Illiquid Assets – Donating and Appraising Promissory Notes, A Tax-Efficient Plan
Get a Tax Deduction for Donating a Non-Cash Asset-Promissory Note Donations
Illiquid Financial Asset
A financial asset that is difficult to sell because of its expense, lack of interested buyers, or some other reason is called “illiquid”. Examples of illiquid assets include Restricted and private stock, LLC and limited partnership interests, deeds and mortgages, promissory 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 absence of liquidity lowers the value of the asset by the amount of an illiquidity discount. All other things being equal, the more illiquid the asset is, 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 may be an effective and tax-efficient method of giving. The donor is entitled to claim a tax deduction of the fair market value– not just the original cost basis. This tax treatment offers significant benefits at the federal level and frequently at the state and local levels as well.
Donated Property-Key Considerations
Donors should obtain a qualified independent appraisal before contributing. 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 the appraisals, file appropriate tax returns, and defend against any challenges to claims of tax benefits.
Tax consequences are important. The donor should consult a professional tax advisor. The tax benefits of gifting the unusual (illiquid) may be substantial – and could include deducting the full fair market value of the assets, avoiding all capital gains tax, and the ability to carry forward deductions for six years. But, the devil is in the details; it must be done correctly, according to IRS rules.
Establishing “Fair Market Value” for a Promissory Note
“Fair Market Value” is 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. For liquid assets trading in active markets, valuations must reflect observable price quotes, recent transactions, or primary issue prices for identical assets.
For illiquid assets, if actual prices cannot be established due to poor 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 values from sales in a hypothetical, 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 sound understanding of the promissory note and its potential buyers.
Appraising the asset requires deciding the appropriate yield rate of return applicable to the note being appraised. This decision is based on its individual, unique, risk/return profile. Benchmark yield rates used for comparison should have a close relationship to current and/or historical yields for comparable assets. This means that valuation experts must have expertise and understanding across several disciplines, including trading, quantitative research, credit analysis, and structured finance.
Conclusion
Donating an illiquid asset, such as a private promissory 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.
