Promissory Note Valuation – Important Tax Consequences
The sum of the unpaid principal balance plus accrued interest may actually overstate the value of the promissory note
A Little Know Fact
At first blush, the Fair Market Value (FMV) of a promissory note, secured or unsecured, appears to be easily determined. The IRS Treasury regulations presume its value to be the unpaid principal, plus any accrued interest and late charges to the date of valuation. To value the note for less, satisfactory evidence must be submitted. The evidence for the lesser valuation can be one or more factors such as: the interest rate, payment amount, payment frequency, duration, collateral security, payment history, or the borrower’s credit status to name just a few.
A qualified promissory note appraiser may establish a lower value or even a value of zero-worthless; the lower FMV reduces the note’s taxable valuation. This fact is not widely known, even to many CPA’s and attorneys, but, it has great importance to the person paying unnecessary taxes.
Fair Market Value Differs from Book Value
Book value, cost, and unpaid balance owed are all accurate historical facts. Their accuracy is not in dispute. But, FMV (the IRS’s preferred definition) is concerned with the note’s “market value”, its current salable value, not its historical cost or its unpaid balance. These two points of view result in two values for the same promissory note. Only one value is the right one for taxation purposes.
Fair Market Value Defined
The definition, as defined by IRS Regulation Section 1.170A-1(c)(2), is “the price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”
Tax Implications
A taxable event can be any of numerous happenings. Examples are the sale of a note, the rolling of a note from a traditional IRA account into a Roth IRA account, the gifting of a note, or the need to value a note in an estate or a trust. In all of these situations the historical cost, the book value, or the unpaid balance of the note may differ significantly from its present Fair Market Value. Usually, the FMV is substantially less than book value, and the tax will be substantially less.
General Conclusions
• The Fair Market Value of a promissory note is usually less than its unpaid balance plus accrued interest
• The IRS calculates many taxes on Fair Market Value, not on cost or book value.
• Many CPA’s and attorneys are unaware that promissory notes are not “valued” at what they appear to be; often they over-value the note and over-pay the tax.
• Valuation is determined based on the definition and the evidence.
• An experience, qualified promissory note appraiser can produce a Fair Market Value report that comports with the IRS definition and regulations. The Fair Market Value is usually less than its book value.
