The most common type of real estate appraisal assignment is the formulation of an opinion of market value. The following information describes each step of the appraisal process.
Identification of the Assignment Parameters
The appraiser will identify the client, intended users and use as well as the purpose. A crucial element to any appraisal is the effective date of valuation as this will determine the data to be selected and analyzed to formulate the opinion of value.
Scope of Work Determination
The appraiser will determine the appropriate scope of work relating to the amount and type of research and analyses to be applied.
Data Collection and Property Description
The appraiser collects data relating to the general market area, specific characteristics of the subject property and comparable properties in the local market.
Assessment of comparable properties provides specific data regarding sale prices, rental terms, rates of return and depreciation. This step also includes the “highest and best use” analysis in which the appraiser considers the use of the land as if vacant and the property as improved.
Application of the Approaches to Value
There are three approaches to value; cost, sales comparison and income capitalization. The appraiser formulates an opinion of property value using one or more of the approaches depending on the type of property, specified use of the appraisal and availability of data.
- Cost Approach – the value is derived by obtaining the current cost of replacing the improvements, adding estimated land value and subtracting depreciation. This approach is very useful in valuing recent improvements and properties that are not frequently sold.
• Sales Comparison Approach – used when a number of similar properties have been sold or are currently for sale in the subject property’s market. The subject property is compared to similar properties referred to as comparable sales. The sale prices of the most comparable properties indicate a range in which the value of the subject property falls.
• Income Capitalization Approach – used for income producing properties purchased as an investment. The earning potential of the property is measured as the present value of the future benefits of property ownership.
Reconciliation of Value Indications and Final Opinion of Value
The appraiser uses his or her experience, expertise and professional judgment to resolve the differences in value derived from the application of the three approaches to value.
Report of Defined Value
The report will be presented in one of three written formats: self-contained, summary or restricted-use. An oral report may be communicated when circumstances do no permit or warrant a written report.
The complex appraisal process provides a model to be followed in performing market research and data analysis as well as drawing on the appraiser’s personal expertise in applying appraisal techniques to formulate the results into an opinion of market value.
Cherie L. Veatch, Valuation Analyst
Source: Appraisal InstitutePosted on November 26 2013 by admin
If you are in the process of divorce and believe your spouse may be hiding assets, a review of your tax returns may provide some indication of those assets. Of course, the spouse who controls the preparation of the tax return does not always report income relating to hidden assets, (hence the word “hidden”). However, often spouses who are hiding assets are actually compliant in reporting the income or expenses relating to those hidden assets on their tax returns. (Perhaps, they are more scared of the IRS than their soon-to-be ex.) I have put together a brief list of items to look for on your tax returns, which may suggest the presence of hidden assets. If you believe your spouse is hiding assets from you, a forensic accountant can assist you, by using more detailed forensic accounting procedures to search for those assets.
Schedule A – Itemized Deductions
• Review real estate taxes and mortgage interest for indication of undisclosed property.
• Look for investment interest expense which may suggest hidden investments.
• Note safe deposit box expenses which may indicate an undisclosed safe deposit box and hidden assets.
Schedule B - Interest and Ordinary Dividends
• Review all names of payers to determine if there are assets not previously disclosed.
• Note any foreign bank accounts or foreign income which may suggest hidden assets in offshore accounts or a Foreign Tax Protection Trust.
Schedule D – Capital Gains and Losses
• Review all reported investment transactions, as you may discover an undisclosed liquidation of assets.
• Look for matching assets to confirm dividends that should have been received and or/reported.
• Note any capital loss carry forwards, as this is a community asset.
Schedule E – Supplemental Income and loss (From rental real estate, royalties, partnerships, S Corporations, estates, trusts, REMIC etc)
• Review all S-corporations and partnerships reporting pass-through income or loss to determine that all ownership interests have been disclosed.
• Review all rental properties listed.
• Review any reported royalties and determine if the asset(s) generating royalties has been disclosed.
• Note any estate and trust income, as the spouse may be an income beneficiary to estate or trust.
Other Items to Look For:
• Retirement Distributions or Contributions;
• Gambling Winnings;
• Stock Option Transactions;
• Amounts reported as “Other Income” (Line 21);
• Overpayment of Income Taxes/Tax Refunds (Sometimes used as a method to divert overpayments into following year’s tax return after the divorce is finalized).
In 1973, Donald Cressey published the results of his research on embezzlement in Other People’s Money: A Study in the Social Psychology of Embezzlement. Mr. Cressey’s hypothesis has become known to many as the “fraud triangle.” The factors identified 40 years ago as an explanation of why someone would commit embezzlement are still relevant today in the context of many occupational frauds.
Pressure is felt by an individual either from within or from external sources. Pressure that is self-imposed may be the need to “keep up with the Joneses.” Or it may be the perceived pressure of meeting family expectations. External pressure may be financial obligations that cannot be met for numerous reasons. They could include medical bills, gambling or substance issues or living beyond ones means. Often, the individual feels the pressure of the financial burden cannot be resolved through legitimate means.
Consider the single mom working as a bookkeeper who is having trouble making ends meet and feels she is unable to provide enough for her son. An everyday occurrence for some but combined with opportunity and rationalization, a stepping stone to fraud for one particular bookkeeper.
Opportunity is the recognized ability to use their position to solve the financial burden with low risk of being caught. If an employee recognizes an opportunity to help themselves to the cookie jar with little risk of getting caught, they may consider this as a solution to their financial burden.
Let’s take that bookkeeper as an example. She is responsible for all aspects of the accounting for a small business including paying bills, making deposits, calling in payroll, etc. One week she finds herself short on cash and asks her boss for a payroll advance. He willingly complies stipulating that it should be paid off with the next payroll. The next week when she calls in the payroll she “forgets” to reduce her paycheck by the amount of the advance. Her boss doesn’t review the payroll ledgers, the bank statements or the check registers.
An employee does not want to be considered a thief so they will find a way to rationalize their actions. Often they start out taking a “loan” which is then not paid back. Or they justify their actions as having deserved it for all the time they have devoted to the business. An employee who is under financial pressure, with an opportunity available to them, who can rationalize their actions is a ticking time bomb when it comes to fraud.
Back to our bookkeeper, she was a long time employee who was in her mind grossly underpaid for all she put up with from her boss. She needed the money, he would never notice, and by golly she deserved it. So she continued to advance herself funds and still take her full payroll. Fortunately for her boss, the outside accountants questioned some entries she was making to account for her advances. But she had advanced herself four months of pay before getting caught. Her boss was lucky it didn’t go on any longer than it did.
Employers should keep the Fraud Triangle in mind when considering the risk of fraud in their organization. Be aware of Pressure, Opportunity and Rationalization when it comes to your employees in positions of trust.Posted on November 6 2013 by admin
CPAs who have been retained as testifying expert witnesses often prepare a written report, sometimes with accompanying exhibits, in support of their opinions to be expressed in the courtroom. Experienced CPAs who do this sort of thing typically include a statement of their qualifications as a part of their reports. This statement of qualifications, or curriculum vitae, might include information about recent speeches that the expert has made and any noteworthy articles they have published.
The CPA must be careful that he or she does not include comments in their referenced speeches or articles for which they could later be impeached on the witness stand. This includes not writing about any topic for which the CPA expert would be embarrassed in the courtroom if a portion of it were read by the opposing attorney to the judge or jury (e.g. an editorial-type article taking an unusual stand on a hot political issue).
I knew a CPA, who I will call Tom, who did a great deal of expert witness testifying. Tom had taken part in a panel involving a national telephone conference call with CPA business appraisers from around the country. The panel’s topic dealt with the best standard of value that should be used for valuing a business owned by a couple going through divorce. The telephone conference was recorded and a transcript was made of the two-hour presentation. Anyone who wanted one could buy a transcript copy or a CD of the entire presentation. Tom was very explicit in his remarks to the program’s telephone participants regarding certain opinions he had regarding values used for divorce business valuations. A few months later Tom was hired to be a testifying expert for “Husband” in a divorce matter involving Husband’s purchase of “Wife’s” 50% ownership interest in the family business. “Husband” owned the other 50%.
On the witness stand Tom stated that he only used a single standard of value, “fair market value,” in divorce business valuations. It just so happened that the fair market value standard put a lower value on Wife’s 50% interest – and, meant Husband was going to pay less to Wife than if the “fair value” standard were used in his valuation.
The attorney for Wife ended up obtaining a copy of the transcript of Tom’s national panel presentation where he expressly stated that he always showed values under both the standard of “fair market value” and “fair value.” He had also indicated that he left it up to the trier-of-fact to determine which value was the most fair.
During Tom’s trial testimony, Wife’s attorney produced a copy of the telephone panel presentation’s transcript and quoted from it. Tom was noticeably shaken when his own words were read aloud – that he “always” presented his divorce valuations with the two standards. He could not effectively explain why he chose only one in this current litigation matter on behalf of Husband. He had impeached himself by testifying in a glaringly different manner from what he said during the panel presentation.
The lesson here, of course, is that the testifying expert should never write or say anything that he or she would not feel comfortable repeating again at deposition or in the courtroom. This is not to say that experts’ views, because of new information that comes to their attention, cannot change from one date to another. However, if the expert now has a different perspective on an opinion previously written or spoken, the expert must be prepared to justify the “new” position in the courtroom.Posted on October 29 2013 by admin
IRS Position: Business Appraisers Should Not Apply Discounts to Undivided Interests in Excess of 20%
This blog and subsequent articles will provide valuable insight into IRS Hot Buttons related to the valuation of undivided interests (‘co-tenancy interests” or “tenants-in –common interests”) and the actions taxpayers and their professional advisers can take to support higher discounts.
WHAT IS A CO-TENANCY INTEREST?
Statutes vest each co-tenant, regardless of the size of his ownership interest, with the equal right to enjoy the entire property and share, on a pro rata basis, revenues and obligations associated with the property. For instance, if a co-tenant holds a 25% undivided interest in an office building, he theoretically is entitled to 25% of the building’s available cash flow and obligated to pay 25% of the building’s expenses such as utilities, property taxes, tenant improvements, debt service and professional fees.
Partition is a term used in the law of real property to describe an act, by a court order or otherwise, to divide real property into separate portions representing the proportionate interests of the co-tenants. Under common law, any tenant who owns an undivided concurrent interest in a property can seek such a division.
WHY WOULD THE OWNER OF AN UNDIVIDED INTEREST WANT TO PARTITION A PROPERTY?
Examples of reasons which motivate a tenant-in-common to file a petition for partition include, but are not limited to, disagreements related to financing; terms and conditions of leases; distributions; disposition of the property; and negligence.
WHAT IS VOLUNTARY AND INVOLUNTARY PARTITION?
When co-owners cannot agree to a voluntary partition, a lawsuit to compel partition can be filed to sever property interests. Unless there are exceptional circumstances, a tenant-in-common has the absolute right to seek a compulsory partition. Partition must be made even if every other owner objects to it. The motives of the party seeking partition are irrelevant, and the court that hears the lawsuit has no discretion to deny partition. Its main function is to determine the method of executing the partition. Commonly the court will order the property sold and the proceeds divided, instead of ordering a physical partition of the property.
THE IRS BELIEVES DISCOUNTS BETWEEN 15% AND 20% SHOULD BE APPLIED TO UNDIVIDED INTERESTS IN REAL PROPERTY
During the last few years, the IRS has taken the position that the business appraiser should only utilize the cost-to-partition method when valuing an undivided interest in real property rather than relying on the asset, sales comparison and/or income approaches to value. The cost-to-partition method typically indicates a discount between 15% and 20%.
Part 2 will explain the cost-to-partition approach to value and offer a simple solution to avoid the Service’s assertion related to discounts.
Determination of Income for Child Support: Consider Income Control When A Parent Holds an Interest in a Closely Held BusinessPosted on October 22 2013 by admin
When a parent has income generated from an ownership interest in a closely held corporation or partnership, it is important to determine how the earnings of the entity flow through to the parent. Both Subchapter S-Corporations and Partnerships are pass-through entities. The income or loss from operations flows through to the parent’s individual return based on the percent ownership interest the parent has in the entity. However, the income or loss does not reflect the cash distributed or paid to the parent. The annual “distributions” or “draws” to an owner may be less or more than the owner’s share of income from the company.
Forensic accountants will consider whether the appropriate amount of income for child support is the pass-through income from the entity, or the distributions paid to the parent. In addition, the forensic accountant may determine an appropriate compensation for the parent, based on his/her position, skills and responsibilities in the company. In establishing income, an important aspect experts keep in mind is the degree of control that the parent has in determining his/her compensation and distributions. The understanding of income control is integral to the income determination to ensure that parents do not manipulate earnings or distributions in order to shield income from child support.
For example, assume that Sarah is the sole owner of an S-Corporation. Sarah can set her wage at $24,000 per year or $60,000 per year. Sarah will also be in control of the distributions that she receives from the company. Therefore, she has substantial control over how much income may be presented for the determination of child support. A forensic accountant is aware of this and will ensure that Sarah does not improperly state income for child support. The forensic accountant may adjust wages to a reasonable market wage, as well as make other adjustments to income. In this case, the forensic accountant will likely use the adjusted income from operations, rather than distributions in establishing income, since the amount of distributions can be manipulated by Sarah.
However, if a parent has no control over the distribution of earnings, the possibility of earnings manipulation is reduced. Therefore, as the degree of control decreases, the forensic accountant may consider using distributions to the parent as income for support purposes rather than the parent’s share of operating income. The forensic accountant also may not make adjustments to wages and other expenses of the company that the parent cannot control. Consider the case of five brothers who own a very profitable restaurant. Max (Husband) owns a 20% interest in the S-Corporation. From review of the tax returns, annual income averages approximately $250,000 allocated to each brother. However, each brother receives approximately $125,000 each year in distributions. Each brother also received a below market wage of $25,000. The brothers agreed to limit the amount of wages and distributions in order to invest into the company and grow a chain of restaurants. For child support purposes, it may be more reasonable to use actual wages and distributions rather than net income in this case. The Court may determine that there is a legitimate reason for keeping the earnings in the business and not include it as income for child support. (However, Max’s wife may petition for an increase in child support in later years, when the business has grown and Max has increased cash flow.)
These two cases illustrate that every income determination case has unique aspects. When a parent has an ownership interest in a closely held business, one of the important factors to consider is the degree of control that parent has over the operations and can influence the income available for child support.Posted on October 15 2013 by admin
A real estate appraisal is an opinion of market value formed by a professional appraiser. The process involves specific market area research, analysis of significant information relevant to the property, specialized expertise and impartial judgment regarding the value of the property.
To begin your search, ask for referrals from an accountant, attorney, real estate agent or lender. These professionals commonly use appraisal services and can likely refer you to competent appraisers. It is recommended that you interview two or three appraisers.
When choosing an appraiser, the following types of questions are appropriate:
- Are you licensed or certified by the State of Arizona and what type of license do you carry?
Ask for a copy of the license/certification, which will be willingly provided by an ethical appraiser. There are three types of licenses in Arizona; Standard, Certified Residential and Certified General. Contact the Arizona Board of Appraisal to confirm that the appraiser’s license/certification is active and in good standing. State licensing and/or certification does not ensure the quality of an appraisal, but it is verification that certain standards have been met and authorization to perform property appraisals has been granted.
- What professional designations do you have?
In addition to a state license and/or certification, an ambitious appraiser will carry a professional designation from an appraisal organization. The Appraisal Institute, regarded as the worldwide leader in appraisal education, grants two of the most prestigious member designations:
- The SRA membership designation is held by appraisers who are experienced in the analysis and valuation of residential real property
- The MAI membership designation is held by appraisers experienced in the analysis and valuation of all types of properties and are also capable of providing advice to clients regarding real estate investment decisions
- What level of experience do you have in this specific market and with this type of property?
Ask the candidate to provide a resume and a list of two or three current and previous clients located in the community of the property you want appraised. After reviewing the resume, interview the appraiser carefully to determine the level of experience she has in your market area and with your specific type of property and its use.
- Are you familiar with the properties in this community?
Determine the appraiser’s knowledge of the specific community by asking questions regarding rezoning, redevelopment, schools, parks, shopping centers, property types, recent residential or commercial sales and prices. Verify the information provided by contacting the City Planning department and/or or the County Assessor’s office.
- What is the appraisal fee and timeframe for delivery of the report?
Appraisers usually quote a fixed fee for the engagement and payment is typically 50 percent in advance as a retainer and the remaining 50 percent due upon delivery of the report. Request a letter of engagement which sets forth the scope of services to be performed including an accurate description of the property, the effective date of valuation, the purpose of the appraisal, the anticipated delivery date, the fee and terms of payment. Review the engagement letter carefully to ensure that all of the information is correct, complete and applicable before signing.
In this unpredictable market, the experience and competence of the appraiser is especially important. There are many well-qualified professional appraisers in the Phoenix area and taking the time to interview two or three of them will allow you to determine which one is the right appraiser for you.
Cherie L. Veatch, Valuation AnalystPosted on October 8 2013 by admin
Damages in commercial litigation are generally determined based on a lost profits calculation or as a reduction in value of the business. Where the damage is temporary, it is usually more appropriate to determine the lost profits from the date the damage was caused to the date the business recovered from the actions of the party that caused the damage. Where the business has been immediately destroyed, the appropriate measure of damages is the value of the business prior to destruction. However, there may be elements of both measures of damages in cases where there has been both a temporary setback and a permanent reduction in value of the business.
Assume the actions of a third party (XYZ) causes a temporary reduction of profits of a business (ABCO), over some time period, from pre-damage levels to an amount insufficient to support the ABCO, forcing it to fail. The damages include the lost profits from the date of XYZ’s actions to the date ABCO failed. The damages also may include the value of the business but for the actions of XYZ at the date ABCO failed. Similarly, had ABCO not failed but its value was permanently impaired (i.e., there is a permanent reduction of profits), damages may include the loss in business value but for the actions of XYZ.
Lost profits and business valuations are complex topics and the above comments do not deal with the many issues that arise in these types of calculations. In all of these determinations it is necessary to satisfy the legal principles of reasonable certainty and proximate cause. Damage periods, other causes for potential lost profits, tax affects, discount rates, and many other issues must be considered. In addition, it is incumbent on the damaged party to attempt to mitigate any resulting damages. Use of a qualified professional is recommended.Posted on October 1 2013 by admin
Have you ever had your business appraised, read a business appraisal, or heard a business appraiser speak and become confused when the terms discount rate, capitalization rate, and multiple are all used in explaining the value of a Company? What exactly is the difference?
Let’s take for example a Company that has stable cash flows that are expected to continue at a consistent growth rate into the future. Under the income approach we would apply what is called the “Capitalization of Cash Flows” method. The first step with this method is to determine the appropriate discount rate for the Company. The discount rate is considered a market rate. It is the rate of return necessary to induce investors to commit available funds to the subject investment, given its level of risk.(1) One common method to determine the discount rate, or rate of return that investors require, is the build-up method. This incorporates the following components:
1) Risk Free Rate - the rate of return available on a risk free security (i.e. 20-yr Treasury Bond yield)
2) Equity Risk Premium – the rate of return to reflect the additional risk of investing in the stock market over the risk free security (i.e. S&P 500 stocks)
3) Size Premium – the reward for investing in smaller companies
4) Specific company risk premium – the reward for investing in a specific company and industry
The sum of each component equals the discount rate. The higher the discount rate the riskier the investment. Let’s assume in our example that the discount rate for the Company is calculated as follows:
1) Risk Free Rate – 2.54%
2) Equity Risk Premium – 6.70%
3) Size Premium – 6.03%
4) Specific company risk premium – 9.00%
Discount Rate (or Rate of Return) 24.27%
The discount rate is indicating that an investor would require a rate of return of 24.27% to invest in the Company. The next step is to calculate the capitalization rate. The capitalization rate is the discount rate less the long term expected growth rate. This percentage is used to convert anticipated economic benefits of a single period into value. If the expected long term growth rate is 4%, the capitalization rate (rounded) is 20%. If the Company has stabilized annual cash flows of $1,000,000 the estimated value of the Company prior to discounts is $5,000,000 ($1,000,000/.20).
Many people are more familiar and comfortable with using multiples when discussing the value of a Company. A multiple is simply the inverse of the capitalization rate. In this example, the multiple of cash flows is 5 (1/.20). Using the multiple of 5, you arrive at the same value prior to discounts of $5,000,000 ($1,000,000 x 5).
Hopefully this simple example provides some clarity when dealing with discount rates, capitalization rates, and multiples in a business valuation context.
(1) Valuing a Business, Shannon P. Pratt et al, 5th Edition 2008.Posted on September 24 2013 by admin
More often than not, when a small business owner looks at the value of their business determined by a business appraiser, they are in total shock at the concluded value. Sometimes they are pleasantly surprised by a value higher than expected. Other times they insist their company is worth much more than the appraiser has determined. Illusions of grandeur sometimes are at work here. There is just no way their life’s work is worth any less than $10 billion!!! I exaggerate for effect of course but some small business owners don’t really have a grasp on reality when it comes to the value of their business.
Other owners may have a better grasp on reality but still expect the value be higher. After all, they have had a steady income for years. What these owners have not considered are the risks associated with their business that a buyer would consider. Specific Company Risks are attributes or factors associated with a specific company. All else being equal, a company with more negative (or riskier) specific company attributes will be worth less than a company with fewer risks.
In my article “Why Isn’t My Company Worth More? Factors That Affect Value” (found here) I discuss some of the specific company risks that we see and consider when valuing small businesses. Some factors can be mitigated if the owner(s) take the time to develop business and succession plans which address these risk factors.Older Entries »
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- Curious About the Real Estate Appraisal Process?
- Is Your Spouse Hiding Assets? A Review of Tax Returns May Uncover Some Red Flags
- The Fraud Triangle – 40 Years Later
- Testifying Awareness – Why CPA Experts Should Be Careful of What They Write
- How Do You Value an Undivided Interest in Real Property? Part I