Promissory Notes and Mortgage Notes May Provide Tax Deductions

Fair Market Value of Promissory Notes May be A Stealth Tax Deduction

Looking for Tax Deductions

Promissory notes and mortgage notes have two primary values-cost value and Fair Market Value. The cost value is what you paid, or what you invested; Fair Market Value is what the note is worth today if it were sold. If $10,000.00 was invested in a note originally, and today its Fair Market Value is zero ($0.00), there may be a $10,000.00 tax deduction available, depending on the specific facts. This tax deduction will happen if and when you take steps to make it happen. The burden is on you.

The promissory note and mortgage note may be held in a self-direct IRA account, Roth IRA account, estate account, or in a trust account. The note may have been a business note, or a note from a friend or family member. It may be in safe deposit box. The note may have lost value, or may be worthless; it may qualify for a tax deduction. Since most taxpayers file tax returns at year-end; now is the time to look for these “stealth tax deductions. The burden is on you.

What is the Reason for the Tax Deduction?

The U.S. Treasury Regulations (IRS) requires valuing promissory notes, at their FAIR MARKET VALUE, not at cost.

Sec. 20.2031-4 Valuation of notes

The fair market value of notes, secured or unsecured, is presumed to be the amount of the unpaid principal, plus interest accrued to the date of death, unless the executor establishes the value is lower or that the notes are worthless. However, items of interest shall be separately stated on the estate tax return. If not returned at face value, plus accrued interest, satisfactory evidence must be submitted that the note is worth less than the unpaid amount (because of the interest rate, date of maturity, or other cause), or that the note is uncollectible, either in whole or in part (by reason of the insolvency of the party or parties liable, or for other cause), and that any property pledged or mortgaged as security cannot satisfy the obligation.

Who Must Do the Fair Market Value Appraisal?

To determine The Fair Market Value of a private party promissory note or mortgage note, an appraisal or valuation report must be prepared by a qualified, experienced appraiser.

Qualified Appraiser Defined – A qualified appraiser has earned an appraisal designation from a recognized professional organization or has otherwise met minimum education and experience requirements under IRS regs; regularly appraises for compensation; and meets any other such requirements prescribed by IRS (Code Sec. 170(f)(11)(E)(ii)). An individual won’t be considered a qualified appraiser for any appraisal unless he demonstrates verifiable education and experience in valuing the type of property subject to the appraisal, and hasn’t been prohibited from practicing before IRS at any time during the three-year period ending on the date of the appraisal (Code Sec. 170(f)(11)(E) (iii)).

What Factors Affect Fair Market Value?

• Collateral security–lack of collateral security, no collateral, or too little collateral

• Credit score information, financial and employment information for the borrower

• Credit scores, financial information and employment information is negative

• Lender’s Title Insurance Policy–not having it

• Written payment history schedule-not having it

• Poor payment history

• Interest rate too low

• Duration of the loan too long

• Payment amount too small or too infrequent

Individually and collectively these impairments and deficiencies reduce the Fair Market Value of a promissory note. An arms-length, third-party buyer will discount the purchase price of the note significantly to compensate for any and all of these deficiencies.

Summary

– Depending upon the individual facts, the discounts applied can range from 5% to 90%.

– Any discount may contribute to a tax saving and a fee saving.

– Always consult and work with an experienced tax expert and promissory note expert.

Promissory Note Valuation-Illiquidity Discounts

The Price of Illiquidity

Lack of transaction data lowers the value of an asset. Fair Market Value of a financial asset (a private promissory note is an example) is based on observing and comparing actual transactions under current marketplace conditions. But, if no transaction data exists that demonstrates the prices and the discounts being applied by the market, assumptions must be made to arrive at Fair Market Value. The lack of actual market transaction data, and the lack of an active market to transact in, automatically lowers the value of an asset. Discounts must be applied that represent the additional risks and costs related to illiquid assets.

Illiquid assets (difficult to sell assets) are worth less than those that can be rapidly and cheaply converted to cash, at a reasonable price. Investors are willing to pay a premium for assets that are more liquid. For illiquid assets like promissory notes, where a market may not exist, the appraiser must develop a Fair Market Value approach based upon a hypothetical market, which incorporates the assumptions potential market participants would use in purchasing the asset. These assumptions invariably include discounting the note to reflect its illiquidity.

Discounts

Illiquidity is a major negative factor for appraisers who value assets that do not have readily available market quotations. The absence of liquidity lowers the value of the asset by the illiquidity discount. All other things being equal, the more illiquid the asset is, the less value it has. Determining the appropriate discount and applying it in the valuation of illiquid financial assets is now, and has always been a challenge.

When an illiquid asset is valued, its level of illiquidity is related to other financial assets of similar nature, and to the economic conditions, as of the appraisal date. A discount amount is derived from this analysis based on mature, reasonable and experienced judgment.

Valuing and Appraising Promissory Note Illiquidity

There is no exact formula or rule-of-thumb for arriving at the Fair Market Value of a private promissory note. It is a “Judgment process” that requires a sound method and an experienced expert to arrive at a reasonable, defensible conclusion of value. It should be based on what investors are willing to pay for similar assets having similar risk characteristics as of the valuation date.

Any method selected to be used will have its shortcomings. Like many other specialty skills, estimating an appropriate discount for an illiquid note requires judgment. The court cases have recognized the value of an appraiser’s judgment over mechanical applications of rules of thumb and theoretical formulas.

What is Fair Market Value?

Fair Market Value is the price at which the note would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. It is the price received for selling an asset in an orderly transaction between anonymous market participants, not adjusted for transaction costs.

Factors Considered

Factors considered relating to the borrower and to the promissory note transaction are: financial statements, credit ratings, employment and earnings, payment history, amount and nature of collateral security, repayment terms and conditions of the loan, economic outlook, amount of control of the asset, restrictions on transferability, and costs associated with collecting if default occurs, plus additional items dictated by the specific asset.

All of these factors must be considered when selecting the appropriate discount for lack of liquidity. These factors are used as a guide, but the judgment of the appraiser remains the key.

Conclusions

Experienced judgment, specialized training and education, and common sense are all keys to arriving at a reasonable and defendable discount for illiquidity.