Fair market value is an estimate of the price at which real property would change hands in an arm’s length transaction. That is, a voluntary transaction between a willing buyer and a willing seller, both having equal bargaining power and a reasonable knowledge of the pertinent facts.
Fair market value represents an impartial valuation or assessment of worth, no matter how much buyers or sellers wish it otherwise. For example, it doesn’t matter how much money the seller needs to pay off the loan or how much the buyer can afford. It is what it is.
Why Fair Market Value is Vital for Real Estate Transactions
Here are three main reasons why knowing the fair market value is important for valuing, buying or selling a home:
1. For Transfer of Ownership
The fair market value is a crucial to know anytime property ownership is being transferred. Knowing fair market value allows a homeowner to fully understand the value of his or her property to avoid being taken advantage of. It also helps the buyer know how much is too much to pay for a property. Here are some examples of situations where it is important to know the fair market value of a property:
- A home is being priced for sale
- Eminent domain is being exercised by the government
- A property is involved in a settlement such as a divorce
- A home is tied up in the probate process
2. For Tax Purposes
Tax authorities also want to know that real property is sold at fair market value. This is especially true for transactions between people not dealing at arm’s length.
Municipal property taxes are often assessed based on the fair market value of the owner’s property. As the difference between the purchase price and the property’s fair market value can be substantial, tax authorities are interested in knowing the current fair market value.
Fair market value also comes into play when someone is trying to determine the value of inherited property or property sold through the probate process. Tax authorities need to ensure that the credit given is for the true fair market value of the property. They often require independent valuations to know this number.
3. For Insurance Purposes
Fair market value is also often used in the insurance industry. For example, when an insurance claim is made as a result of a house burning down, the insurance company covering the loss will often only cover the amount up to the fair market value.
How Is Fair Market Value Determined?
Since determining fair market value of a property is not simply a matter of plugging numbers into a spreadsheet, the IRS has a list of accepted methods. Here are five ways real estate professionals determine fair market value for real property:
1. Comparative Market Analysis
The first method that real estate professionals use to determine the fair market value of real property is to compare the property in question to comparable properties currently on the market, or other comparable properties that have recently sold. This is called a comparative market analysis (CMA) and it’s commonly performed by a licensed real estate agent. The current asking price for comparable properties and recent selling prices of comparable properties can give an agent a reasonable estimate of what a property might sell for if placed on the market today.
How Real Estate Pros Find Fair Market Value with a CMA
Looking at comparable sales or comps is a big part of creating a CMA. For most CMA’s, agents look at roughly 2-3 years of recent sales to find comparable properties. In order for the CMA to be accurate, the comparable properties need to be as similar as possible in square footage, number of bedrooms and condition, as well as sold under similar conditions. For example, foreclosure sales of comparable properties are not accurate assessments of the value of a property not being sold at foreclosure.
2. Professional Appraisal
Another way to find the fair market value of a property is to hire a real estate appraiser. A real estate appraiser is a certified professional with training and experience concerning the many factors that determine property value.
When real estate appraisers value a property, they use slightly more sophisticated models of comparative market analysis. For example, they might take current economic or other trends into account before arriving at their valuation.
Most lenders requires a professional appraisal before approving your loan to purchase the property.
3. Replacement Cost
This third method is often used by insurance companies. If the value of a house has changed over time, the cost of replacing it might be used as an indicator of the fair market value.For example, If a home you bought for $300,000 burns down, because of increases in land value or construction costs, rebuilding the same home may now cost $350,000.
4. Selling Price
Selling price, according to the IRS, is the actual selling price of the property that is received by an organization. It’s one of the easiest ways to get a sense of the fair market value of a property. After all, if the transaction is arm’s length, then the selling price is what a buyer is willing to pay for the property on the market.
However, the selling price will only give an accurate idea of fair market value if the transaction takes place near the time the fair market value is needed. As you can imagine, the selling price of a property that was sold ten years ago tells us little about the fair market value in today’s market.
Even if the property is sold very recently, many factors can also lead to a property being sold for less or more than fair market value. The season, marketing efforts, and the experience of the real estate agent selling them home can all affect the the selling price. This means that a property’s selling price is not always an accurate reflection of the home’s fair market value.
5. Valuations by Third Party Websites
The fifth and final method is to use third-party websites that make estimates using their own proprietary formulas. For example, Zillow makes calculations (which it calls “Zestimates”) regarding the fair market values of property based on recent local sales on Zillow, and public tax records. But perhaps the most accurate property valuations can be obtained from an analytics company called HouseCanary. Its valuation algorithm incorporates all available market data to estimate the most likely value a property would currently sell for in an arm’s length transaction. The company claims to have an error rate of only 0% to 3.6%.
The Bottom Line
Fair market value is an impartial estimate that establishes a realistic price if the real property was sold in the existing market conditions. It provides a solid starting point for pricing a property for sale or inheritance. Without knowing fair market value, risk of loss or tax liability increases.