When talking about major assets, such as houses or cars, you may come across the term "fair market value." But what does it mean? And how do you calculate it?
Fair market value is the selling price of an asset if put on the open market. It's what people would pay with enough knowledge of its condition and features, without pressure, and acting in their own best interests.
Take a closer look at fair market value, including when we use it, how to calculate it, and why it matters.
Fair Market Value: What It Is and How to Calculate It
The fair market value is what an asset like a house, car, or stock would sell for if:
- Both buyers and sellers are knowledgeable about it
- Both buyers and sellers act in their own best interest
- No one feels undue pressure to buy or sell it
- The transaction period is reasonable rather than rushed
- Fair market value is most commonly used for tax, insurance payouts, and when buying or selling large assets like real estate or cars.
How Is Fair Market Value Different From Other Related Terms?
When you first learn about fair market value, you may easily confuse it with a few other similar terms.
Fair Market Value vs. Market Value
Market value is the price of an asset on the marketplace. You can find an asset's market value just by looking at a listing for the asset in question. It has fewer influences than fair market value and is much easier to find.
Fair Market Value vs. Appraised Value
Appraised value is yet another way of valuing an asset. However, appraised value is its value according to a single appraiser. An appraisal may be enough to determine fair market value, but at the same time, other factors influence fair market value. In most cases, you determine the fair market value by considering other information and assessments.
Fair Market Value vs. Book Value
When talking about stocks and other investments, you may also find yourself comparing fair market value to the book value. The book value is the price you paid for the asset, minus any other costs like depreciation. Many investors compare the book value and fair market value to make investment decisions. Comparing the two gives an idea of current profits or losses.
What Is Fair Market Value Based On? How Is Fair Market Value Calculated?
There are several ways to calculate fair market value. To some extent, the calculation depends on the type of asset and the reason you need the fair market value. The most common method for computing is by looking at comparable prices and having the asset appraised by a professional. Sometimes, the fair market value will be a combination of these two factors.
Depending on the situation, you can also use replacement costs and comparable sales. Using replacement costs is especially common for insurance claims. Meanwhile, using recent comparable sales is common for assets like cars and especially, real estate.
What Is Fair Market Value Of A Car?
Kelley Blue Book and Edmunds are known as authorities for listing the fair market value of autos. They let you look up the comparable value of a car based on specific make, model, and year. The prices are then divided based on condition.
But finding the fair market value of a car will also involve checking local listings to see what the auto is being sold for in the area. For new cars, it will also involve looking at the manufacturer's suggested retail price (MSRP).
What Is Fair Market Value Of A House?
The most common method of finding the fair market value of a house is by hiring a professional appraiser. These professionals use standards and guidelines in their appraisals. They will also account for local and national regulations.
What Is Fair Market Value Of A Stock?
If a stock is publicly traded, you can simply check the stock prices to get the fair market value. The typical practice is to average the lowest and highest selling prices of the day. On non-trading days, the averages will come from the closest trading day.
Calculating fair market value is more challenging for private stocks as you won't find daily pricing data. The most common method for private stocks is by looking at the valuation ratios of the private company and comparing them to that of a comparable public company. Analysts also look at future growth and risk factors.
Complications When Calculating Fair Market Value
Because there are so many ways to calculate fair market value and some of them are somewhat subjective, there are a few challenges that you need to keep in mind.
When Fair Market Value Is Very Different From What You Paid
To some extent, you can manipulate fair market value to your benefit. A common example is when you purchase something for much less than it's worth. Maybe it was a good find or a rush sale. But if you donate the item to charity, you could use its fair market value for your tax deduction rather than the price you paid. You would end up with a much higher deduction on your taxes than if you based it on how much you paid for the item. This scenario can happen with art, cars, and nearly any other asset.
Potential Bias In Appraisals
Anytime you rely on a professional appraisal to calculate the fair market value, there is a small risk of bias or ulterior motives influencing the appraiser. Despite that, best practices and standards will help you minimize the possibility of unfair appraisals. Simply put, the most respected appraisers are trustworthy because they are objective during the appraisal process. So, you can circumvent this issue by choosing an appraiser with a good reputation. You could even get several appraisals and compare them.
Lack Of Expertise In Appraisals
Issues with professional appraisals don't even have to include conscious bias. A new appraiser may not have enough expertise in a particular market segment. Or they may not know enough about your asset. If they don't have access to complete information or enough expertise, their appraisals can be off. Once again, however, you can avoid this by choosing your appraisers carefully and comparing two or more appraisals.
Challenges With Comparable Costs
As mentioned, one of the ways to calculate fair market value is by looking at sales of comparable assets. Remember that this requires you to accurately estimate costs and factors like depreciation.
Unique Items Are Very Challenging
On top of the above challenges, it is especially hard to determine the fair market value of unique items, such as handmade assets or art. Information on comparable or recent sales will likely not be available. There may even be a lack of experts on that particular type of asset.
When Do You Use Fair Market Value?
We touched on some use cases of fair market value, but a few are worth mentioning in more detail.
When Buying Or Selling
Whether you are buying or selling an asset, fair market value is crucial. It helps you ensure that you pay or receive a fair amount. It is especially crucial when negotiating the price.
Determining Property Taxes
Fair market value is incredibly important for taxes, especially municipal property taxes. Most municipalities use the fair market value instead of the price paid for the property, as there can be a significant difference between the two. This is particularly true for instances when someone has owned a house for a long time and the real estate price naturally increased over time.
For Insurance Claims and Payouts
It is incredibly common for insurance companies to use fair market value, especially for auto insurance. In most cases, an auto insurer will cover damages as long as they are less than the fair market value. If repair of the damages costs more than the fair market value, the insurance company will typically declare the car as totaled.
Bankruptcies are yet another common situation where you can expect to use fair market value. During the process, it will be used to estimate the value of assets like cars and homes.
More Complicated Tax Situations
Fair market value is also used in more complicated tax situations, such as when valuable assets are exchanged for minimal amounts or given. For example, a retiring business owner may sell their business to their child for $1. The IRS may charge the father taxes for the sale based on the fair market value of his business, not the $1. Donations pose another complicated situation. If someone donates art or other assets, they receive a tax deduction based on the fair market value of the property.
Fair market value is the selling price of an asset when both the seller and the buyer are well informed, not under any pressure, and have ample time to make a decision. It is a common term in real estate, auto sales, insurance, and taxes. You can calculate fair market value via appraisals, comparable sales, recent sales, or replacement costs.
Shawn Manaher is a former financial advisor, has founded 5 online businesses, and is a coach, speaker, podcast host, and author. He's been featured on Forbes, The Consults Corner on TAE Radio, The Writing Biz, What's Your Story, and more.