Illiquid Assets – Donation and Appraisal of Promissory Notes, A Fiscal Efficiency Plan
Get a Tax Deduction for Donating a Non-Cash Asset: Gifts of Notes
illiquid financial asset
A financial asset that is difficult to sell due to cost, lack of interested buyers, or some other reason is called “illiquid.” Examples of illiquid assets include: Restricted and private stocks, LLC 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 they are difficult to price and sell.
The lack of liquidity reduces the value of the asset in the amount of a discount for lack of liquidity. Other things being equal, the less liquid the asset is, the less value it has. Measuring this discount and applying it in illiquid asset appraisal estimates has always been a challenge.
A tax efficient way to make a charitable difference
Many charities welcome contributions from illiquid assets. For the donor it can be an effective and profitable donation method. The donor is entitled to claim a tax deduction from the fair market value, 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 illiquid asset appraisal no sooner than 60 days before the gift date and no later than the due date. It is the donor’s responsibility to obtain the appraisals, file the appropriate tax returns, and defend against any challenge to claims for tax benefits.
The tax consequences are significant. The donor should consult a professional tax advisor. The tax benefits of giving away the unusual (illiquid) can be substantial, and could include deduction of full fair market value of assets, avoidance of all capital gains taxes, and the ability to carry over 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 Note
“Fair market value” is the price at which the property would change hands between a willing buyer and a willing seller, with no obligation to buy or sell and both with reasonable knowledge of the relevant facts. For liquid assets 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 illiquidity and lack of trading activity, an alternative approach is needed. An appraisal from a qualified appraiser must reflect “fair market values” that approximate the 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 note and its potential buyers.
Appraisal of the asset requires deciding the appropriate rate of return applicable to the note being appraised. This decision is based on your individual and unique risk/reward profile. Benchmark rates of return used for comparison should be closely related to current and/or historical returns on comparable assets. This means that valuation experts must have experience and understanding in various 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.
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.