Choosing the Most Common Market for IRS Appraisal Reports
By Kirsten Rabe Smolensky, JD, ISA CAPP
The Core Course instructors recently received the following question:
“I have a client who is challenging a Fair Market Value (FMV) I assigned to a Motherwell print he plans to donate. He asked me to explain the big difference between the $2,500 FMV assigned based on auction comps, and the $8,000 that retail galleries are selling them for.
It seems the most common market is both retail gallery and auction. Would it be appropriate to use 3 retail gallery sales comps minus the gallery's consignment fee (usually 20%), and 3 auction comps? And to use the mean average as FMV?”
This question raises the thorny issue of which market is the most common market for an IRS appraisal report. It also touches on questions related to the fees that should be included in your comparable sales, the difference between the mean and mode when determining FMV, and how appraisers should deal with clients trying to “guide” appraisal results.
The Most Common Market
The first place to find guidance is within the IRS regulations.
Treasury Regulation §1.170A-1(c)(2) defines FMV for IRS noncash charitable contributions as, “The price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.”
Estate Tax Regulation §20.2031-1(b) expands upon this definition, adding that, “The fair market value of a particular item of property includible in the decedent’s gross estate is not to be determined by a forced sale price. Nor is the fair market value of an item of property to be determined by the sale price of the item in a market other than that in which such item is most commonly sold to the public, taking into account the location of the item wherever appropriate.” Note that this is where most appraisers stop reading and quoting the estate tax regulations.
However, the regulations continue: “Thus, in the case of an item of property includible in the decedent’s gross estate, which is generally obtained by the public in the retail market, the fair market value of such an item of property is the price at which the item or a comparable item would be sold at retail. For example, the fair market value of an automobile (an article generally obtained by the public in the retail market) includible in the decedent’s gross estate is the price for which an automobile of the same or approximately the same description, make, model, age, condition, etc., could be purchased by a member of the general public and not the price for which the particular automobile of the decedent would be purchased by a dealer in used automobiles.”
In Anselmo v. Commissioner, 757 F.2d 1208 (11th Cir. 1985), the 11th Circuit Court of Appeals affirming the Tax Court held that “there should be no distinction between the measure of fair market value for estate and gift tax and charitable contribution purposes.” Therefore, when determining fair market value for any federal function, the full definition of fair market value should apply. (Read more in the ISA Core Course Manual, Lesson 2.) The court also stated that “the public" refers to “the customary purchasers of an item. The most appropriate purchaser of an item is not invariably the individual consumer. For example, the general buying public for live cattle would be comprised primarily of slaughterhouses rather than individual consumers. The fair market value of live cattle accordingly would be measured by the price paid at the livestock auction rather than at the supermarket. In this case, the Tax Court found the ‘public’ for low quality, unmounted gems to be the jewelry manufacturer and jewelry stores that create jewelry items, rather than the individual consumer.” The 11th Circuit affirmed this finding.
So, how does this apply to your Motherwell prints? Generally, with fine art, antiques, and collectibles, the most common market is often considered to be the auction market. While there are instances where a retail market should be considered, they are relatively rare. In my personal experience, I have only considered a retail market in two instances (although I am sure there are other situations where a retail market is appropriate). The first situation involves used automobiles. In these instances, I consider completed sales between private individuals where the data is available, as opposed to sales by individuals to dealers. This is easy because it is the example given in the regulations.
The second situation involves an artist (usually living) who has a very thin or non-existent secondary market. This can be tricky. My general rule is that I first consider all recent completed sales, both in galleries and at auction. Then I compare the number of completed sales in each setting. If in the past five years there have been four completed auction sales but forty confirmed gallery sales, then I argue in my report that the most common market for that particular artist is the retail market. Items rarely come to auction and there are not enough recent comparables to reach an accurate valuation. The only robust market is the retail market.
A detailed justified reasoning section explaining how you chose the relevant market, followed by your comparables within that market, is a must. In the case of a print, you might want to consider the specific print that you are appraising, e.g., if that specific print is no longer being sold at retail. I know that some appraisers disagree with this approach and would use the auction results even though the market is thin. Their argument is that the “used” secondary market is the only market available to the donee. However, the regulations do not focus on the markets available to the estate or donee if it needed to sell the item. Instead, the regulations focus on where the public buys the item. Remember, the public is “the customary purchasers of an item” and may not always be the individual consumer. Hence, the example of loose gems. Though, I believe that fine art is different. Depending upon the artist, the market may be a retail gallery or an auction gallery. In some categories of art, particularly at the high end of the market, sale prices at galleries may not even differ substantially from auction results. The bottom line is that an appraiser really needs to understand the markets for the item he is appraising.
We also appear to live in a time when markets are changing drastically. Consumers now have access to sites like eBay and Art Brokerage, where they can set up a storefront that does not differ significantly from an online storefront that may be run by a retail art gallery or antique store. Sure, reputation matters and can drive prices drastically (think of eBay’s ratings system as a way to build reputation). However, individuals also have the option of consigning an item to a gallery, where the sales price and not the netted price would be considered. In my mind, the customary purchasers of the artist in the above example (4 completed auction sales and 40 completed gallery sales during the past 5 years) are buying at galleries, not auction. Therefore, the relevant market is the retail market.
Unfortunately, there are no crystal clear rules. In Anselmo, the 11th Circuit specifically says that determining the “relevant market” is a “question of fact.” This means that the “relevant market” is a question to be determined on a case-by-case basis by a jury after listening to all relevant evidence. There are no clear legal rules and every case result will be different. A jury will decide what the relevant market is after listening to all of the facts, i.e., the arguments made by both sides, the arguments made by the battling experts, etc. As you can imagine, this is time-consuming and very expensive. Yuck!
As appraisers, most of us want to be told exactly what to do. Tell us the answer so that we can get it right 100% of the time. Unfortunately, the only thing that is clear is that fair market value should be the same whether you are working on an IRS taxable estate or a charitable donation. What gives the IRS pause when an appraiser considers a retail market in a charitable donation situation is fear that the appraiser might not make the same decision in an estate setting. Why? Because using a retail market in a charitable donation situation generally creates a higher FMV and, therefore, provides the client with a larger tax deduction. In an estate situation, choosing a retail market also creates a higher FMV, but the end result is that the client pays higher estate taxes.
Personally, I do not think that most appraisers spend too much time analyzing the effects on the client (or perhaps I’m just naïve). Instead, I think that most appraisers follow what they think is appropriate appraisal methodology. Unfortunately, the IRS does see appraisers who will always choose retail for the charitable contribution situation and auctions for a taxable estate, even when appraising the same item. This is bias. The IRS has publicly spoken about this problem and openly stated that it is looking “to make an example” out of an appraiser who is engaging in this sort of behavior (either undervaluing estates or overvaluing donations on a regular basis). In fact, I just read an article the other day about a Ferrari that was valued in France for $30M for estate purposes, but then sold for something like $65M 18 months later at auction. The article noted that the estate had gone to a “special appraiser” to obtain the estate valuation. The IRS sees the same kinds of problems and wants to stop this behavior and get all of the money that it is owed.
Our duty as appraisers is to remain neutral. When doing a charitable donation, I always like to run through my numbers at the end pretending it is an estate report (and vice versa). I find it to be a good double check on my neutrality.
In the question posed above, the appraiser found that the most common market is both the auction and retail gallery market. I assume that both markets have enough recent comparables that the appraiser can reach a valid determination of fair market value in both markets. If so, I would stick with the auction sales price, plus buyer’s premium, because the appraiser can reach a reasonable determination of fair market value. There probably is not a good enough argument for turning to the retail market in this situation. And, I would imagine, at least some collectors of Motherwell prints are buying at auction.
Of course, you may disagree with my assessment. I have never appraised a Motherwell print. If you do, that is fine, but you need to explain why in the appraisal report. An appraiser should first pick the relevant market and then explain in detail why that is the correct market. Next, the appraiser needs to choose good comparables from within the chosen market. Do not mix comparables from two different markets (e.g., retail comps and auction comps). While it may seem easier to split the baby, it simply is not good appraisal methodology.
What Fees Are Included in Comparables?
The question also raises an issue about using fees in comparables. Remember that fair market value is a hypothetical value; it’s what the appraiser determines the item’s most probable sales price to be. At an auction, the price that the public pays is hammer price plus buyer’s premium. So, at auction, all comparables should include the actual buyer’s premium charged to the buyer. It does not matter what the seller retains at the end of the day. In a retail setting, the appraiser should consider the actual selling price of the item, i.e., what the buyer paid. Do not deduct any gallery commissions or fees.
Selecting Good Comparables & the Mean vs. the Mode
Finally, one last point on working with comparables. First, select good comparables. Second, use the mode (most common number) and not the mean (average) to determine fair market value.
In this case, selecting good comparables means choosing prints by Robert Motherwell (not a different artist), ideally of the same or similar size, subject matter, condition, and from the same date/period, etc. You need to know and understand the value relevant characteristics of the item being appraised, and you need to make sure that the comparables used have the same or very similar value relevant characteristics as the appraised item. Obviously the date of sale matters significantly. I do not like any comparables to be more than two or three years old if I can help it. The closer the sale is to the effective date, the more relevant that sale is (all other value-relevant characteristics being equal). When considering a list of comparables, I like to order them in my report beginning with the most relevant and concluding with the least relevant. Generally, appraisers give more weight to the more relevant comps and less weight to the less relevant comps. Do not forget to throw out any outliers, high or low. I like to keep a copy of all comparables, even outliers that I do not use, in my workfile. I often write notes on them explaining why I chose not to use that particular comp. Therefore, if my work is ever called into question, I am quickly able to recreate my thought process and explain it. Of course, a good justified reasoning should make this unnecessary.
The number of comparables an appraiser uses generally depends upon the value of the item being appraised and the intended use of the appraisal report. For example, higher value items generally require more comparables. An appraiser might not use any comparables for a $100 item, three comparables for a $5,000 item, five comparables for a $25,000 item, and so on. The intended use is also important. For any IRS report, an appraiser should use more comparables than he might for other types of reports (e.g., an insurance coverage report). In some instances, the clients will tell you whether they want comparables included in the report.
Once you have selected and ordered your comparables, look for the mode, or the most common number. With auction results, you might see a string of numbers that looks like this: $4,500; $5,000; $6,000; $8,250; $8,450; $8,500; $8,600; $10,000; and $11,000. No single number is repeated. However, the mode seems to be somewhere in the $8,250-8,600 range. In Core Course, we affectionately refer to this as the “modal range.” Once you get to the modal range, you are close. In this particular example, I might argue that $8,500 is the mode. Others might make an argument that mode is something slightly different (e.g., $8,450). At this point, we are splitting hairs. Our numbers are very close to one another and within an acceptable margin of error. Also, this part of appraising is more an art than a science. Use common sense. Follow your gut. Sit on your results for a few days and then review with fresh eyes.
Note that the mean, or average, of this example is $7,811. This number is below the modal range and not even close to a realized sale result. Therefore, it would be inappropriate to use the mean to determine fair market value.
Clients Trying to Steer Appraisal Results
We have all been there. An estate where the heirs follow you around proclaiming, often loudly, what bad condition everything is in and how it is all a worthless pile of junk. Or the attorney in a divorce who suggests that the husband’s collection of vintage fishing lures is priceless and invaluable, while all of the Lladro figurines are inexpensive chachkies. You guessed it: the attorney works for the wife.
Even worse, is when an appraiser has completed his or her work and then the values are questioned by the client. Unless the appraiser has made an honest mistake, there is no wiggle room in the numbers. An appraiser’s USPAP certification statement says that the appraiser has no bias towards the parties or property involved, and that the fees charged are not contingent on the value of the items being appraised. This means that you cannot change your numbers because a client is unhappy and you want repeat business from them (this would be bias towards the parties). It also means that you cannot change your numbers to make sure that your bill is paid.
The ISA Code of Ethics also has several rules that likely apply in this situation. Rule 3.08 succinctly hits the nail on the head: “ISA members shall arrive at an independent numerical conclusion based on knowledge, thorough research and experience without regard to undue influences.” If you have a moment, read the ISA Code of Ethics and see what other rules might apply.
So, how do you deal with clients or other parties trying to exert undue influence over your appraisal results? Over the years, I have developed two hard and fast rules.
First, politely ignore all attempts to influence value conclusions. If necessary, remind the client that you are required by USPAP and the ISA Code of Ethics to remain neutral. In rare situations, you might need to explain the repercussions to you for violating neutrality. For example, you could have an ethics complaint brought against you or be barred from practicing before the IRS. If all else fails, you may have to suggest that the client hire someone else if they do not want a neutral appraiser. I have yet to be fired.
Second, get paid before you hand in the final report. Have your contract state that you must be paid in full before the final report will be provided to the client. Do not cheat and give them your final conclusion before you are paid. This alleviates the possibility of someone holding payment over your head in exchange for a certain result. It also has the added benefit of ensuring that you will be paid 99% of the time.
I am sure your ISA colleagues have other good suggestions as well.
Kirsten is a Core Course Instructor for ISA and also teaches the Requalification Course. She lives in Brentwood, TN.