Fair Market Value for Alternative Investments
First, let’s start with the legal definition of “fair market value”:
The fair market value (FMV) is the value of a property, as determined by the marketplace (or other objective purchasing agents) as opposed to as determined by a subjective individual or agent.
Why Do I Need to Care About FMV?
Most important is to remember that FMVs can affect your tax liability. In some cases, depending on the asset type held in your self-directed IRA account, for example, the valuation may be provided by the investment issuer. In other cases, it will be YOUR responsibility to obtain this valuation, putting the burden of responsibility squarely on your shoulders.
By Jan 31…
By January 31 of the current year, your self-directed IRA custodian should provide a Fair Market Value (FMV) for your IRA investments as of December 31 of the previous year. This FMV will usually be provided to you as part of a year-end account statement. In some cases, including “hard-to-value” investments such as real estate or other assets that do not have an easily determined Fair Market Value, you may need to provide the FMV.
Alternative Investing in Review
Alternative assets include investments such as residential and commercial real estate, private equity, private debt, cryptocurrency, commodities (such as gold), hedge funds, energy, crowdfunding (such as peer-to-peer lending, structured settlements and precious metals.
A self-directed IRA is required for investing IRA funds in an alternative investment, a clear advantage of self-directed IRAs is the ability to invest IRA money more broadly in assets not tied to the stock market, or to invest in various kinds of tangible assets, such as real estate, or intangible assets, like cryptocurrency (unless used as part of a transaction to buy something tangible).
Note to Self: Get a Valuation on Time
Part of the personal “time and energy” costs of investing in alternative investments is the fact that as an investor in these types of investments, you may be in charge of making sure an accurate valuation (or good faith estimate) of your investment is provided to your IRA custodian.
EXAMPLE: Strata Trust Waco Texas
For example, Strata Trust, an IRA custodian based in Waco, Texas, states in its policy that it requires an FMV or a Good Faith Estimate for “hard-to-value” investments once each year before April. Strata Trust Company Waco TX offers asset custody services for alternative opportunities beyond traditional investments across real estate, gold and precious metals, crowdfunding, private equity, private debt, public investments, and structured settlements.
Alternative Investments Are Here to Stay
According to their website, Strata Trust states that “As 2020 unfolded, several major drivers prompted investors to begin exploring self-directed IRAs (SDIRAs) for their investment strategy and we saw four key investment trends emerge that continue to support the demand for alternative assets in years to come.”
Take a look at their trend projections for self-directed IRA trends continuing to drive 2025 alternative asset growth projections. In other words, you need to stay abreast of the current drivers for SDIRAs and future drivers. You need to understand not only how alternative investments fit into your portfolio, but how to manage them, or at least, how to find the right firms to manage them for you.
Should You Use a Third-Party for the FMV?
Whether or not you use a third-party to determine the FMV or GFE, you will ultimately be responsible for obtaining it for the value of your alternative investment and providing it to your IRA custodian. (On another note, while you are at it, remember to make a note to yourself to take advantage of the once-in-a-lifetime tax-free IRA to HSA transfer.)
The reason for the April date is that your IRA custodian is required to report year-end values of your IRA to the IRS via Form 5498 (IRA Contribution Information) in May of each year. The value of certain types of “hard-to-value investments” individually must be reported.
What is a Good Faith Estimate?
In the mortgage loan world, a Good Faith Estimate (GFE) was a standard form that was given to you by a mortgage lender (or broker) prior to 2015. This form, as well as the Loan Estimate form (which replaced the GFE form in October of 2015), is used to standardize the process of comparing mortgage or reverse mortgage loan offers between lenders or brokers. An itemization of fees and costs listed individually for each loan offer is provided as part of this estimate. (A GFE is also used in the healthcare industry as a result of the No Surprises Act.)
What Are “Hard-to-Value” Assets?
According to the IRS and Form 5498 (IRA Contribution Information), ownership interests in these assets are considered “hard-to-value”:
- Real estate
- A corporation, limited liability company, partnership, or trust not traded on an established securities market
- Short- and/or long-term debt not traded on an established securities market
- Option contracts or similar products not traded on an established options exchange
- Assets that do not have a readily available fair market value
IRS Revenue Ruling 59-60 gives you a suggested approach, method, and factors to consider when determining the market value of “hard-to-value.”
EXAMPLE: How do you evaluate the FMV for a private company?
How to Determine Fair Market Value of Private Company Stock METHOD #1
- Calculate the overall worth of the assets.
- Calculate the current worth of the future cash flows.
- Calculate the amount of a common stock’s worth in similar organizations.
- Calculate your company’s equity in similar industries or businesses.
How to Determine Fair Market Value of Private Company Stock METHOD #2
The formula is generally quite simple: the business value = assets minus liabilities.
These Moves Might Also Require a Valuation
If there has been a major change in the asset value of your alternative investment, you may be required to provide additional valuations. You may also need to provide an evaluation prior to the following events, as well:
- a distribution of an asset in-kind
- a conversion or recharacterization of an asset
- an asset is transferred in an account to beneficiaries
What Does In Kind Mean?
The term “in kind (also referred to as in-kind)” refers to goods, services, and any transactions that do not involve money or are not measured in money.
What Does it Mean to Transfer or Distribute Assets in Kind?
When you transfer or distribute “in kind,” you simply move your investments “as is.” According to Investopedia: “Distributions-in-kind are payments made in an alternative format, such as property or stock, instead of cash. Companies and organizations use distributions-in-kind to minimize their tax liabilities and circumvent capital gains tax accruing from an increase in the asset’s value.”
According to the IRS…
OR, as the United States Internal Revenue Code defines it, a distribution in kind (also referred to as an “in-kind” distribution) is a concept under the US Internal Revenue Code that refers to distributions from a company in the form of property other than cash, for example, securities and/or assets.
Why You Should Care: Tax Consequences of FMVs
The most important thing to remember is that FMVs affect your tax liability. In some cases, depending on the asset type held in your IRA account, the valuation may be provided by the investment issuer. In other cases, it will be your responsibility to obtain a valuation. If it is your responsibility, you may need to hire an independent third party such as a certified real estate appraiser or licensed real estate broker in the case of a real estate investment, or a CPA for other types of assets. Supporting documentation for the valuation may also be required, with a notarized signature from the third party.
The IRS is Ramping Up for Audits
The IRS is ramping up on hiring auditors, according to USA Today. One of the main reasons the IRS audits a small percentage of tax returns is the agency didn’t have the staff to do more in the past. But that could be changing, and you need to be aware of this, especially if you or your spouse is a high earner. As of January 2022, more than 2,500 new auditors will be (or have already been) hired, and it stands to reason that increased audit activity is surely coming.
How Long Does an Audit Take?
How much time does the IRS take to complete an audit? The answer to this all too familiar question is usually: it depends, but as the IRS ramps up its hiring, the audit period itself should generally take no more than five to six months and maybe even shorter. With proper documentation, they can be resolved faster. So it makes sense to gather these documents now.
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Disclaimer: All the information provided above and on this site is for informational purposes only and should not be considered as professional investment, legal, or tax advice. You should conduct your own research or consult with a professional financial advisor when investing.