Fair market value definition
/What is Fair Market Value?
Fair market value is the price that two parties are willing to pay for an asset or liability, if both parties are well-informed about the item in question, neither one is under pressure to buy or sell, and there is no time pressure to complete the deal. If these conditions are present, the final price established between the parties should reasonably reflect the fair market value of the asset or liability on the date of the transaction.
The Characteristics of Fair Market Value
Here are the primary characteristics of a fair market value transaction:
Knowledgeable buyers and sellers. Both the buyer and seller must be fully informed about the asset, including its condition, market conditions, and any other relevant factors. Each party should understand the true value and specifics of what they are negotiating.
Willingness to transact. Both parties must be willing to buy or sell without being pressured, forced, or under any compulsion to act. This ensures that the agreed-upon price reflects genuine interest rather than desperation.
Open market conditions. The transaction occurs in an open and unrestricted market, where the asset is publicly available to any interested buyer. An open market increases competition, which typically leads to a price closer to the asset's true value.
Reasonable exposure to the market. The asset must be exposed to the market for a reasonable amount of time, allowing potential buyers to assess the opportunity. This gives a fair chance for the value to be tested by market demand.
Arm’s length transaction. The buyer and seller are independent, with no relationship to each other that could distort the price (e.g., family members, business partners). An arm’s length transaction minimizes bias, as neither party is inclined to offer a favorable or unfavorable price due to personal relationships.
Absence of unusual conditions. The transaction is not impacted by unique conditions, such as liquidation sales, which might undervalue or overvalue the asset.
Each of these characteristics helps ensure that the value derived is a true reflection of what the asset would fetch under fair and typical market conditions.
How to Estimate Fair Market Value
When it is not possible to locate one of the preceding transactions, it may be possible to estimate fair market value based on a cluster of data points from prior actual market transactions, extrapolated for the asset or liability that is under review. Another option is to derive it from the fair market values of similar products, or by estimating the net present value of the cash flows estimated to be derived from it in the future.
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How Fair Market Value is Used
The fair market value concept is used for many purposes, including establishing the replacement cost of an insured asset, establishing the tax basis upon which property will be assigned a property tax, and establishing the basis for damages in a court award.