Note Value Using Applicable Federal Interest Rates (AFR)

Posted on 26 September 2012   |   By Lawrence Tepper

Promissory Note Valuation for Estate, Gift & Bankruptcy

Definition of Fair Market Value
For gift and estate tax purposes fair market value is defined as the price at which the property 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.

Treasury Regulations Section 25.2512-4: The fair market value of notes, secured or unsecured, is presumed to be the amount of unpaid principal, plus accrued interest to the date of the gift, unless the donor establishes a lower value. Unless returned at face value, plus accrued interest, it must be shown by satisfactory evidence that the note is worth less than the unpaid amount (because of the interest rate, or date of maturity, or other cause), or that the note is uncollectible in part (by reason of the insolvency of the party or parties liable, or for other cause), and that the property pledged or mortgaged as security is insufficient to satisfy it.

Note’s Unpaid Balance Not Fair Market Value
When the Applicable Federal Rate (AFR) is used for a note, it usually devalues the note. The (AFR) is usually lower than market interest rates for a similar note; a note issued at the current AFR will not be worth its face value in the Fair Market Value context—the price that a hypothetical willing buyer would pay to a hypothetical willing seller. Since the goal of promissory note investing is income generation, the lower the interests rate the lower the market value of the note.

Real World Promissory Note Valuation Factors
An actual note buyer determines the risks associated with a promissory note investment as the starting point for making a buying decision. The higher the risk or uncertainty associated with the future payments on the note, the higher the required yield rate. This causes discounts to be applied. If the interest rate paid on alternative investments is higher than the note pays, a larger discount will be demanded by the note buyer to compensate. Discounts are frequently applied to notes using AFR because comparable notes paying market rates offer a higher yield. The discounts adjust for the yield disparity.

Factors Causing Discounts
Numerous risk factors are considered by note buyers. In fact, a competent note buyer can be considered a “risk identifier and risk quantifier”. Listed below are the key risk factors evaluated.

Note Terms, Conditions and Loan Documents: interest rate, maturity date, prepayment penalties, late fees, default penalties, financial coverage ratios and due on sale clause

Collateral Security: type and amount of collateral security—deed of trust, mortgage, UCC filing statement, pledge agreement, personal guarantee

Collateral Security: value, liquidity and marketability as determined by a third-party appraiser

Borrower: financial statements, tax returns, credit score

Borrower: payment history

Borrower: cash flow to satisfy installment and balloon payments

Marketability: of the promissory note and loan package

The value of a promissory note using the Applicable Federal Interest Rates (AFR) is usually must be discounted to make its yield comparable to a similar promissory note having a higher market interest rate.

Disclaimer: Information is not advice. This article is for your information; it is not financial, legal or tax advice. The information and opinions provided are based on my own research and experience. Always consult a tax expert and valuation expert for your advice

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