Valuation of Promissory Notes for Assets, Donations and Bankruptcy
Fair Market Value Definition
For gift and estate tax purposes, fair market value is defined as the price at which the property would change hands between a willing buyer and a willing seller, with neither being obligated to buy or sell, and both have a reasonable knowledge of the relevant facts.
Treasury Regulations Section 25.2512-4: The fair market value of notes, secured or unsecured, is presumed to be the amount of unpaid principal, plus accrued interest as of the date of gift, unless the donor states a lower value. Unless repaid at face value, plus increased interest, it must be shown by satisfactory evidence that the note is worth less than the unpaid amount (because of interest rate, maturity date, or other cause), or that the note is uncollectible in part (due to the insolvency of the party or of the obligors, or for another reason), and that the assets pledged or mortgaged as collateral are insufficient to satisfy it.
The unpaid balance of the note is not the fair market value
When the Applicable Federal Rate (AFR) is used for a note, it generally devalues the note. The (AFR) is typically lower than market interest rates for a similar note; A note issued at the current AFR will not be worth its face value in the context of fair market value: the price that a hypothetical willing buyer would pay to a hypothetical willing seller. Since the purpose of investing in notes is to generate income, the lower the interest rate, the lower the market value of the note.
Real World Note Valuation Factors
An actual purchaser of notes determines the risks associated with an investment in notes as a starting point for making a purchase decision. The greater the risk or uncertainty associated with future payments on the note, the higher the required rate of return. This causes discounts to be applied. If the interest rate paid on alternative investments is higher than that paid by the note, the buyer of the note will demand a higher discount to compensate. Discounts are frequently applied to notes using AFR because comparable notes paying market rates offer a higher yield. Discounts are adjusted for performance disparity.
Factors that cause discounts
Note buyers consider numerous risk factors. In fact, a competent note buyer can be considered a “risk identifier and risk quantifier.” The key risk factors evaluated are listed below.
Terms, conditions, and loan documents for the notes: interest rate, maturity date, prepayment penalties, late fees, default penalties, financial coverage ratios, and maturity-for-sale clause
Collateral: type and amount of collateral — deed of trust, mortgage, UCC filing statement, pledge agreement, personal guarantee
Collateral: value, liquidity, and marketability as determined by a third-party appraiser
Borrower: financial statements, tax returns, credit score
Borrower: payment history
Borrower: cash flow to meet installment and balloon payments
Negotiability: of the promissory note and loan package
The value of a note using Applicable Federal Interest Rates (AFRs) generally must be discounted so that its yield is comparable to a similar note that carries a higher market rate of interest.
Disclaimer: The information is not advice. This article is for your information; it is not financial, legal or tax advice. The information and opinions provided are based on my own research and experience. Always consult a tax expert and valuation expert for advice.