What is Fair Market Value?

Introduction

Fair market value (FMV) determines the worth of an asset in the marketplace. It represents an asset's price in an open and unrestricted market, assuming the buyer and seller are knowledgeable and acting freely.

FMV applies in various contexts, including mergers and acquisitions, taxation, financial reporting, and litigation. [1] In a survey of over 200 finance professionals, 75% of respondents reported using FMV in their financial analysis and reporting processes. 
 

Fair market value (FMV) determines the worth of an asset in the marketplace. It represents an asset's price in an open and unrestricted market, assuming the buyer and seller are knowledgeable and acting freely. FMV applies in various contexts, including

The Fair Market Value (FMV) is the current price a potential buyer is ready to pay, and the seller would agree upon in an open and competitive market. 

[2] In a survey of business valuation professionals, 70% of respondents said that FMV is the most important factor in determining the value of a business. Accurately determining FMV is essential for making informed decisions about buying or selling assets, settling legal disputes, and assessing the fair value of assets for accounting purposes.
 

Understanding Fair Market Value (FMV)

Understanding Fair Market Value is important when making informed financial decisions. Several factors, including the asset's state, its location, and its market demand are vital to calculating the FMV of an asset. Additionally, it's vital to conduct a comparative market analysis (CMA), which assesses the recent sales of similar assets.

FMV helps to ensure that buyers and sellers are making fair deals. For instance, Let's say you own a house you want to sell. You want to determine the FMV of your property to set a fair price and attract potential buyers.

To do this, you can consider your property's location, the house's condition, and the demand for real estate in the area. You could also look at recent sales of similar properties in the neighbourhood.

After careful analysis, you estimate the FMV of your house to be Rs.5 Crs. You list the property for sale at this price, and interested buyers come to view the house. Eventually, a buyer offers you Rs.4.8 Crs.

You can use the FMV as a benchmark to negotiate with the buyer and arrive at a fair price acceptable to both parties. Similarly, if you're planning to invest in a company or asset, understanding its FMV can help you decide whether or not it's a good investment opportunity.

Practical Uses of Fair Market Value

Fair Market Value has many practical uses in various fields, including finance, real estate, taxation, and business valuation. Here are some practical uses of FMV.

1.    Real estate transactions: FMV is commonly used in real estate transactions to determine the value of a property for sale or purchase. By understanding the FMV, sellers can set a fair asking price, and buyers can make informed decisions about whether or not to make an offer on the property.
2.    Business valuations: FMV is used in business valuations to determine the worth of a business, including its assets and liabilities. It is important for many reasons, including potential mergers and acquisitions, shareholder disputes, or estate planning.
3.    Taxation: FMV is used by the IRS and other tax authorities to determine the fair value of assets and properties for tax purposes. For example, if you donate a piece of artwork to a charity, the IRS will use the FMV of the artwork to determine your tax deduction.
4.    Investing: FMV is used by investors to determine a company's or asset's value before making investment decisions. By understanding the FMV, investors can make informed decisions about whether or not to invest in a particular asset or company.
 

Fair Market Value (FMV) and Taxation

In the context of taxation, FMV determines the amount of tax to pay on the sale of an asset. Fair Market Value is vital because it determines taxpayers' tax liability when they sell, donate, or inherit an asset. 

●    Tax liability on sale: In the case of a sale, the taxpayer must pay capital gains tax on any profit made from the sale. The profit is calculated by subtracting the cost basis (the taxpayer paid for the asset) from the sale price. However, if the sale price is lower than the FMV, the taxpayer may have a capital loss, which can be used to offset other capital gains or income. 
●    Tax liability on donations: Similarly, when a taxpayer donates an asset to a charitable organisation, they can claim a tax deduction for the FMV of the asset at the time of donation. The FMV determines the value of the charitable contribution and the tax deduction.
●    Tax liability on inherit: In the case of inheritance, the FMV determines the basis of the inherited asset. The basis is the value used to calculate future capital gains tax liability when the asset is sold. The basis is generally equal to the FMV of the asset at the time of the decedent's death.

For example, if you sell a property for more than its FMV, you must pay tax on the difference between the sale price and the FMV. Similarly, you may have to pay tax on the excess value if you receive a gift or an inheritance worth more than its FMV.
 

How to Calculate Fair Market Value (Step-by-Step)

Determining the FMV of an asset involves six steps:

1.    Define the asset
2.    Research comparable sales
3.    Adjust for differences
4.    Consider income potential
5.    Consult experts
6.    Determine a final value
By following these steps, you can determine an accurate FMV for assets such as real estate, businesses, and other items with measurable value.

To determine the FMV of a 2015 Honda Civic, priced at Rs. 12 to 14 lakh, with 50,000 miles in excellent condition, you must research similar sales and adjust any differences. If it has a premium sound system and aftermarket rims worth Rs. 15,000, its FMV would be

FMV = (Rs. 12–14 lakhs)/2 + Rs. 15,000 = Rs.13,15,000.
 

Fair Market Vs. Intrinsic Value

Fair market value and intrinsic value are two different ways to measure the worth of an asset. 

The following table summarises the main differences between fair market value and intrinsic value:

Conclusion

Understanding the importance of FMV is crucial to make sound financial decisions. With the evolving methods used to determine FMV, businesses must keep up with trends to remain competitive. You must consider relevant factors, and an expert should conduct the valuation for a fair market value.