Illiquid assets: donation and appraisal of promissory notes, a fiscally efficient plan
Get a tax deduction for donating donations of non-cash asset promissory notes
Illiquid financial asset
A financial asset that is difficult to sell because of 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, 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 they are difficult to price and sell.
The absence of liquidity reduces the value of the asset by the amount of an illiquidity discount. All other things being equal, the more illiquid 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 a tax-efficient and cost-effective 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 level as well.
Key Considerations About Donated Property
Donors must obtain a qualified independent evaluation before making a contribution. The IRS requires a donor to obtain a qualified appraisal for illiquid assets no earlier than 60 days before the donation date and no later than the expiration date. It is the responsibility of the Donor to obtain the appraisals, file the corresponding tax returns, and defend itself against any challenge to claims for tax benefits.
The tax consequences are important. 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 over deductions for six years. But the devil is in the details; It must be done correctly, according to IRS rules.
Establishing the “fair market value” for a promissory note
The “fair market value” is the price at which the property would change hands between a willing buyer and a willing seller, with neither of them being forced to buy or sell and both having a reasonable knowledge of the relevant facts. For trading liquid assets 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 low liquidity and lack of business 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 “trial process”. It requires a solid understanding of the promissory 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 / return profile. The benchmark rates of return used for comparison should be closely related to the current and / or historical returns of comparable assets. This means that valuation experts must have experience and understanding in various disciplines, including trading, quantitative research, credit analysis, and structured finance.
Donating an illiquid asset, such as a private promissory note, can be a fiscally 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.