Chapter 10Property Taxes

Property Taxes

Solely implemented by State and local govt.Accounts for about $240 billion annuallyLess than either local income or sales taxGenerally unpopular, but they tend to

produce stable revenue for government units closest to the electorate

US has a heavier reliance on property taxes than do most industrialized democracies

Historically, property taxes form the basis for most of local govt. revenue

Today, states gain only about 2% of revenue from property taxes, while local govt. about 75%

School districts rely on property taxes for about 96% of revenue

Property tax as wealth tax

Applies to cumulated wealth not income, so less effect on work and investment incentives

However, since they are not based on economic transactions (cannot use a market price to estimate value as with sales tax) they rely on value assessment

Two main types of property

1. Real Property – Real estate and any rights that accompany it. Land and all attributes of that land that may affect its value (soil quality, crops, plants). Improvements to the land (buildings, dams, roads, etc.). And any other rights associated with the land (air, water, mineral rights).

2. Personal property a). Tangible property – machinery, jewelry,

autos, inventory, etc. b). Intangible property – stocks, bonds, financial

assets, patents.

Some states rely heavily on personal property taxes, while other only tax real property

Most taxes are set by legislation and require a change in law to alter the rate

Property taxes are often set as part of the annual budget process

Rates are adopted at a level sufficient to yield enough revenue to balance the operating budget financing costs (debt)

Formula for setting tax rates

Property tax rate (r)

r = (E – NPR)/NAVTotal approved expenditure (E)Estimate of revenue from non-property tax

sources (NPR)Property tax levy – amount govt. plans to

collect (E – NPR)Net assessed value (NAV) – value of

assets (as assessed)

Example:Suppose a town estimates that it needs

$95,000 for the fiscal year (E=95,000)It estimates it will receive $15,000 from

non-property tax sources (NPR=15,000)Assessed value of all property in the town

is $1.75 million (NAV =1,750,000)Property tax rate is then

r = (E – NPR)/NAV r = (95,000 – 15,000) /

1,750,000r = 0.0457 or 4.57%

A land parcel would then be taxes $4.58 for every $100 of assessed value

If total assessed value was $8,000; total tax bill would be $366.40

Typically different jurisdictions have different rates, so while a county rate might be 4.58%, there would also be a state and maybe city rate

Typically only one payment is made (at county level)

Assessed value and effective tax rate

If City A has a tax rate of 10% and City B has a rate of 15%, is a property worth $100,000 taxed at 50% more in City B?

Not necessarily.The legal rate (incidence) is higher, but it

says nothing about the assessed value of the property

To compare two tax rates, need to adjust the legal tax rate for different assessed values

Assessed value

Market value is the price at which a property would be exchanged between a willing seller and willing buyer

“Assessment” is the assigned value of a property, by a professional property assessor

May follow a legally-specified standard or may even be determined by the skills of the assessor

Effective property tax rate

Effective tax rate (ETR) = T / MV

T = property tax

MV = Market value of the property

Property tax rate (T) = r * AVr = legal tax rate

AV = assess property value

So, ETR = r * (AV / MV)

Where AV/MV is the assessment ratio

Assume that City A assesses property values at 100% of market value and City B only assesses its property at 50% of market value.

City A assesses at 10% and City B at 15% But the assessment ratios are: City A = 100% and

City B 50%, so

City A ETR = r * (AV / MV) = .10 (1) = 0.10 City B ETR = .15 (.50) = 0.075

The effective tax rate is higher in City A = 10%

than City B = 7.5%

Doing Property Assessments

Purpose of any property assessment is to match the tax value of a property with the capacity to pay, in other words, to estimate the value of a property as a source of wealth

Choosing the standard to use

Market value is the best (or most common) standard

Assumes a competitive, open market: 1. Adequate time to function and reach an

equilibrium between demand and supply 2. No pressure is exerted by buyer or seller

(exchange is voluntary) 3. Both buyer and seller have adequate

information about the value of the property 4. There are not too many intermediaries that

provide information or other market information

Exceptions for using market price as the standard of value

Agricultural properties – the potential for a different use (housing development or commercial use) may increase the real value of a property against its current assessed value

Important when there is a changing land market, such as urban expansion

Assessed values attempt to protect the current user from higher tax rates until a property is actually exchanged and to prevent land markets from being distorted by property tax policies

Most assessment systems use something that is based on market value

Some states use market value directly, others try to approximate it

California, Michigan, Florida uses acquisition value or assessment-on-sale system

Properties are re-valued for taxation only when sold and at the new transaction price

State argument for assessment-on-sale

1. Avoids taxing owners on unrealized gains in value and possibly taxing people out of their homes

2. Assures predictable tax payments over time for the property owner

3. Assures revenue stability for local governments

Assessment Cycles

Refers to how and how often value of a parcel is assessed

Three types within the US

1. Mass cyclical assessment 2. Segmental assessment 3. Annual assessment

Mass cyclical assessment

All properties are assessed for tax purposes in a particular year and value does not change unless significant change to the assets on a parcel (demolition of buildings, construction, etc.)

Can be anywhere from 2 to 10 yearsMay include a physical inspection of a

property

Segmental assessment

Partial amount of all properties in a jurisdiction is re-assessed, moving across all properties in sequence

Ex: 1/3rd year 1, 1/3rd year 2, 1/3rd year 3

Typically annual assessment

Some inequity since inflation occurs between years and land values may change, but method is retained to minimize administrative costs of assessment

Annual assessment

Updates values for all parcels each year

Since an annual physical inspection is usually not possible, computer models are typically used

Conducting assessments

Three general approaches to conducting assessments. All are related to private appraisal techniques used in real estate.

1. Market-data 2. Income approach 3. Cost approach

1. Market-data

Uses data on comparable sales by examining the selling price of properties with similar characteristics

Requires actual transaction and does not work for unique properties (specific residential properties, commercial or industrial)

2. Income approach

Converts future returns from ownership to present-value equivalent

Uses idea that property is equal to the value of the stream of benefits it provides in the future

Requires knowing returns from holding the parcel, expenses, rate of interest.

Most useful for evaluating value of revenue producing properties such as apartments, commercial areas, retail, agricultural, etc.

3. Cost approach

Cost method – adds the depreciated cost of improvements to a parcel to the estimated basic land value

Estimates the value of a standard unit (ex: house with two bedrooms) and adds the additional value of extra features based on the cost of that improvement

Two methods of Cost Approach

Reproduction costs – how much it would cost to rebuild an exact replicate of the improvement

Replacement cost – the costs of having a building with the exact same characteristics (using current standards but having the same utility)

Selecting which approach to use

Each approach has different applicationsIncome approach useful for income-

producing propertiesCost approach is generally useful, but

especially for unique properties that are seldom exchanged on the market and have characteristics difficult to compare

Market data approach useful whenever there is sufficient number of transactions, such as private residential homes

Property Tax Relief Mechanisms

Just as there is tax relief provided to individuals for income spent on activities deemed socially desirable (charitable deductions) or necessary (job training) there are similar types of tax forgiveness programs direct to relief the tax burden of specific individuals or activities

Individually specified, Type of property or Use of property

Reasons to forgive property tax burdens

1. Specific characteristics of the owner – exemption is granted on conditions of ownership.

Examples:Government property not used for commercial

purposesProperty held by religious, educational, charitable

or nonprofit entitiesResidential properties through homestead,

veteran’s, mortgage or old-age exemption

Problems with individually-specified exemptions (veteran, old-age, etc.)

1. Programs are administered at the State level, but revenue consequences are local

Ex: while a program may be popular at State level, can impact local govts. Severely (ex: School districts and CA prop 13).

2. No way to focus program on needy since not means-tested

Problems with individually-specified exemptions (veteran, old-age, etc.)

3. If too wide-spread it may force tax burden on other properties

4. Can only reach homeowners and not renters (lower income). Limits overall impact.

2. Characteristics of the property

Commercial and industrial properties May include tax breaks to attract

investment Or for rehabilitation (urban depressed

areas, brownfields, etc.)

3. Use of the property

- tax breaks intended to induce favorable activities

- economic development- pollution control facilities- natural areas

Property Tax Instruments

Methods to equalize tax burden among property owners Circuit-Breakers Deferrals Classification

Methods to induce economic development Tax Increment Financing

Circuit-Breakers

Because property taxes cannot target low income households, system of “circuit-breakers” is used

Focuses relief of property tax by ratio of income to property tax

Integrates both state’s individual income tax and property tax structure

State then returns some portion of excess payment as a refund

Serves to reduce the tax burden, but at State govts. expense

Deferrals

Additional form of tax relief applicable to elderly, disabled, low income, and farmers on edge of developing areas

Individuals whose property values have risen dramatically are permitted to pay tax based on old value

Difference is deferred, not forgiven With agricultural land it is paid when the land is

converted into development (higher-valued use) With elderly, the claim is charged against the estate

after death

Classification

Different tax rates applied to different types of properties

Assumes some properties represent better ability to bear tax burden than others

Can be accomplished via assessment ratio that devalues the effective rate

Ex: Owner-occupied housing vs. seasonal housing

Tax Increment Financing (TIF)

Reducing the tax burden to attract investment, simply shifts the burden elsewhere and is not always efficient

(if development is large enough, it may increase the overall revenues to pay for the lost revenue source, if not, then both a revenue and economic loss)

TIF Offers an alternative to inducing development Usually used in economically depressed areas TIF program freezes the assessed value of all

properties in an designated area (development district)

Those tax rates go to overall public services same as any property tax

Any tax above the frozen value only goes toward new infrastructure within the development district

Becomes a geographically-designated tax and expenditure tool

Popular with industry and development officials, but not with other public service agencies

Argued that they serve as a means to bypass paying for broad public goods

Also that it allows industries to re-coup costs not directly related to infrastructure (tax “kickback”)

Limits and Controls

Established tax rates set the basic taxation level

There may be other limits beyond rates establish a special tax structure

Four primary types:

1. Statutory property-tax rate limits

2. Property-tax rate freeze

3. Levy limits

4. Local expenditure lid

Through late 1970’s early 1980’s there were a series of “property tax revolts” due to rising property values and increasing demand for public services

Led to a number of public referendums creating mechanisms limiting tax rate increases

Often these targeting the rate property is taxed at (Statutory property-tax rate limits, Property-tax rate freeze)

Others limit the total dollars that property can be assessed at, rather than the rate (Levy limits, Expenditure limits)

Response of government to limits

Since demand for services still exists, local governments have been forced to look elsewhere for funds

1. Burden other government entities or non-governmental organizations with additional services

2. Increased use of intergovernmental revenues3. Use more charge for service instruments and

search from revenues outside jurisdiction. 4. Hide property taxes with new fee services (ex: fire

or police protection charge based on property value)