannot be created because of location, unusual construction, or some other reason. Generally, this method serves to support the value determined from other methods. When the replacement cost method is applied to improved realty, the land and improvements are valued separately. The replacement cost of a building is figured by considering the materials, the quality of workmanship, and the number of square feet or cubic feet in the building. This cost represents the total cost of labor and material, overhead, and profit. After the replacement cost has been figured, consideration must be given to the following factors:

a. Physical deterioration—the wear and tear on the building itself,

b. Functional obsolescence—usually in older buildings with, for example, inadequate lighting, plumbing, or heating, small rooms, or a poor floor plan, and

c. Economic obsolescence—outside forces causing the whole area to become less desirable. With this definition in mind, the IRS has told you exactly what it considers a valid appraisal. You may want to make sure your appraisal conforms.