Whether you currently own property or are trying to buy your first home, it's important to understand the role fair market value (FMV) plays in owning real estate.
Let's take a look at what fair market value is, how it's calculated, and what it's used for.
What is fair market value?
Fair market value is the determined worth or value of an asset based on its likely sales price to a third-party purchaser. In essence, it's the reasonable amount a buyer would pay to purchase it at a given moment in time.
In real estate, FMV isn't solely derived from comparable properties like a comparative market analysis (CMA) or broker's price opinion (BPO). It also takes into account what the free market will pay for the property.
When fair market value is used in real estate
Fair market value is most commonly used in legal settings:
- Taxation, including local or federal government bodies
- Eminent domain
- Insurance claims
The value of a property is ultimately used for many purposes. For example, the fair market value of a property can be used in bankruptcy to determine whether a mortgage is underwater, making it possible for a second mortgage to be stripped.
If a property is destroyed in a catastrophic event such as a fire, the fair market value will play a role in determining the payout from the insurance claim. However, the most common use for fair market value is for taxation purposes. This can include the taxation rate for property taxes as set by local municipalities or determine the potential tax rate an heir may be charged based on the value of assets inherited.
How fair market value is calculated
Fair market value can be calculated in several ways. In formal cases, FMV is determined through a formal third-party appraisal. This includes situations like when a property is:
- inherited by an estate,
- assessed for tax purposes, or
- going through an insurance claim.
However, there are informal situations where you might want a fair market value, too. These situations include contesting a tax appraisal, divorce, and bankruptcy. Or just for your general knowledge.
Fair market value can be determined by:
- A Realtor with a comparative market analysis,
- a broker with a broker's price opinion, or
- on your own, using an automated valuation model (AVM).
An automated valuation model is a program that uses algorithms to sort through an online database of comparable properties that are for sale or have been sold recently. Zillow.com's Zestimates and Realtor.com's estimated values come from their internal AVM systems.
Although AVMs can give you a general idea of your property's potential value, it's important to note that there are many inconsistencies and inaccuracies. The quality of the neighborhood, including any unfavorable features, the interior or exterior condition of the property, and the character or appearance of the property aren't taken into account. Most free AVMs wouldn't hold up as a fair market valuation. However, there are paid AVMs you can use that provide a more accurate FMV. CoreLogic’s AVM model is an example.
Fair market value is used frequently in real estate and goes beyond determining the value of a property when it's time to buy or sell. If you find yourself in one of the situations above, the representative handling it will probably dictate which method of determining the FMV is acceptable. However, it can be helpful to have resources that you can check on your own.