According to the IRS, fair market value is defined as “the price at which the property would change hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”
But what does that mean? Fair, but in what sense of the word? Market, but in what market? Value, but on what terms? Here’s an example of how these terms work together.
Say you have a large property that you and several other persons own in a partnership. Much of the neighboring land has been converted to other uses. But your property has certain limitations and less-than-ideal features affecting its attractiveness for conversion. The family business on the property is agricultural and intends to remain that way until the day an offer comes that the partnership “can’t refuse.”
The family business is a separately owned operation, deriving revenues from product sales and returning enough funds to cover the expenses of the land ownership of the partnership. The partnership has a corporate general partner – to prudently limit liability – and more than a dozen limited partners who have no real say in the general partner’s management of the partnership.
So, what is the fair market value of a limited partnership interest in this property-owning partnership?
Market. There is a market for real estate. Someone buying this large property could develop it, though their expectation of profit is affected by the aforementioned limitations.
Problem is, you own a partnership interest in the land, and a limited partnership interest at that. Ignore for the moment the often-onerous transferability restrictions typical of partnership agreements and their draconian consequences. Your interest cannot even be registered for public offering. So, while under fair market value, a market of hypothetical willing buyers (the partnership market) is presumed to exist, you quickly sense that the value of your limited partnership interest is significantly less than if you could sell the property outright today and collect your share of the net proceeds.
For one thing, you have to try to sell the partnership interest on your own. There is no securities firm that will help sell your unregistered interest.
Perhaps if the property is worth tens or hundreds of millions of dollars, your interest alone may be valuable enough to attract a patient and hard-working broker intent on collecting a sizeable brokerage commission – if the broker can find a very wealthy and patient investor, that is. This particular property is not quite that large, though your interest in it is large enough to require a well-heeled buyer.
All of this will take time. And, because bank financing isn’t typically offered for partnership interests, a transaction will likely require you to offer some seller financing over a prolonged period.
Value. Will value be the face amount of the contract, once you or a broker procures a buyer who will purchase your interest using your seller financing? If your seller financing is at a favorable rate of interest, will value be the present value as of the contract date of the payments due under the financing?
No. Value actually needs to factor in how long you’ll be in the market and at what reasonable rate of return you expect your investment to perform all this while.
Fair. A reasonable rate of return is the “fair” part of fair market value. If you can earn a certain return on real estate, unimpeded by limitations, you should certainly hope to earn a greater return for this more complex investment. This partnership interest presents a far greater risk to you (the seller) and to the buyer, because your flexibility to sell – and your influence on management until sale – is marginalized.
That analysis of fair market value quickly diminishes value today, even if the payoff in the future might be quite a bit more than you would receive today.