Note Valuation

A promissory note that provides for a fixed rate of interest and regularly scheduled payments of interest and principal must often be valued for the purpose of the federal estate tax, federal gift tax, state death taxes, distribution from an estate or trust, or other transactions.

Typically, a note is valued by comparing the rate of interest payable on the note to a "market" rate of interest, and the determination of a market rate of interest usually includes two considerations:

• The time value of money, without regard to any risk of the borrower's ability to pay. The securities of the federal government are considered to be the safest investments in the world, and so the yield on federal securities is the rate that would ordinarily apply without considering any risk factor. The yield on federal securities is codified in the Internal Revenue Code as the "applicable federal rate," and those rates are one possible measure for valuing a promissory note.
• The risk of repayment, which is dependent on the credit wothiness of the borrower and the borrower's ability to pay. Bonds of municipalities and corporations are frequently rated for the borrower's ability to pay, and lower credit ratings require higher interest yields in order to balance the reward with the risk. For individual borrowers, the risks include the risk of death and the possibility that the assets of the decedent's estate may be insufficient to repay all debts.

Once a market rate of interest has been determined, the payments on the note can be discounted by that market rate of interest and the fair market value of the note can be determined.

If the rate of interest payable on the note is less than the market rate, then the value of the note will be less than the principal balance of the note, and the difference in values will be a discount. If the rate of interest payable on the note is more than the market rate, then the value of the note will be more than the principal balance of the note, and the difference will be a premium.

A complete explanation of the possible tax consequences of valuing a note with a premium or discount is beyond the scope of this overview, but if a note is transferred on death and as a result has a tax basis equal to its value at death, payments of principal on the note may result in gain or loss if the note is valued at a premium or a discount.