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Fair Market Value FMV – Meaning, Importance to Mutual Fund Investors

Fair Market Value (FMV)

What is the fair market value?

Fair market value FMV is the price at which one can purchase an asset under normal market conditions. The fair market value represents the accurate valuation of asset under the following conditions:

  • Both the parties (buyers and sellers) are reasonably and equally knowledgeable about the asset under consideration.
  • The parties must be good economic agents and logisticians. This implies that the parties must behave in their own self interest.
  • Both the parties have to be free from undue pressure to execute the transactions. That is the willing seller, and the willing buyer are not forcefully executing the transaction.
  • There should be a reasonable amount of time to execute the transaction.

All the above listed conditions are economic principles that determine the degree of openness and freedom in any market activity. Hence, the fair market value is different from the market value. Market value is the current price of an asset in a given market place. For instance, the price of a T-bill that is allotted during a competitive bidding process doesn’t reflect the instrument’s FMV. The supply and demand forces determine the market value of a security.

Understanding the fair market value

Fair market value FMV is the actual measure of the worth of an asset. It is the price at which the buyer is willing to pay, and the seller is willing to sell. Fair market value is different from market value and appraised value.

Market value is the price at which the asset is trading in the market. The market value of listed financial securities can be found on exchanges. The supply and demand forces determine the market value of a security. Whereas, FMV is difficult to determine as it’s not available on exchanges.

The appraised value is the value of an asset determined by appraisers. For each appraiser, this value can be different. Various methods, like comparative analysis and risk analysis, are used to find the appraised value. However, if not immediately, the appraised value can qualify as fair market value.

One can determine the FMV by using any of the following methods:

Comparative analysis

The comparative analysis is the most common method to calculate fair market value. By comparing the price of an asset with the price of an asset having similar features, one can calculate fair market value.

Professional appraisal

Hiring a certified professional to appraise an asset to determine its FMV is one of the most common methods. However, hiring a professional appraiser who appraises similar assets should only be hired.

Real estate markets most commonly use fair market value. It is used to value properties. Also, the assessment of investment property taxes is on the fair market value of the investment property. Insurance companies also use FMV to determine the damage or compensation that has to be paid. Financial securities like stocks and bonds also use fair value. Determining fair market value will help investors make important investment decisions like buying and selling. If the fair market value is close to the market price, they can consider buying or selling the security. However, if the fair market value is way below the market price, they wouldn’t want to buy it and vice versa.

What is the fair market value of mutual funds?

Fair market value is widely used across multiple asset classes and markets. For example, real estate markets, insurance, investment assets like stocks, bonds and mutual funds etc.

Knowing the FMV of an investment will help investors in planning their finances. For instance, while purchasing an asset is it important to know the price of the asset in the market (ask price).

For mutual funds, the FMV is often used interchangeably with the Net Asset Value (NAV). Net Asset Value of a mutual fund is the market price of a mutual fund unit. Investors can buy and sell mutual funds at the NAV. A mutual fund’s NAV is the difference between the total assets and liabilities (expenses and liabilities) upon the total number of units.

NAV = [Total Assets – (Liabilities + Expenses)] / Number of outstanding units

Additionally, returns from mutual funds are estimated using the change in NAV of the fund. The increase or decrease in the NAV from the time of purchase to sale determines profit or loss.

However, investments decisions cannot be based purely on the NAV of a fund. In addition to historical performance, one should also consider other qualitative and quantitative factors. Some of the factors that help in shortlisting a mutual fund are:

  • Fund house
  • Fund manager’s experience and expertise
  • Investment strategy
  • Asset Allocation
  • Exit load
  • Expense Ratio
  • Sharpe ratio
  • Treynor’s ratio
  • Alpha

These are some of the many parameters that help an individual in shortlisting mutual funds.

In 2018, the long term capital gains from an investment attract tax. For mutual funds, all investments made before January 31st 2018, have a different calculation for long term capital gain tax. The fair value of all mutual fund investments before January 31st 2018 is the NAV of the mutual fund unit. For the purpose of taxation, the cost of acquisition is determined as follows.

The cost of acquisition (CoA) of the mutual fund will be higher of:

  • The actual cost of acquisition of the mutual fund
  • The lower of
    • The fair market value of assets as on January 31st 2018
    • Total proceeds from selling the mutual fund

How is it important to investors?

Determining the FMV is essential for every transaction. This is because it helps investors to make important investing decisions. Also, it helps for the purpose of taxation.

Investment decisions

By knowing the FMV of an asset, an investor can decide whether to buy or sell the asset. They can compare the fair market value with the current market price to make a decision. For example, if the fair market value is less than the current market price, then the buyer wouldn’t be willing to pay for the asset. However, the seller would be willing to sell it. Similarly, if the FMV is more than the current market price, then the buyer would want to buy the asset, but the seller won’t be willing to sell it.

Taxation

Tax authorities across the world ensure that the transactions are realised at fair market value for the purpose of taxation. This is to ensure that the capital gains (both long term capital gains and short term capital gains) on the transactions are determined fairly.

The transactions can take place at any value, even an amount as low as INR 1 per share. But for the purpose of taxation, the tax authorities consider the transaction is done at FMV. Then the seller will have to pay taxes on the long term capital gains. The long term capital gains will be the difference between the sale price (in this case, the fair market value), and the cost price.

In case of inheritance of any property or asset, then the person inheriting the property is liable to pay tax on it. In this case, the taxes are determined based on the difference between the sale value and fair market value.

Fair market value is useful even at the time of claiming tax deductions on donations made. In case the donation is in terms of properties or artwork, then one has to determine the FMV of the donation. The tax deductions will be on the fair market value of the donation.

Hence determining the fair value becomes important to avoid any complications or claim of fraud from tax authorities.

Published on September 25, 2020