Definition of Fair Market Value

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The fair market value of a property is the value of a property on the open market with no external factors. This value has many important uses and is essential in divorces, when calculating taxes, for home sales and insurance claims. While any given property has one given theoretical fair market value, determining that true value can be nearly impossible. That is why there are many different methods for calculating the fair market value, each of which can be more or less accurate based on the specifics of a given property.

What Is Fair Market Value?

Fair market value is one of those seemingly simple concepts that can become incredibly complex in practice. To put it simply, the fair market value is the price a given piece of property would sell for in the current open market with no external pressures such as time or financial constraints. Essentially, the term refers to the lowest price a seller would be willing to accept and the most competitive price a buyer would be willing to pay if neither was in a rush to buy or sell, neither was subject to financial constraints, and both had a reasonable knowledge of the pertinent facts. The fair market value is subject to supply and demand and will rise and fall based on the current market.

Why Fair Market Value Is Important

The fair market value is an impartial valuation of an asset. It is unaffected by a buyer or seller's financial or emotional situation. For this reason, the concept is often used for legal purposes, most often those involving taxes, insurance and real estate transactions. It can also be used in divorce settlements to ensure both parties receive an equal financial share of the assets even though both parties can not own equal parts of all of the real property involved in the divorce. Governments also use the domain for eminent domain purposes when they seize property from its owners and reimburse them based on the fair market value.

Fair Market Value and Taxes

Fair market values are useful when determining the value of a property used in a tax deduction after a casualty loss or for charitable donations. For example, if a vehicle owner donates his car to Good Will, he can write off the fair market value based on what the car would be worth in an open market transaction.

The fair market value for tax purposes has been the subject of many IRS court cases as it can be difficult to determine. If the person who donated his car to Good Will is looking for the fair market value of his vehicle, for example, he could look at comparable sales on eBay Motors. He could also use the value he paid for the car if he bought it recently, base his price on an appraisal from a local expert or calculate it in a number of other ways. But each of these methods could result in a different price, so if the IRS believes his fair market value is too high, they could audit him as a result.

Fair market value is also used in determining the value of a home for property taxes. The difference between the purchase price and the fair market value will fluctuate as time wears on, which is why this value must be assessed regularly by a city tax assessor or property valuation administrator.

Probate courts will also use the fair market value of properties for tax purposes as it can help determine how much the deceased's beneficiaries need to pay in estate taxes. This value is particularly important in these cases because generally if the inherited property is not kept by the family, it will be sold off quickly, so the value cannot be calculated accurately by what it is sold for. Additionally, the fair market value must be established in probate courts as many pieces of property are inherited by multiple beneficiaries who must determine a fair market value if one person wishes to keep the property and give the other beneficiaries a fair share of the property's value.

Real Estate Uses

When a homeowner decides to sell her property, it is beneficial for her to understand the fair market value before listing to know what she should sell it for. She would not want to list the home for too little, but she similarly would not want to list the home for so much that it would detract buyers.

Fair Market Value for Insurance

The insurance industry is also largely dependent on fair market values for reimbursement of damaged or destroyed properties. For example, if a home is destroyed in a fire, the insurance company will use the fair market value of a property to determine how much to pay for the claim. This figure does not take into account the person's emotional attachment to the property, which means the actual amount paid through the claim might be much lower than a person would be willing to accept were they to attempt to sell the property before it was destroyed.

Differences From Similar Terms

Whereas "market value" refers to the price of an asset in a real marketplace, the fair market value represents the property's value in a hypothetical perfect marketplace where buyers and sellers are on equal footing. While a home's actual market value will be available in a property listing, the fair market value of a home isn't so easy to calculate. The actual market value could be higher than the fair market value in many cases if the seller overvalues their property or lower if the seller is trying to make a quick sale out of desperation.

The "appraised value" of a property is a similar concept, but because it refers to only one appraiser's opinion of the item's value, not the true fair market value as it can vary from appraiser-to-appraiser. Appraisers use standards, guidelines, local regulations, economic trends and comparable sales to determine the fair market value of a property. In most cases where the fair market value is required, the appraised value is considered acceptable, however, appraised values can often be a little higher than the true fair market value.

Finally, the "assessed value" is the value of a property as determined by a local tax assessor or property valuation administrator. This value is used to calculate property taxes. Generally speaking, the assessed value of a property will be based on the last time it was sold, recent home inspections and comparable home sales. Like the appraised value, the purpose of these assessments is to determine the fair market value, but the assessments are limited by the fact that they are only one person's opinion. While the assessed value should resemble the fair market value, it is often a little lower. Assessed values are public figures and can be accessed on certain websites or at the local county tax assessor's office.

Comparative Market Analyses

There are many ways to determine the fair market value, and while there is hypothetically one definitive fair market value of a given property, every method of calculating the value is likely to result in a different number. The most common method for calculating fair market value is to do a comparative market analysis. This involves looking at other comparable properties on the market or comparable properties that recently sold within the last two-to-three years.

In markets like real estate, it is important to consider the location of the properties up for sale, but with items like collectibles and antiques, it may be better to look at comparable recent sales throughout the globe as collectors do not generally limit their purchases to a local area. When comparative market analyses involve real estate, they are generally performed by licensed real estate agents and should involve comparisons to homes with similar square footage, in similar condition and with a similar number of bedrooms. They should also only include homes sold for the fair value on the open market, not homes sold at foreclosure or otherwise sold at drastically low or high values.

Professional Fair Market Appraisals

Another commonly used way to determine a property's fair market value is to hire an appraiser. Appraisers should specialize in the type of property they are examining. For example, a real estate appraiser is a certified professional with experience and training to determine property value, while an art appraiser has extensive knowledge of the art world, art history and current trends in the sales of artwork. Appraisers use both competitive market analysis and other factors, such as economic trends, to determine the fair market value of a property. Many lenders require a home go through a professional appraisal before approving loans for the property.

Property Replacement Cost

Property replacement cost is common for both insurance companies and tax write-off purposes. The replacement cost is often similar to a competitive market analysis in that it can involve looking at the sale prices of comparable properties. For example, if you crash your car, the insurance company would only need to give you the fair market value of the car to replace it with a car in similar condition.

When an item, such as a house, needs to be rebuilt, the replacement cost needs to take these costs into account. For example, if your home was destroyed in a tornado and had to be rebuilt, it may have cost you $250,000 just last year, but rebuilding the same home with new materials could cost $300,000.

The Selling Price

In some cases, the selling price can be used to determine the fair market value of a property. This generally only applies if the sale was recent and if it was in an open market with no external pressures. If a home was just purchased last year at a value that was considered fair to both the buyer and seller, for example, this could be considered the fair market value for tax purposes. After about three-to-four years though, this value will likely no longer reflect the current market and an assessment must be performed before the property tax value will be determined.

Third Party Valuations

If you've ever looked at homes on a website such as Zillow, you may have noticed that even homes that are not up for sale have values listed on them (in the case of Zillow, these are called "Zestimates"). These property valuations are calculated using factors such as recent local sales and public tax records. Each site has a unique proprietary formula, which is why the values may vary greatly from site-to-site.

A company called HouseCanary claims it has the most accurate property valuations online that incorporate all available market data into its analytics. According to the site, their error rate from the true fair market value should be no more than 3.6 percent, which means the site could quite possibly have the most accurate fair market home valuations available online.