As defined by the IRS, "fair market value (FMV) is the price for which you could sell your property to a willing buyer when neither of you has to sell or buy and both of you know all the relevant facts." In other words, the value is determined when neither buyer nor seller is under pressure to act, and when both are fully informed about the property and circumstances of sale.
Need for Valuation
Taxation depends on business transactions. Profit or loss depends on the sale price. A buyer and a seller must agree on a price, before a sale occurs and profit is calculated. Taxpayers cannot whimsically overvalue deductions or undervalue income to evade tax. An actual sale fixes the market value for a particular transaction.
Valuation Must Be "Fair"
Taxation sometimes requires valuing an asset or property, when no actual sale occurs. Some method of estimating the market value is necessary. The estimate must be "fair" to all and as close as possible to actual market value. That value is called fair market value.
Suppose two people trade services, but no cash is paid. They barter. How does each report that transaction for tax purposes? An accountant has a leaky sink and a plumber needs a tax return prepared. They agree to fix the leaky sink and to prepare the tax return. How much should each report for tax purposes as the sale price for the service rendered to the other? If each paid the other in cash, that answer is obvious. However, the two agreed no cash would be exchanged. The accountant and the plumber must make an accurate estimate of the fair market value of the service provided for tax purposes.
What is "Fair"?
For the plumber and accountant in that particular set of circumstances, both agreed their delivered service to the other had the same market value. Suppose the plumber needed a haircut and he went to his barber. Like the accountant, the barber had a leaky sink. The plumber and the barber agreed, just as did the plumber and the accountant, to trade services without exchanging cash. Would the accountant agree to prepare the barber's tax return in exchange for a haircut? That depends. Does the accountant look like Kojak (bald) or Rapunzel (long hair from castle turret to ground)?
Taxation Applications for Fair Market Value
FMV has a number of taxation applications, such as with the division of assets in a divorce. Homes and heirlooms get appraised by experts for estate and death taxes, and a buyer needs a realistic value before offering to purchase a business. FMV is also important when valuing casualty losses.
The IRS provides a definition of FMV, but the IRS cannot provide a measuring stick. Fair market value is set by a willing buyer and a willing seller, when neither is hiding relevant information from the other, and neither is being unduly forced to buy or sell.