Promissory Note Valuation – Important Tax Consequences
The sum of the outstanding principal balance plus the increased interest may actually overstate the value of the note
A little known fact
At first glance, the fair market value (FMV) of a note, secured or unsecured, appears to be easily determined. IRS Treasury regulations assume its value to be the unpaid principal, plus any accrued interest and late fees as of the valuation date. To value the note for less, satisfactory evidence must be presented. Evidence of lower valuation can be one or more factors such as: interest rate, payment amount, payment frequency, duration, collateral, payment history, or borrower’s credit status, to name a few. only some.
A qualified promissory note appraiser can set a lower value or even a value of zero worthless; the lower FMV reduces the taxable valuation of the note. This fact is not widely known, even to many CPAs and attorneys, but it is of great importance to the person who pays unnecessary taxes.
Fair market value differs from book value
The book value, cost and outstanding balance are accurate historical facts. Its accuracy is not in dispute. But, FMV (the IRS’s preferred definition) refers to the “market value” of the note, its current sales value, not its historical cost or unpaid balance. These two points of view result in two values for the same promissory note. Only one value is appropriate for tax purposes.
Fair market value defined
The definition, as defined in IRS Regulations Section 1.170A-1(c)(2), is “the price at which property would change hands between a willing buyer and a willing seller, without being under any obligation to buy or sell and both having a reasonable knowledge of the relevant facts”.
A taxable event can be any of numerous events. Some examples are the sale of a note, the transfer of a note from a traditional IRA to a Roth IRA, the gift of a note, or the need to value a note in an estate or trust. In all of these situations, the note’s historical cost, book value, or outstanding balance may differ materially from its current fair market value. Generally, the FMV is substantially less than the book value and the tax will be substantially less.
• The fair market value of a note is usually less than its unpaid balance plus increased interest.
• The IRS calculates many taxes on fair market value, not cost or book value.
• Many CPAs and attorneys are unaware that promissory notes are not “valued” at what they appear to be; they often overstate the bill and overpay the tax.
• Valuation is determined based on definition and evidence.
• A qualified and experienced note appraiser can produce a report of fair market value that meets the IRS definition and regulations. The fair market value is usually less than its book value.