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How to Determine the FMV of Like kind Property You Received

October 10, 2023

The prices of properties in a like-kind exchange may fluctuate due to various factors such as property size, market conditions, location, etc. As a result, it’s vital for property owners to determine the fair market value (FMV) of a like-kind property before initiating an exchange.  

FMV gives an estimate of the value of a real property to help you know the best price to sell your existing property to defer capital gain taxes in a 1031 exchange.

This article will walk you through all you need to know about the FMV of like kind property you received in 1031 exchanges and the various methods to calculate FMV.

Background on Like-Kind Exchanges

Background on Like-Kind Exchanges

Section 1031 of the Internal Revenue Code (IRC) allows investors to postpone tax return on the realized gain from profitable sales and purchase of like-kind property. Generally, only real property of like-kind qualified for tax deferral. So, if an investor receives a property that is not like-kind or money for the sale, then the transaction is subject to capital gains taxes. Thus, the investor must use all the proceeds from the sale of the relinquished property to acquire the other property from the other party.

The Revenue Act of 1921 was renewed in 1928 because it only permits like-kind properties that don’t have “readily realized market value”. However, the Revenue Act of 1928 authorizes capital gain tax deferment for the like-kind exchange of investment real property.

Types of Properties that Qualify for a Like-kind Exchange

It’s crucial to note that certain properties don’t qualify for a successful like-kind exchange. According to Section 1031 of the IRC, both the relinquished and replacement property must meet the following requirements.

Types of Properties that Qualify for a Like-kind Exchange

  • The properties must be held for investment, trade, or business purposes in the U.S. Properties held primarily for personal use do not qualify.
  • Both real properties must have the same nature or class but can differ in grade or quality. For example, you can swap a plot of land for a rental property as long as both properties are held for investment or business purposes.
  • Properties like securities, partnership interests, certificates of trust, and inventory do not qualify for like-kind exchange.

Benefits of a Like-kind Exchange

Aside from tax deferment, property owners can freely swap their current property for multiple properties, provided they comply with the 200% rule.

It can also act as a long-term savings strategy if you continually utilize the 1031 exchange. Furthermore, like-kind exchange helps investors diversify their investment portfolio and maximize gain by acquiring properties with higher rental income and other possible advantages.

The Concept of Fair Market Value (FMV)

The Concept of Fair Market Value (FMV)

The FMV is the price at which an informed and unpressured seller would sell a property to an informed and unpressured buyer. It is the value of a real property that a buyer is willing to pay.

Understanding the FMV is crucial in like-kind exchanges. It gives investors and real estate agents an idea of how to price a property and the best offer strategy to use when purchasing. Determining the accurate FMV of the exchange properties also helps you avoid boot and other tax liabilities. Boot in 1031 exchange is the taxable gain that is not invested in the purchase of replacement property.

Factors That Determine the FMV

Comparable sales

This involves comparing recent properties in your area in size and other significant features to other properties within the same area. How low or high their sale price is can impact your property’s FMV.

Current market conditions

Market conditions such as supply and demand, interest rates, seasonal variations, changes in government policies, etc. can affect a property’s fair value.

The property’s physical condition

Physical conditions such as size, quality, location, and design layout can also affect a property’s FMV.

Location and external factors

Location and external factors

The FMV of a real property can also be influenced by location and other external factors such as accessibility, proximity to infrastructure such as highways, entertainment, and recreation.

Importance of Determining FMV in Like-Kind Exchanges

Legal and tax implications

Determining the accurate FMV of your property helps to ensure your like-kind property exchange complies with legal and tax regulations. You can consult a reputable qualified intermediary (QI) to help you manage the exchange, structure the exchange costs, and ensure compliance with IRS rules and requirements.

Gaining full benefits of Section 1031

To explore the full tax benefits of a like-kind exchange, the FMV of the replacement property must be equal to or greater in value than the FMV of the relinquished property. Otherwise, you may be on the hook for tax liabilities on capital gains.

Avoiding potential pitfalls or financial losses

Determining the FMV helps you avoid potential pitfalls and financial losses due to overvaluing and undervaluing of real property. Both situations can increase your tax liability, especially when you eventually sell the replacement property.

Methods to Determine the FMV of Like Kind Property You Received

Professional appraisals

Licensed and experienced appraisers conduct appraisals on properties to determine the market valuation of real property and ensure that the process complies with legal requirements. They consider measuring determinant factors such as size, location, age, construction type, and property type.

An appraiser starts the process by inspecting the property based on recent comparable sales and their unique features. Afterward, they release an appraisal report detailing their findings, methodology, and the property’s FMV.

Lastly, lenders, buyers, sellers, or real estate agents review and verify the appraisal report for accuracy and compliance. 

Methods to Determine the FMV of Like Kind Property You Received

Comparative Market Analysis (CMA)

Comparative Market Analysis (CMA) is mostly used by investors, real estate brokers, and realtors mostly use this method to estimate the value of assets. The method involves comparing the property with three or more recently sold similar properties (comps).

Automated Valuation Models (AVM)

The AVM uses a combination of mathematical modeling and the property’s database to determine the FMV of an investment property. It’s an algorithm that estimates FMV from information about a property’s size, location, and comps.

Income-based approaches for rental or investment properties

This is a lesser-used technique where investors analyze generated income and other related factors to estimate the FMV of real property under market conditions. It’s the ratio of the net operating income (NOI) of rent to the capitalization rate. When applying this method, an investor must consider vacancy, operating efficiency, and property conditions that might influence future gain or loss.

Replacement cost approach for unique properties

The cost approach applies to unique properties like schools or churches. It assumes that a property’s FMV is equal to the cost of building a similar property from scratch. According to this cost approach, a property’s value is the sum of the production costs and land value minus accrued depreciation.

Reporting FMV in IRS Form 8824

When engaging in a like-kind exchange, it’s crucial to accurately report the FMV of the properties involved on IRS Form 8824. This form is essential for complying with IRS regulations and ensuring the tax-deferred status of your exchange.

  • In Part I of the form, provide details about the properties exchanged, including descriptions and dates of the transactions.
  • In Part II, indicate the FMV of the like-kind properties you received and the relinquished properties you transferred. Ensure that the values are accurate to avoid potential tax liabilities.
  • Complete the form carefully, as it will be used to calculate any gain that might be taxable in the exchange.

In addition to FMV, there are several other important terms and considerations you need to pay attention to when filling out IRS Form 8824. They include:

  • Realized Gain or Loss
  • Ordinary Income
  • Net Liabilities Assumed
  • Taxable Installment Sale Income
  • Tax-Exempt Organization

Case Studies: Real-world Example of FMV in Like-Kind Exchanges

Two friends, Philip and Anna, are rental property owners who wanted to perform a like-kind exchange. With the help of an appraiser, Philip was able to accurately determine his rental property value of $500,000. However, Anna couldn’t hire an appraiser because she merely believed her asset was worth $650,000.

Eventually, Philip sold his property and identified a commercial replacement property with a greater FMV of $650,000 within the 45-day identification timeline. After his purchase, he was able to defer capital gains tax since the FMV of both properties is accurate.

On the other hand, Anna purchased a commercial investment property supposedly equal in value to her relinquished property at $650,000. After the exchange, the IRS performed an audit on Anna’s exchange and discovered that the true FMV of her relinquished property was $600,000. This made her liable to capital gains tax on the $50,000 overvaluation and increased her total tax liability on the property received. 

Challenges and Criticisms of FMV of Like kind Properties

Possible manipulation or bias in appraisals

During appraisals, investors face challenges of fraud and manipulation such as when an appraiser inflates the property’s FMV. Also, a homeowner, buyer, or seller can alter an honest appraisal report for personal gain.

Market volatility and its impact on FMV

Estimating the accurate FMV of properties can be very challenging when the real estate market is volatile. For such markets, it might be difficult to get an up-to-date value for property due to the rapid changes in prices. With an unstable appraised FMV, lenders and borrowers also find it difficult to estimate loan-to-value ratios and secure mortgages.

Criticisms of Like-kind Exchanges as a Tax Deferment Strategy

The like-kind property exchange looks promising, but it has limitations and criticisms too. Some argue that it doesn’t offer immediate cash flow to investors who have an immediate need for funds for exchange expenses or other investments. Also, complex rules like the 45-day/180-day timeline and determining the accurate FMV for properties can be challenging for investors.

The Future of Like-Kind Exchanges and the Role of FMV

FMV continues to play a pivotal role in the evolving landscape of 1031 exchanges. Its future performance depends on various factors like legal changes, tax changes, and technological advancements in property valuation.

Recently, the Biden administration of the United States proposed its intention to limit Section 1031 like-kind property exchange deferral to a maximum overall value of $500,000 (for single taxpayers) and $1 million (for married taxpayers).

Also, technologies like big data and machine learning can precisely evaluate property features, historical sales data, and market trends to determine the accurate FMV of properties. Lastly, FMV is now efficient and readily accessible with the presence of online property listings, increased transparency, and digital tools that help mitigate risks.

Conclusion

The FMV in like-kind exchanges is a useful metric that helps investors enjoy a successful tax deferred exchange, maximize returns, and ensure compliance. An accurate FMV is a crucial key to a successful 1031 exchange as it helps to make correct assessments of the replacement property and avoid financial losses.

However, it’s recommended to seek professional guidance from QIs, appraisers, and legal experts for a smooth and compliant 1031 exchange considering its complexity and costs. At Universal Pacific 1031 Exchange, we help you simplify the exchange process, offering expert guidance and precision in FMV assessment. Book a free consultation today to start your exchange.

About The Author

Michael Bergman, CPA
Michael Bergman is a California licensed CPA and Real Estate Broker with over 32 years of experience in commercial real estate. Specializing in 1031 tax-deferred exchanges and financial oversight, his expertise is invaluable for complex real estate transactions. Michael’s unique blend of financial acumen and real estate knowledge positions him as a trusted advisor in the industry, offering sound advice and strategic insights for successful property management and investment.

Don’t let taxes hinder your property investment decisions. Connect with us today for a free, no-obligation 1031 exchange consultation. Let us help you navigate the process with ease.