Fair market value (FMV): What is it and how to defend it

So what is fair market value (FMV)? According to the IRS, it's the price that property would sell for on the open market. This is the price that would be agreed on between a willing buyer and a willing seller. Neither would be required to act, and both would have reasonable knowledge of the relevant facts.

This is the standard the IRS uses to determine if an item sold or donated by you is valued correctly for income tax purposes. It is also a definition that is so broad that it is wide open to interpretation.

Understand when FMV is used

Fair market value is used whenever an item is bought, sold or donated and has tax consequences. The most common examples are:

* Buying or selling your home, other real estate, personal property or business property

* Establishing values of other business assets like inventory

* Valuing charitable donations of personal goods and property like automobiles

* Valuing bartering of services, business ownership transfers or assets in an estate of a deceased taxpayer

Know how to defend your FMV determination

If the IRS decides your FMV opinion is wrong, you are not only subject to more tax, but also penalties. Here are a few tips to help defend your FMV in case of an audit.

Properly document donations. Fair market value of non-cash charitable donations is an area that can easily be challenged by the IRS. Ensure your donated items are in good or better condition. Properly document the items donated and keep copies of published valuations from charities like the Salvation Army. Don't forget to ask for a receipt confirming your donations.

Get an appraisal. If you sell a major asset such as a small business, collections, art or capital asset, make sure you get an independent appraisal of the property first. While still open to interpretation by the IRS, this appraisal can be a solid basis for defending any differences between your valuation and the IRS.

Keep pricing proof for similar items and transactions. This is especially important if you barter goods and services. If you have a copy of an advertisement for a similar item to the one you sold, it can readily support your FMV claim.

Take photos and keep detailed records. The condition of an item is often a key consideration in establishing FMV. It is fair to assume an item has wear and tear when you sell or donate it. Visual documentation can be used to support your claimed amount. And keeping copies of invoices for major purchases is also a good idea.

With proper planning, establishing FMV of an item can be done in a reasonably defendable way if ever challenged.

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