Anyone who has ever tried to purchase or sell a home has probably heard a lot about the property’s fair market value, or FMV. Similarly, anyone who has to pay taxes on a property or take a property-based deduction needs to find the FMV. Incidentally, this is also a common terminology in the investment real estate market. Unfortunately, there is no easy or universal way to determine market value for real estate. However, nearly every market valuation comes down to two factors: real estate appraisals and recent comparable sales.
Economics of Market Value
The value of every good in a market economy arises out of a discovery process. Producers and resellers propose hypothetical values and hope to find buyers with similar valuations. On the other end, consumers bid up or push down prices based on their changing interpretations of the value of goods. This process is imperfect and ever-changing.
For real estate, this means a buyer must value the property more than the money he is trading for it. At the same time, the seller must value the property less than the money offered.
Appraisals and Comparable Sales
Appraisals are simply professional opinions of value. During a home sale, the bank that makes the home loan normally selects an appraiser to render an opinion about the value of real estate as of a specific date. Comparable sales, also known as the “market data” approach, is the most common way to arrive at market value. Here, the recent sales of properties of similar stature are reviewed to inform judgment.
IRS Publication 561
The governing tax code publication for fair market value of real estate is IRS Publication 561. This publication deals with all kinds of property valuations, such as cars, boats, collections, used clothing, securities, patents, annuities, and many others, but it does not set aside a section for determining real estate market value.
Publication 561 explicitly states “a detailed appraisal by a professional appraiser is necessary” for proper valuation. Three approaches are considered acceptable by the appraiser: the comparable sales approach, capitalization of income approach or the replacement cost new method.