Promissory note valuation: important tax consequences
The sum of the unpaid principal balance plus the increased interest may actually exaggerate 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 presume that your value is the principal default, plus any increase in interest and late fees up to the valuation date. To value the grade for less, satisfactory evidence must be presented. Evidence of the 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 only Some.
A qualified note appraiser can establish a lower value or even a zero value; the lower fair market value 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 balance owed are accurate historical facts. Its accuracy is not in dispute. But, fair market value (the preferred IRS definition) refers to the “market value” of the note, its current salable value, not its historical cost or unpaid balance. These two views result in two values for the same promissory note. Only one value is correct for tax purposes.
Definition of fair market value
The definition, as defined in IRS Regulation Section 1.170A-1 (c) (2), is “the price at which property would change hands between a willing buyer and seller, without being under any obligation to buy. or sell and both have a reasonable knowledge of the relevant facts. “
Tax implications
A taxable event can be any one of many events. Examples are the sale of a promissory note, the transfer of a promissory note from a traditional IRA account to a Roth IRA account, the gift of a promissory note, or the need to value a promissory note in an estate or trust. In all of these situations, the historical cost, book value, or unpaid balance of the note may differ significantly from its current fair market value. Generally, the fair market value is substantially less than the book value and the tax will be substantially less.
General conclusions
• The fair market value of a note is generally 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 overvalue the promissory note and overpay the tax.
• Valuation is determined based on definition and evidence.
• An experienced and qualified note appraiser can produce a fair market value report that meets the definition and IRS regulations. The fair market value is usually less than its book value.