The Role of Property Tax in American Government (Part 3)

By Todd D. Jones, MAI, CRE, FRICS and Michael J. Mard, CPA/ABV, CPCU

Note to reader: This article is third in a series of columns addressing The Role of Property Tax in American Government culminating in the generally accepted methodology of the real estate appraisal, business valuation and accounting industries reconciled and properly applied to a property tax case study. The series of columns will address trends in government, statutory limitations available to tax payers, industry standards applicable and a sample case study.

Structural Flaws in Local Government

Public Trust, Fairness, & Independence

Public trust is the foundation of our society. The concept is at the root of democracy and self-governance. Fairness is the state, condition, or quality of being free from bias or injustice. Equitable treatment flows from the principle of fairness.

Auditors, appraisers, judges, investment ratings agencies, and stock analysts value to society hinges on independence, objectivity, and fairness. These professionals are the guardians of the economy, and society at large. The unbiased and objective independence of their opinions is key to the economy’s health, even to its survival. Protecting and balancing that independence is complicated. Too much independence gives rise to various forms of tyranny. Too little independence undermines credibility and public trust, which leads to anarchy.

The Founding Fathers balanced the competing interests of the executive and legislative branches by creating the judicial branch of the federal government. Balancing competing interests equitably is at the core of what auditors, appraisers, judges, ratings agencies, and stock analysts do. An independent opinion of value is required under a wide range of circumstances. Courts, businesses, regulators, shareholders, and taxing authorities all need an objective expert to provide an independent opinion of value of property.
Although in different ways, each of these professionals gathers, arrays, filters, and analyzes data, makes compensating adjustments, and renders a conclusion. In a civilized society, the rule of law resolves disagreements. In a civilized economy, referees (i.e. auditors, appraisers, judges, investment ratings agencies, and stock analysts) are paid to “keep it fair.”

Separation and Balance of Power

The Founding Fathers wisely created three branches of government for a reason, but most state and local governments have not followed suit with regard to the adjudication of property tax matters. The International Association of Assessing Officers (IAAO) is a founding member of The Appraisal Foundation and exerts great influence within the policy setting organization that oversees nationwide appraiser regulation. Local tax assessors are part of local government and politically organize internationally via their professional organizations, the IPTI and the IAAO. Thus, in every state in which the local taxing authorities control, or influence, the administrative assessment challenge forum, the proverbial deck is stacked against taxpayers. Instead, state legislatures should strive to ensure that one of the parties to the dispute does not control the administrative dispute forum.

Taxable Property

Exactly what is taxable, when and by which particular taxing authority also varies considerably from state to state. Determining taxability requires understanding certain property tax fundamentals. A starting point is recognizing that property tax professionals generally categorize taxable property as either real or personal.

Real Property

Real property is “[t]he interests, benefits, and rights inherent in the ownership of real estate.”[2] Alternatively, “[a]ll the rights, interests, and benefits related to the ownership of real estate. Real property is a legal concept distinct from real estate, which is a physical asset. There may also be potential limitations upon ownership rights to real property.”[3]  Blacks Law Dictionary states “[r]eal estate is defined as land and anything permanently affixed to the land, such as buildings, fences, and those things attached to the buildings, such as light fixtures and plumbing and heating fixtures. Ordinarily, synonymous with real estate is realty, or land. Land includes soil and things permanent in nature affixed thereto by nature (water, grass, trees, crops, minerals) or by man (buildings, fences, bridges, canals, dams).” Real estate represents the vast majority of taxable property available to local governments. Privately owned real estate is generally subject to taxation.

Personal Property

Personal property is everything else. It is defined as:

“In a broad and general sense, everything that is the subject of ownership, not coming under the denomination of real property.”[4]

Personal property is segregated into two categories: tangible and intangible.

TANGIBLE PERSONAL PROPERTY is “[i]dentifiable tangible objects that are considered by the general public as being “personal” – for example, furnishings, artwork, antiques, gems and jewelry, collectibles, machinery and equipment; all tangible property that is not classified as real estate.”[5] Tangible personal property “[c]onsists of every kind of property that is not real property; movable without damage to itself or the real estate; subdivided into tangible and intangible. Also called personalty.”[6]

INTANGIBLE PROPERTY are “[n]onphysical assets, including but not limited to franchises, trademarks, patents, copyrights, goodwill, equities, securities, and contracts as distinguished from physical assets such as facilities and equipment.”[7] Or “The rights and privileges granted to the owner of intangible assets.”[8]

Consistent with those definitions, the Financial Accounting Standards Board (FASB) defines Intangible Assets as “assets (not including financial assets) that lack physical substance.”[9]

All real and personal property is subject to classification, exemption, equalization, and uniformity in the administration of property taxation. In most jurisdictions, tangible business personal property is taxable. Tangible household personal property (e.g., home furnishings and personal possessions) and intangible personal property (e.g., contracts, goodwill, and patents) are generally not taxed.

Classification

By law, assessors must classify property within their jurisdictions. Classification of property is the dividing of a particular category into a number of smaller groups, or classes, having common characteristics. Classification is frequently based solely on the use of the property. Most state classification systems exist pursuant to statutory law and are implemented administratively as a de jure system. For example, vacant land is frequently classified as: agricultural, residential, commercial, industrial, open storage, parks, public, municipal, county, state, or federal use. In sophisticated jurisdictions, each of these may have subcategories. The US Supreme Court has upheld the practice of property classification, so long as there is some rational basis for it. [10]

Exemption

By law, assessors must exempt certain property within their jurisdictions from taxation. The US Constitution specifically exempts religious, charitable, and educational entities from taxation; thus, any property they might own is likewise exempt. In addition, the “supremacy clause” and sovereign immunity exempt property owned by federal, state, and municipal governments (including public schools). Also, property owned by foreign governments (i.e. embassies, etc.), property inside US Foreign Trade Zones, and US Customs Department bonded warehouses is exempt from property taxation.

Most states have enacted even more exemptions to foster economic development, or to assist the disadvantaged. Most state and local governments extend preferential treatment such as tax incentives, or manufacturing and pollution control exemptions in the pursuit of economic development. Of course, the property of religious, charitable, educational, and non-profit organizations is exempted, but also residential properties (especially for veterans and senior citizens) are, or may be, wholly or partially exempt from property taxation. Altogether, exempt property may constitute as much as one third of all otherwise taxable property in the US.

Uniformity

By law, assessors must value similar property within their jurisdictions in a similar fashion. Taxpayers’ enjoy a constitutional right to be free from discrimination in the assessment of their property by virtue of the equal protection clause of the 14th Amendment of the United States Constitution. The U.S. Supreme Court ruled on this issue in the 1923 Sioux City Bridge case,[11] and again in the 1946 Hillsborough v. Cromwell case. In 1946, the United States Supreme Court explained “[t]he equal protection clause of the Fourteenth Amendment protects the individual from state action which selects him out for discriminatory treatment by subjecting him to taxes not imposed on others of the same class. The right is the right to equal treatment.”[12]

Equalization

The concept of equalization is pervasive in property tax administration. Simply put, some states assess property at 100% of market value. In other words, the assessments are levied at market value. Other states apply an “equalization rate” (ratio or percentage) to the market value estimate, assessing at a percentage of market value. An equalization rate is simply the percentage of market value at which the property is assessed. In most jurisdictions, legislative bodies determine the assessment ratios, while local governments set the tax rates. In the end, equalization is a tax shifting policy but results in some obfuscation of the basis for individual assessments.

The Current Political Dilemma

State legislatures have explored various ways to ease the burden of property taxation. Two, in particular, have garnered significant attention recently: assessment caps and circuit breakers.

Assessment Caps

In a 1998 paper entitled “The Continuing Redistribution of Fiscal Stress: The Long Run Consequences of Proposition 13,” prepared for the Lincoln Institute of Land Policy, Professor Jeffrey Chapman of Arizona State University demonstrated that local governments’ fiscal autonomy is critical to ensure a vital local economy and that assessment limitations undermine that autonomy.

In 2006, Standard & Poor’s published two Public Finance reports on the potential credit rating implications for state and local government stemming from a similar property tax reform proposal in Texas. Some of the concerns expressed in the reports include:

  • Appraisal caps have the potential to negatively affect credit quality by impacting an issuer’s ability to support their debt…
  • We believe that tax caps will have an impact on the ability of state and local governments to finance capital programs and infrastructure needs and meet their day-to-day operations. Regarding capital improvement plans, municipalities could become more reactive rather than proactive in planning infrastructure and facility needs based on funding availability.

One of the main strengths of having a higher property appraisal cap is that there is a direct correlation between economic growth and a government’s ability to benefit from that growth through taxation. Tax abatement is one of the main incentives that municipalities can offer companies in the region. If appraisal caps are put in place, municipalities won’t be able to offer special incentives to keep existing businesses or attract new businesses to the region, as they will be constrained by their revenue sources. Local governments have a limited ability to cut operating expenditures since they must provide basic services and infrastructure. If local governments want to meet their infrastructure and basic operational needs, their ability to reap the benefits of economic growth through taxation is perhaps the most important tool in their arsenal. S&P credit analyst Ms. Smaardyk said:

Over the long term, limiting this ability could result in budgetary pressures and the accumulation of unmet infrastructure needs. Unless alternative revenue sources are put in place to counter the effect of property appraisal caps, the potential for a significant budgetary mismatch remains.

Again, it is our belief that the implementation of a cap on the growth of property appraisals without a more comprehensive tax reform that addresses all sides of the budget equation could lead to fiscal stress and budgetary pressures that might potentially harm credit quality.

As with other fiscal challenges, the effect on credit quality will be evaluated on a case-by-case basis. The big question is whether or not local governments will be able to rise to the occasion and successfully address the budgetary challenges facing them.

The 1992 Save Our Homes amendment to the Florida Constitution was intended to prevent local governments from taxing people out of their homes by limiting annual assessment increases to three-percent or CPI, whichever is lower: a noble public policy that accomplished its goal. In hindsight, however, most Floridians acknowledge that the Save Our Homes amendment resulted in sometimes dramatically disproportionate tax burdens among homeowners during the recent real estate boom. In 2008, Florida voters expanded the policy to include non-homestead properties because business interests convinced the Tax and Budget Reform Commission that they carried a disproportionate share of the overall property tax burden, as a result of the diminished residential share brought about by Save Our Homes. Constitutional Amendment 1 set an annual ten-percent assessment increase limit for non-homestead property.

Also in 2008, the Lincoln Institute of Land Policy released a report entitled Property Tax Assessment Limits: Lessons from Thirty Years of Experience. Authors Haveman and Sexton provide numerous examples of legislative actions and the resulting outcomes of property tax reform efforts nationwide. Their research demonstrates that setting limits on assessed values is a deeply flawed approach to offsetting rising property taxes. While assessment caps are proffered as a straightforward strategy for reducing tax bills and slowing the shift in tax burdens to residential property, they often result in higher taxes for the homeowners they are intended to assist, and they can cause unpredictable and unanticipated shifts in tax liabilities. As we already know from Florida’s experience with Save Our Homes, by detaching the connection between property values and property taxes, assessment limits impose disproportionate tax obligations on the owners of otherwise identical properties, reduce economic growth by distorting taxpayer decision making, and greatly reduce the transparency and accountability of the property tax system as a whole, which contributes to the public’s continued ire.

From a practical standpoint, studying

California’s economy provides a view of a state’s potential future if assessment caps are implemented and maintained. The enactment of Proposition 13 in 1978 has forced California’s state and local governments to enact and rely on some of the nation’s highest sales and personal income tax rates to fund local government operations. Sales and income taxes actually exacerbate the situation because they fluctuate in sync with the economic climate; in boom times, they generate large revenue surpluses, and, in recessionary periods, they dry up and huge deficits are experienced. What the proponents of enacted assessment caps failed to foresee was that, once homeowners accumulated a substantial portion of sheltered equity in their homesteads, they would become disinclined to sell. In economic science, this has come to be known as the “lock-in” effect. The lock-in effect was compounded during the boom by a dramatic escalation in residential property values. Many homeowners found that they could not afford to relocate, even to a smaller home, because the unsheltered property tax burden on potential new purchases was simply too great; it made the move unaffordable.

Understanding the lock-in effect on homestead property owners, it is not difficult to comprehend that prudent owners and operators of income producing properties subject to such a cap will adopt a new investment strategy, similar to the one adopted by the beneficiaries of assessment caps… long-term hold. The longer an investor holds his property, the greater his competitive advantage. To wit, the following table illustrates the benefits of such a strategy. By year ten, a property originally worth $10M could enjoy a 34% tax shelter resulting in a $1.61 per square foot competitive leasing advantage. See Table 1 Year 10 row. Additional years are provided for the reader’s edification.

Assessment limitations create a significant inducement for property owners to invest for the long term, because they create a barrier to entry in an already extremely competitive marketplace. By way of example, imagine two identical office buildings erected adjacent to one another in the same year. Imagine also that they are fully tenanted at competitive lease terms with similar creditworthiness. Under these conditions, the taxable value should be the same for each. Now assume ten years has passed and one of the buildings is sold for its current market value. The new owner is faced with an imposing competitive disadvantage. To account for this in underwriting the purchase, a prudent analyst would

  1. decrease projected achievable rents by the amount of the competitive disadvantage on a per square foot basis,
  2. factor in a higher vacancy and collections loss in anticipation of tenant turnover resulting from the associated increase in pass-through expenses,
  3. increase the projected real estate tax liability expense as a result of the sale, and
  4. increase the discount rate to reflect the additional market risk.

All of this contributes to downward pressure on profit margins and therefore on the property’s value.

These facts lead us to the inescapable second step that any prudent investor will undertake: the implementation of net leases. In order to maximize the income-producing asset’s value, operators will pass-through all expenses that the market will bear. And while this is common practice in many markets, especially for office, retail, and industrial properties, multifamily apartment community operators would be inclined to convert traditionally gross leases to a net format. Like separately metered utilities, renters could become responsible for paying their pro rata share of the property taxes.

Preliminary comparative analyses based on Table 1 indicate that the impact on value will be considerable. Discounted cash flow models of gross rent properties (e.g. full service leases with no expense pass-through provisions, like apartments) evidence value declines of greater than eleven percent when underwritten in this manner. Otherwise comparable net leased property analyses reveal declines of over six percent of market value.

Such dramatic devaluation on ownership transfers also presents a threshold barrier to renovation and new construction and development activities. Significant renovation could subject a property to reassessment under current law. Any new product would be valued at its current market value in the year it came into service, yet it would have to compete for tenants against existing properties which could offer space at significantly lower rental rates. On the other hand, the five percent assessment cap could potentially solve an overbuilding problem, because no new development will occur until demand exceeds supply by an amount sufficient to offset the competitive disadvantage that the new properties will face.

Despite that income producing property owners actually write the checks, most economists would argue that the ultimate end user of the property actually pays the taxes. That means that the retail shopper and the clients of office or industrial tenants are the ones who pay the tax, because the costs are passed through to the ultimate end user. In the end, assessment limitations deliver:

  • lower tax revenues for local government,
  • lower municipal bond credit ratings,
  • local governments that are hamstrung in adapting to changing economic conditions,
  • greater reliance on other types of taxes,
  • an unnecessarily complicated system for taxpayers,
  • reduced real estate transaction activity,
  • fewer jobs and lower compensation for transaction facilitators, and
  • an impediment to a vibrant economy.

Circuit Breakers

Understanding that tax policy is, by definition, discriminatory, state legislators seeking to provide property tax relief to homeowner constituents have two categorical options: across-the-board tax cuts for taxpayers at all income levels (e.g. such as a homestead exemption or a tax cap), or targeted tax breaks given only to certain groups of low-income and middle-income taxpayers. “Circuit breaker” schemes are an increasingly popular type of targeted property tax relief program. “Circuit breaker” schemes protect taxpayers from property tax “overloads” similar to an electric circuit breaker: when a property tax bill exceeds a certain percentage of a taxpayer’s income, the circuit breaker reduces property taxes in excess of the “overload” amount.

The basic idea behind the “circuit breaker” approach to property tax relief is simple: when taxpayers earn below a certain set income level, they become entitled to tax relief when their property taxes exceed a certain percentage of their income. However, the 33 states and the District of Columbia, which have implemented the concept, have made very different choices about who should receive the credit, and how the credit should be calculated. Generally, there are a series of basic choices to make in designing a circuit breaker:

  • Who should be eligible?
  • What is the maximum income level for eligibility?
  • What percentage of income triggers eligibility?
  • Is the circuit breaker indexed for inflation?

Circuit Breaker Advantages

The circuit breaker is the only form of property tax relief that is explicitly designed to reduce the property tax load on those low-income taxpayers hit hardest by the tax. Circuit breakers offer several advantages over more general property tax relief measures:

  • Circuit breakers are targeted to selected income groups. As a result, they are much less expensive than “across the board” property tax breaks – and the benefits go to the taxpayers for whom property taxes are most burdensome.
  • The low-income taxpayers who typically benefit from circuit breakers do not itemize their federal income taxes, so this form of property tax relief is usually not offset by increases in federal income taxes. By contrast, property tax cuts for wealthier taxpayers will result in a federal income tax hike, since these cuts will reduce the amount of state tax that wealthy taxpayers can write off on their federal tax forms.

Circuit Breaker Disadvantages

The biggest drawback to circuit breakers is that, generally, they only are given to the taxpayers that apply for them. Typically, “homestead exemptions” are given automatically. Eligible taxpayers will only apply for circuit breaker credits if they are aware of their existence; thus, an advertising and education outreach is required.

Citations

  1. Note: The authors thank Joryn Jenkins, Esq. for her legal insights and contributions to this article.
  2. SPAP, 2012-2013 Edition.
  3. International Valuation Standards Glossary.
  4. Black’s Law Dictionary, 9th Edition.
  5. Appraisal Institute, The Dictionary of Real Estate Appraisal, 5th ed. (Chicago: Appraisal Institute, 2010).
  6. Ibid.
  7. Ibid.
  8. International Valuation Standards Glossary
  9. Financial Accounting Standards Board Master Glossary
  10. Nordlinger v. Hahn, 505 U.S. 1 (1992)
  11. Sioux City Bridge Co. v. Dakota County, 260 U.S. 441, 43 S. Ct. 190, 67 L. Ed. 340 (1923).
  12. Township of Hillsborough v. Cromwell, 326 U.S. 620, 623, 66 S. Ct. 53, 90 L. Ed. 358 (1946).

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