Fair Market Value and Replacement Cost - What’s the Difference?
Monday, November 16, 2020 in News
This is not an uncommon question in the Core Course in-person class, but it is even more common from the Core Course Distance Education students. The confusion is not limited to the beginner appraiser courses. I have also had requalification course attendees and students in the AF+DA courses who are not clear on the differences. Therefore, now seemed like a good opportunity to review the differences in use and the selection of comparables for these two objectives.
Fair market value is defined in both Treasury Regulation §1.170A-1(c)(2) and Treasury Regulation §20.2031-1(b). Initially the IRS developed a definition for fair market value to be used for non-cash charitable contributions for income tax deductions (§1.170A-1(c)(2)). Later the Treasury added additional language for use in estate appraisals for the determination of estate taxes (§20.2031-1(b)). As a result of the tax court case, Anselmo v. Commissioner, the court determined that there should be no difference in the definition of fair market value for estate tax, gift tax, and non-cash charitable contribution appraisal reports. As such, we now commonly use the longer definition cited in the estate tax regulations for all federal function reports, as well as most fair market value reports when fair market value is not defined by another source appropriate to the intended use. The complete definitions of fair market value can be found in the Core Course manual, 2020 edition, on pages 2-4 and 12-2.
The key point for this article is that determining fair market value employs the sales comparison approach which utilizes actual completed sales of sufficiently similar items to the subject property to warrant comparison. Where do we find comparables for fair market value? The most common source is auction records, as the auction market is typically the market where the property being appraised is most commonly sold. There are a number of internet sources which list auction results. Most of the data bases are subscription sources with costs ranging from inexpensive to quite expensive. You can quickly run up a bill that would eat up your income. Most of these, however, allow users to subscribe at daily or weekly rates. I always recommend that new appraisers try out the databases until they have established which they will use regularly before getting annual subscriptions. There are free resources as well. Most auction houses list their completed sales on their websites. eBay is actually a valid resource for many items, but you have to look at completed sales. In Fine Art, if there is no auction market for the artist, but there is an active trading market for the artist at retail, then the actual completed retail sale results can be used for fair market value. The bottom line is that the data needs to come from completed sales. Note that we are DETERMINING fair market value.
Replacement cost is used for insurance appraisals. Some use the term replacement value instead of replacement cost. ISA prefers to use replacement cost, as cost is the price paid for an item which may not be the same as its value or justified worth. Both terms are used interchangeably in the insurance industry. With replacement cost we are ESTIMATING the future cost to replace the item being appraised. The client is seeking insurance coverage against a future loss. When is the loss going to occur? We don’t know. What will the loss be due to? Fire? Theft? Breakage? We don’t know. What will the value of the item be at that future date? We don’t know. Since we don’t have a crystal ball, we must use a different methodology.
Estimating replacement cost makes use of the cost approach. In the cost approach we base the future replacement cost on the current asking price. Hardly anyone pays full asking price for anything anymore (I’m sure you can name a hundred exceptions but go with me here.) Someone is always having some kind of sale or overstock or can be convinced to discount. That’s true, but the insurance company is required to make a settlement in a timely manner. The client may not want go to 50 auctions or wait six months for a sale or bargain with a dealer. Therefore, the insured amount should allow them to purchase a replacement at an undiscounted asking price. We use the asking price to estimate replacement cost, as this is the amount necessary to make your client whole after a loss. Asking prices of comparable or identical items are usually not too difficult to find. There are lots of websites, galleries, shops, etc. that list the asking price of their inventory. Or, if the prices are not listed, then you can email to inquire about the asking price. Sometimes it may be necessary to pay a fee to the gallery for the requested information. eBay is also useful for a variety of items with Buy-it-Now pricing.
Hopefully this clears up at least a little of the confusion and provides a reasonable understanding of why the comparables for fair market value and replacement cost are not interchangeable.
By, Michael Logan, ISA CAPP