The concept of the fair market value of a property is very important to the buyer as well as the seller for a variety of reasons. This is especially significant under the Income Tax laws. If the transaction price as stated in the sale agreement is lower than the fair market value of the property, then both the seller and the buyer will be impacted by different provisions of the Income Tax laws.
Why Ascertaining Fair Market Value is Important
When a profit is made on the sale of a property, it is taxed under the Income Tax laws. The profit is generally arrived at by deducting the cost of acquisition and cost of improvement, from the sale consideration amount. If the property is held for more than two years, you are allowed to avail of the benefit of indexation, on the costs. For properties that are acquired prior to April 1, 2001, you have the option to take the fair market value of the property as of April 1, 2001, in place of the cost of acquisition. So, the concept of fair market value is important for finding out the cost of acquisition, for capital gains purposes.
In the case where the sale price of a property is lower than the property registration valuation, the registration valuation is taken as the fair market value. This is considered based on the stamp duty paid during the property registration.
The difference between the agreement value and the fair market value, if it is more than 5%, is taxed in the hands of the buyer, as well as the seller, under different provisions of the income tax laws. Hence, it is important to arrive at the fair market value, before executing the agreement, to avoid the payment on such difference.
How to Ascertain Fair Market Value of a Property
According to the Income-tax Act, 1961, fair market value shall be the higher of the two considerations as follows.
The cost of acquisition of the property, or, the price that the property shall ordinarily sell for if sold in the open market.
However, there is no fixed formula to calculate the fair market value of a property. One technique most widely used is to look at the sale instances of similar properties in the same neighbourhood.
For the purposes of calculating capital gains on properties bought before 2001, the base year of the cost inflation index, you have to know the fair market value of a property in 2001.
However, it is not as easy to find out the fair market value of a property as it seems, because the real estate market is a very heterogeneous market, where the rates of properties can vary very much, even within the same area. It becomes more difficult, in case you have to find out the fair market value for properties as old as 2021.
Another option to calculate the fair market value of properties is to look at the circle rates or ready reckoner rates as they are called.
The Importance of Circle Rates
Circle rates are the floor rates below which no property can be sold and registered in an area. Circle rates are notified and revised regularly by local authorities to keep them as close to the prevailing market rates as possible. These rates vary in different localities.
You are required to pay stamp duty based on the circle rate or the actual transaction price, whichever is higher.
So, you can find out the fair market value from the stamp duty ready reckoner of 2001, if the property was acquired before April 1, 2019. If you had received the property as a gift, or as an inheritance, or had constructed it during any year after April 1, 2001, then, you can take the ready reckoner value to find out the fair market value of the property.
How about a Valuation Report?
Most experts believe that sellers should take the help of a registered property valuer, rather than arbitrarily deciding the fair market value of the property. Assumptions of any type for consideration of value shall not be entertained by the income tax department. In case of any enquiry, the department will give higher weightage to the value stated in the valuation report from a registered valuer.
Government-approved valuers follow a standard process for the valuation and provide a detailed report, in addition to other parameters. To ascertain the fair market value of a property, a valuer also considers the area and dimensions of the property, whether it is freehold or leasehold, whether there is any restrictive covenant in regard to the use of such property, insurance of the land and property, whether the land falls under any development plan of the government.
The Income Tax Department generally accepts the valuation report of the registered valuer. Out of the methods discussed above, the method of obtaining the valuation report from a registered valuer is preferable, as this makes the case stronger and convincing.