Illiquid Assets – Donation and Appraisal of Promissory Notes, A Tax Efficiency Plan
Get a tax deduction for donating a non-cash asset: IOU gifts
Illiquid financial asset
A financial asset that is difficult to sell due to its cost, lack of interested buyers, or some other reason is called “illiquid”. Examples of illiquid assets include: Restricted and private shares, LLCs and limited partnership interests, deeds and mortgages, notes, mineral rights including oil and gas partnerships, royalties, existing trusts, insurance policies and real estate.
Illiquid assets have value, and in many cases very high value, but are difficult to price and sell.
The lack of liquidity reduces the value of the asset by the amount of a discount for lack of liquidity. All other things being equal, the less liquid the asset, the less value it has. Measuring this discount and applying it in appraisal valuations of illiquid assets has always been a challenge.
A tax-efficient way to make a charitable difference
Many charities welcome contributions of illiquid assets. For the donor it can be an effective and profitable method of donation. The donor is entitled to claim a fair market value tax deduction, not just the original cost basis. This tax treatment offers significant benefits at the federal level and often at the state and local levels as well.
Key Donated Property Considerations
Donors must obtain a qualified independent appraisal before making a contribution. The IRS requires a donor to obtain a qualified appraisal for illiquid assets no earlier than 60 days before the date of the gift and no later than the due date. It is the donor’s responsibility to obtain appraisals, file appropriate tax returns, and defend against any disputed claims for tax benefits.
The tax consequences are significant. The donor should consult a professional tax advisor. The tax benefits of gifting the unusual (illiquid) can be substantial, and could include deducting the full fair market value of assets, avoiding all capital gains taxes, and the ability to carry deductions over six years. But the devil is in the details; it must be done correctly, according to IRS rules.
Establishing “fair market value” for a note
“Fair market value” is the price at which the property would change hands between a willing buyer and a willing seller, under no obligation to buy or sell and both with reasonable knowledge of the relevant facts. For liquid assets that are traded in active markets, valuations should reflect observable price quotes, recent transactions, or primary issue prices for identical assets.
For illiquid assets, if actual prices cannot be established due to lack of liquidity and lack of trading activity, an alternative approach is needed. An appraisal from a qualified appraiser should reflect “fair market values” that approximate actual sales values in a hypothetical and orderly transaction.
The appraiser must use experienced judgment; that is the key to valuing illiquid assets. There is no mathematical formula, rule-of-thumb calculation, or textbook process; it is a “Judgment Process”. It requires a solid understanding of the promissory note and its potential buyers.
Asset valuation requires deciding on the appropriate rate of return applicable to the note being valued. This decision is based on your individual and unique risk/return profile. Benchmark rates of return used for comparison must bear a close relationship to current and/or historical returns on comparable assets. This means that valuation experts must have experience and understanding in various disciplines, including business operations, quantitative research, credit analysis, and structured finance.
conclusion
Gifting an illiquid asset, such as a private note, can be a tax-efficient plan.
The tax deductions for donating a non-cash asset, such as a promissory note, can be very valuable. The devil is in the details; it must be done correctly, according to IRS rules.
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