The Benefits of Discounting Your Promissory Note Lessons I've Learned Promissory notes can be excellent investments, if their benefits and detriments are understood, and if the investor values them properly.
During my note appraisal career (over 35 years) I have found that most note investors do not fully understand that promissory notes usually have a "Fair Market Value" that is less than their original cost, and less than their present unpaid balance.
The basic problem is investors confuse their "cost" or their "investment" with "Fair Market Value".
These are two separate value concepts and value amounts.
Because of misunderstanding which valuation to use, investors are falling into costly IRS taxation pitfalls; they are paying millions of dollars in unnecessary taxes.
Promissory note holders are victims of valuation mistakes.
Fair Market Value vs.
Cost Value, Book Value, Net Asset Value What is the difference in valuation between the appraised valuation of a promissory note at "Fair Market Value" compared to its cost, or book value, or net asset value? The answer: Usually it is a very large difference.
That large difference impacts the income tax paid upon sale of the note; it impacts the fees paid to an IRA administrator or trustee; it impacts the taxes paid on mandatory distribution from an IRA account; it impacts the taxes paid on voluntary withdrawals from an IRA account.
The Internal Revenue Service (IRS) has created a specific legal definition for Fair Market Value: "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 sell and both having reasonable knowledge of the relevant facts.
" Treasury Regulations Section 25.
2512-1, 20.
2031-1(b) and Revenue Ruling 59-60, 1959-1 C.
B.
237 This is the controlling definition to be used when appraising and valuing promissory notes.
Why is a Discounted (Reduced) Appraised Value a Good Thing? It reduces the value of the note; it reduces the taxes paid; and it reduces fees paid to administrators and trustees.
Thus a low FMV is an attractive feature when a taxable event occurs! When the promissory note holder engages in some taxable event, Fair Market Value is the required value for all tax reporting instances.
Fair Market Value is the value required for all IRA reporting purposes including Forms 5498 and 1099-R, and the value used in calculating required minimum distributions (RMDs).
What Causes the Discounted Valuation? Promissory notes are not bought and sold (traded) on a public or private exchange.
They are bought and sold individually, in private transactions.
There is no published price for these individual transactions.
Stocks, bonds, gold, silver, oil and gas all have public markets and the buy/sell prices are publicly published.
Their values are clearly reported daily.
Because there is no public market for promissory notes, and because the transactions are done in private, valuation must be determined via an appraisal.
The appraiser is the key player in determining the Fair Market Value of notes.
The appraiser must be experienced, knowledgeable, and independent (no bias) from the parties doing the transaction.
The appraiser applies adjustment (discounts) when evaluating these non-publicly traded notes.
Promissory notes are generally subject to one or more discounts when determining the appropriate FMV due to lack of marketability, lack of liquidity, and other specified negative factors.
These factors must be spelled out by the appraiser in the appraisal report.
Words of Wisdom--Value Price is what you pay.
Value is what you get.
Warren Buffett I conceive that the great part of the miseries of mankind is brought upon them by false estimates they have made of the value of things.
Benjamin Franklin We get paid for bringing value to the market place.
Jim Rohn
During my note appraisal career (over 35 years) I have found that most note investors do not fully understand that promissory notes usually have a "Fair Market Value" that is less than their original cost, and less than their present unpaid balance.
The basic problem is investors confuse their "cost" or their "investment" with "Fair Market Value".
These are two separate value concepts and value amounts.
Because of misunderstanding which valuation to use, investors are falling into costly IRS taxation pitfalls; they are paying millions of dollars in unnecessary taxes.
Promissory note holders are victims of valuation mistakes.
Fair Market Value vs.
Cost Value, Book Value, Net Asset Value What is the difference in valuation between the appraised valuation of a promissory note at "Fair Market Value" compared to its cost, or book value, or net asset value? The answer: Usually it is a very large difference.
That large difference impacts the income tax paid upon sale of the note; it impacts the fees paid to an IRA administrator or trustee; it impacts the taxes paid on mandatory distribution from an IRA account; it impacts the taxes paid on voluntary withdrawals from an IRA account.
The Internal Revenue Service (IRS) has created a specific legal definition for Fair Market Value: "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 sell and both having reasonable knowledge of the relevant facts.
" Treasury Regulations Section 25.
2512-1, 20.
2031-1(b) and Revenue Ruling 59-60, 1959-1 C.
B.
237 This is the controlling definition to be used when appraising and valuing promissory notes.
Why is a Discounted (Reduced) Appraised Value a Good Thing? It reduces the value of the note; it reduces the taxes paid; and it reduces fees paid to administrators and trustees.
Thus a low FMV is an attractive feature when a taxable event occurs! When the promissory note holder engages in some taxable event, Fair Market Value is the required value for all tax reporting instances.
Fair Market Value is the value required for all IRA reporting purposes including Forms 5498 and 1099-R, and the value used in calculating required minimum distributions (RMDs).
What Causes the Discounted Valuation? Promissory notes are not bought and sold (traded) on a public or private exchange.
They are bought and sold individually, in private transactions.
There is no published price for these individual transactions.
Stocks, bonds, gold, silver, oil and gas all have public markets and the buy/sell prices are publicly published.
Their values are clearly reported daily.
Because there is no public market for promissory notes, and because the transactions are done in private, valuation must be determined via an appraisal.
The appraiser is the key player in determining the Fair Market Value of notes.
The appraiser must be experienced, knowledgeable, and independent (no bias) from the parties doing the transaction.
The appraiser applies adjustment (discounts) when evaluating these non-publicly traded notes.
Promissory notes are generally subject to one or more discounts when determining the appropriate FMV due to lack of marketability, lack of liquidity, and other specified negative factors.
These factors must be spelled out by the appraiser in the appraisal report.
Words of Wisdom--Value Price is what you pay.
Value is what you get.
Warren Buffett I conceive that the great part of the miseries of mankind is brought upon them by false estimates they have made of the value of things.
Benjamin Franklin We get paid for bringing value to the market place.
Jim Rohn
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